VMWARE, INC. - Quarter Report: 2015 June (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 June 30, 2015
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 July 29, 2015, the number of shares of common stock, par value $0.01 per share, of the registrant outstanding was 422,071,688 of which 122,071,688 shares were Class A common stock and 300,000,000 were Class B common stock.
TABLE OF CONTENTS
Page | ||
Item 1. | ||
Item 2. | ||
Item 3. | ||
Item 4. | ||
Item 1. | ||
Item 1A. | ||
Item 2. | ||
Item 3. | ||
Item 4. | ||
Item 5. | ||
Item 6. | ||
VMware, vSphere, vCloud, vCloud Suite, Horizon Suite, VMware NSX, Virtual SAN, vCloud Air, Horizon, vRealize, Immidio, Workspace Environment Management, and AirWatch 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 | Six Months Ended | ||||||||||||||
June 30, | June 30, | ||||||||||||||
2015 | 2014 | 2015 | 2014 | ||||||||||||
Revenues: | |||||||||||||||
License | $ | 638 | $ | 614 | $ | 1,214 | $ | 1,175 | |||||||
Services | 959 | 843 | 1,894 | 1,642 | |||||||||||
GSA settlement | (76 | ) | — | (76 | ) | — | |||||||||
Total revenues | 1,521 | 1,457 | 3,032 | 2,817 | |||||||||||
Operating expenses (1): | |||||||||||||||
Cost of license revenues | 46 | 46 | 96 | 96 | |||||||||||
Cost of services revenues | 204 | 172 | 397 | 323 | |||||||||||
Research and development | 322 | 317 | 627 | 610 | |||||||||||
Sales and marketing | 565 | 544 | 1,100 | 1,018 | |||||||||||
General and administrative | 180 | 179 | 367 | 330 | |||||||||||
Realignment charges | (2 | ) | (1 | ) | 21 | (1 | ) | ||||||||
Operating income | 206 | 200 | 424 | 441 | |||||||||||
Investment income | 13 | 9 | 25 | 18 | |||||||||||
Interest expense with EMC | (7 | ) | (7 | ) | (13 | ) | (12 | ) | |||||||
Other income, net | 1 | — | — | — | |||||||||||
Income before income taxes | 213 | 202 | 436 | 447 | |||||||||||
Income tax provision | 41 | 35 | 68 | 81 | |||||||||||
Net income | $ | 172 | $ | 167 | $ | 368 | $ | 366 | |||||||
Net income per weighted-average share, basic for Class A and Class B | $ | 0.41 | $ | 0.39 | $ | 0.86 | $ | 0.85 | |||||||
Net income per weighted-average share, diluted for Class A and Class B | $ | 0.40 | $ | 0.38 | $ | 0.86 | $ | 0.84 | |||||||
Weighted-average shares, basic for Class A and Class B | 424,169 | 430,216 | 426,055 | 430,050 | |||||||||||
Weighted-average shares, diluted for Class A and Class B | 426,797 | 434,199 | 428,772 | 434,218 | |||||||||||
__________ | |||||||||||||||
(1) Includes stock-based compensation as follows: | |||||||||||||||
Cost of license revenues | $ | — | $ | 1 | $ | 1 | $ | 2 | |||||||
Cost of services revenues | 10 | 11 | 22 | 20 | |||||||||||
Research and development | 53 | 66 | 107 | 126 | |||||||||||
Sales and marketing | 43 | 43 | 81 | 84 | |||||||||||
General and administrative | 17 | 18 | 31 | 35 |
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 | Six Months Ended | ||||||||||||||
June 30, | June 30, | ||||||||||||||
2015 | 2014 | 2015 | 2014 | ||||||||||||
Net income | $ | 172 | $ | 167 | $ | 368 | $ | 366 | |||||||
Other comprehensive income (loss): | |||||||||||||||
Changes in market value of available-for-sale securities: | |||||||||||||||
Unrealized gains (losses), net of taxes of $(4), $2, $0 and $2 | (5 | ) | 3 | 1 | 4 | ||||||||||
Changes in market value of effective foreign currency forward contracts: | |||||||||||||||
Unrealized gains (losses), net of taxes of $0 for all periods | 5 | — | (3 | ) | — | ||||||||||
Reclassification of (gains) realized during the period, net of taxes of $0 for all periods | (2 | ) | — | — | — | ||||||||||
Net change in market value of effective foreign currency forward contracts | 3 | — | (3 | ) | — | ||||||||||
Total other comprehensive income (loss) | (2 | ) | 3 | (2 | ) | 4 | |||||||||
Total comprehensive income, net of taxes | $ | 170 | $ | 170 | $ | 366 | $ | 370 |
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)
June 30, | December 31, | ||||||
2015 | 2014 | ||||||
ASSETS | |||||||
Current assets: | |||||||
Cash and cash equivalents | $ | 1,791 | $ | 2,071 | |||
Short-term investments | 5,205 | 5,004 | |||||
Accounts receivable, net of allowance for doubtful accounts of $2 and $2 | 1,214 | 1,520 | |||||
Due from related parties, net | — | 49 | |||||
Deferred tax assets | 240 | 248 | |||||
Other current assets | 262 | 238 | |||||
Total current assets | 8,712 | 9,130 | |||||
Property and equipment, net | 1,112 | 1,035 | |||||
Other assets | 171 | 174 | |||||
Deferred tax assets | 195 | 165 | |||||
Intangible assets, net | 682 | 748 | |||||
Goodwill | 3,981 | 3,964 | |||||
Total assets | $ | 14,853 | $ | 15,216 | |||
LIABILITIES AND STOCKHOLDERS’ EQUITY | |||||||
Current liabilities: | |||||||
Accounts payable | $ | 163 | $ | 203 | |||
Accrued expenses and other | 762 | 811 | |||||
Due to related parties, net | 8 | — | |||||
Unearned revenues | 3,022 | 2,982 | |||||
Total current liabilities | 3,955 | 3,996 | |||||
Notes payable to EMC | 1,500 | 1,500 | |||||
Unearned revenues | 1,791 | 1,851 | |||||
Other liabilities | 296 | 283 | |||||
Total liabilities | 7,542 | 7,630 | |||||
Contingencies (refer to Note I) | |||||||
Stockholders’ equity: | |||||||
Class A common stock, par value $.01; authorized 2,500,000 shares; issued and outstanding 122,920 and 129,359 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 | 2,737 | 3,380 | |||||
Accumulated other comprehensive loss | (3 | ) | (1 | ) | |||
Retained earnings | 4,566 | 4,198 | |||||
Total VMware, Inc.’s stockholders’ equity | 7,304 | 7,581 | |||||
Non-controlling interests | 7 | 5 | |||||
Total stockholders’ equity | 7,311 | 7,586 | |||||
Total liabilities and stockholders’ equity | $ | 14,853 | $ | 15,216 |
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)
Six Months Ended | |||||||
June 30, | |||||||
2015 | 2014 | ||||||
Operating activities: | |||||||
Net income | $ | 368 | $ | 366 | |||
Adjustments to reconcile net income to net cash provided by operating activities: | |||||||
Depreciation and amortization | 159 | 164 | |||||
Stock-based compensation | 242 | 267 | |||||
Excess tax benefits from stock-based compensation | (26 | ) | (26 | ) | |||
Deferred income taxes, net | (22 | ) | (79 | ) | |||
Other | (1 | ) | 2 | ||||
Changes in assets and liabilities, net of acquisitions: | |||||||
Accounts receivable | 305 | 130 | |||||
Other assets | (13 | ) | (43 | ) | |||
Due to/from related parties, net | 63 | (33 | ) | ||||
Accounts payable | (33 | ) | (8 | ) | |||
Accrued expenses | 27 | 56 | |||||
Income taxes payable | (49 | ) | 112 | ||||
Unearned revenues | (21 | ) | 251 | ||||
Net cash provided by operating activities | 999 | 1,159 | |||||
Investing activities: | |||||||
Additions to property and equipment | (184 | ) | (153 | ) | |||
Purchases of available-for-sale securities | (2,095 | ) | (1,976 | ) | |||
Sales of available-for-sale securities | 1,373 | 941 | |||||
Maturities of available-for-sale securities | 524 | 322 | |||||
Purchases of strategic investments | (4 | ) | (40 | ) | |||
Business acquisitions, net of cash acquired | (21 | ) | (1,068 | ) | |||
Decrease (increase) in restricted cash | 1 | (76 | ) | ||||
Other investing | 2 | (10 | ) | ||||
Net cash used in investing activities | (404 | ) | (2,060 | ) | |||
Financing activities: | |||||||
Proceeds from issuance of common stock | 69 | 99 | |||||
Proceeds from issuance of notes payable to EMC | — | 1,050 | |||||
Reduction in capital from EMC | — | (24 | ) | ||||
Proceeds from non-controlling interests | 4 | — | |||||
Repurchase of common stock | (850 | ) | (407 | ) | |||
Excess tax benefits from stock-based compensation | 26 | 26 | |||||
Shares repurchased for tax withholdings on vesting of restricted stock | (124 | ) | (94 | ) | |||
Net cash provided by (used in) financing activities | (875 | ) | 650 | ||||
Net decrease in cash and cash equivalents | (280 | ) | (251 | ) | |||
Cash and cash equivalents at beginning of the period | 2,071 | 2,305 | |||||
Cash and cash equivalents at end of the period | $ | 1,791 | $ | 2,054 | |||
Supplemental disclosures of cash flow information: | |||||||
Cash paid for interest | $ | 14 | $ | 13 | |||
Cash paid for taxes, net | 136 | 46 | |||||
Non-cash items: | |||||||
Changes in capital additions, accrued but not paid | $ | (22 | ) | $ | 11 | ||
Fair value of stock-based awards assumed in acquisition | — | 24 |
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
The 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 2015. 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 2014 Annual Report on Form 10-K.
As of June 30, 2015, EMC Corporation (“EMC”) held 81.1% of VMware’s outstanding common stock and 97.4% 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 may not be considered arm’s length with an unrelated third party. Therefore, the financial statements included herein may not necessarily reflect the results of operations, financial position 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 results of operations, financial position 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.
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 included in other income, net on the condensed consolidated statements of income and are not presented separately as the amounts were not material for the periods presented. All intercompany transactions and account balances between VMware and its subsidiaries have been eliminated in consolidation. Transactions with EMC and its subsidiaries are generally settled in cash and are classified on the condensed consolidated statements of cash flows based upon the nature of the underlying transaction.
Reclassification
Certain prior period amounts related to the notes payable to EMC have been reclassified within the financing activities section of the condensed consolidated statements of cash flows. The reclassifications had no effect on total cash flows used in or provided by operating, investing or financing activities as previously reported.
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
7
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
not limited to trade receivable valuation, marketing development funds and 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.
New Accounting Pronouncement
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 2018 and permits the use of either the retrospective or cumulative effect transition method. Early adoption is permitted, but not earlier than the first quarter of 2017. The Company has not selected a transition method and is currently evaluating the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures.
B. Business Combination, Definite-Lived Intangible Assets, Net and Goodwill
Business Combination
On February 2, 2015, VMware acquired all of the outstanding shares of Immidio B.V. (“Immidio”) for approximately $21 million of cash, net of liabilities assumed. VMware acquired Immidio to expand VMware's Workspace Environment Management solutions within the End-User Computing product group. The preliminary purchase price primarily included $8 million of identifiable intangible assets and approximately $17 million of goodwill that is expected to be non-deductible for tax purposes. The impact of the acquisition was not material to VMware's condensed consolidated financial statements.
Definite-Lived Intangible Assets, Net
As of June 30, 2015 and December 31, 2014, definite-lived intangible assets consisted of the following (amounts in table in millions):
June 30, 2015 | |||||||||||||
Weighted-Average Useful Lives (in years) | Gross Carrying Amount | Accumulated Amortization | Net Book Value | ||||||||||
Purchased technology | 6.5 | $ | 698 | $ | (299 | ) | $ | 399 | |||||
Leasehold interest | 34.9 | 149 | (18 | ) | 131 | ||||||||
Customer relationships and customer lists | 8.2 | 157 | (62 | ) | 95 | ||||||||
Trademarks and tradenames | 8.6 | 61 | (13 | ) | 48 | ||||||||
Other | 2.9 | 20 | (11 | ) | 9 | ||||||||
Total definite-lived intangible assets | $ | 1,085 | $ | (403 | ) | $ | 682 |
December 31, 2014 | |||||||||||||
Weighted-Average Useful Lives (in years) | Gross Carrying Amount | Accumulated Amortization | Net Book Value | ||||||||||
Purchased technology | 6.5 | $ | 699 | $ | (252 | ) | $ | 447 | |||||
Leasehold interest | 34.9 | 149 | (15 | ) | 134 | ||||||||
Customer relationships and customer lists | 8.2 | 157 | (53 | ) | 104 | ||||||||
Trademarks and tradenames | 8.6 | 61 | (9 | ) | 52 | ||||||||
Other | 2.7 | 18 | (7 | ) | 11 | ||||||||
Total definite-lived intangible assets | $ | 1,084 | $ | (336 | ) | $ | 748 |
8
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Amortization expense on definite-lived intangible assets was $37 million and $74 million during the three and six months ended June 30, 2015, respectively, and $36 million and $67 million during the three and six months ended June 30, 2014, respectively.
Based on intangible assets recorded as of June 30, 2015 and assuming no subsequent additions or impairment of underlying assets, the remaining estimated annual amortization expense is expected to be as follows (table in millions):
Remainder of 2015 | $ | 72 | |
2016 | 128 | ||
2017 | 121 | ||
2018 | 108 | ||
2019 | 87 | ||
Thereafter | 166 | ||
Total | $ | 682 |
Goodwill
The following table summarizes the changes in the carrying amount of goodwill during the six months ended June 30, 2015 (table in millions):
Balance, January 1, 2015 | $ | 3,964 | |
Increase in goodwill related to a business combination | 17 | ||
Balance, June 30, 2015 | $ | 3,981 |
C. Realignment Charges
During the first quarter of 2015, VMware eliminated approximately 350 positions across all major functional groups and geographies to streamline its operations. As a result of this action, $21 million of realignment charges were recognized during the six months ended June 30, 2015, which consisted of severance-related costs. An immaterial credit was recognized during the three months ended June 30, 2015. As of June 30, 2015, $2 million remained in accrued expenses and other on the condensed consolidated balance sheets and is expected to be paid during 2015.
The following table summarizes the activity for the accrued realignment charges for the six months ended June 30, 2015 (table in millions):
Six Months Ended June 30, 2015 | |||||||||||||||
Balance as of January 1, 2015 | Realignment Charges | Utilization | Balance as of June 30, 2015 | ||||||||||||
Severance-related costs | $ | 8 | $ | 21 | $ | (27 | ) | $ | 2 |
No realignment charges were recognized during the three and six months ended June 30, 2014.
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, performance 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 net income per share as both classes share the same rights in dividends, therefore basic and diluted earnings per share are the same for both classes.
9
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The following table sets forth the computations of basic and diluted net income per share during the three and six months ended June 30, 2015 and 2014 (net income in millions, shares in thousands):
Three Months Ended | Six Months Ended | ||||||||||||||
June 30, | June 30, | ||||||||||||||
2015 | 2014 | 2015 | 2014 | ||||||||||||
Net income | $ | 172 | $ | 167 | $ | 368 | $ | 366 | |||||||
Weighted-average shares, basic for Class A and Class B | 424,169 | 430,216 | 426,055 | 430,050 | |||||||||||
Effect of dilutive securities | 2,628 | 3,983 | 2,717 | 4,168 | |||||||||||
Weighted-average shares, diluted for Class A and Class B | 426,797 | 434,199 | 428,772 | 434,218 | |||||||||||
Net income per weighted-average share, basic for Class A and Class B | $ | 0.41 | $ | 0.39 | $ | 0.86 | $ | 0.85 | |||||||
Net income per weighted-average share, diluted for Class A and Class B | $ | 0.40 | $ | 0.38 | $ | 0.86 | $ | 0.84 |
The following table sets forth the weighted-average common share equivalents of Class A common stock that were excluded from the diluted net income per share calculations during the three and six months ended June 30, 2015 and 2014, because their effect would have been anti-dilutive (shares in thousands):
Three Months Ended | Six Months Ended | ||||||||||
June 30, | June 30, | ||||||||||
2015 | 2014 | 2015 | 2014 | ||||||||
Anti-dilutive securities: | |||||||||||
Employee stock options | 2,100 | 1,085 | 2,206 | 1,007 | |||||||
Restricted stock units | 90 | 2 | 399 | 4 | |||||||
Total | 2,190 | 1,087 | 2,605 | 1,011 |
10
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
E. Cash, Cash Equivalents and Investments
Cash, cash equivalents and investments as of June 30, 2015 and December 31, 2014 consisted of the following (tables in millions):
June 30, 2015 | |||||||||||||||
Cost or Amortized Cost | Unrealized Gains | Unrealized Losses | Aggregate Fair Value | ||||||||||||
Cash | $ | 787 | $ | — | $ | — | $ | 787 | |||||||
Cash equivalents: | |||||||||||||||
Money-market funds | $ | 990 | $ | — | $ | — | $ | 990 | |||||||
U.S. and foreign corporate debt securities | 7 | — | — | 7 | |||||||||||
Municipal obligations | 7 | — | — | 7 | |||||||||||
Total cash equivalents | $ | 1,004 | $ | — | $ | — | $ | 1,004 | |||||||
Short-term investments: | |||||||||||||||
U.S. Government and agency obligations | $ | 654 | $ | 1 | $ | — | $ | 655 | |||||||
U.S. and foreign corporate debt securities | 3,293 | 4 | (5 | ) | 3,292 | ||||||||||
Foreign governments and multi-national agency obligations | 27 | — | — | 27 | |||||||||||
Municipal obligations | 887 | 1 | — | 888 | |||||||||||
Asset-backed securities | 36 | — | — | 36 | |||||||||||
Mortgage-backed securities | 308 | — | (1 | ) | 307 | ||||||||||
Total short-term investments | $ | 5,205 | $ | 6 | $ | (6 | ) | $ | 5,205 | ||||||
Other assets: | |||||||||||||||
Marketable available-for-sale equity securities | $ | 15 | $ | — | $ | — | $ | 15 |
December 31, 2014 | |||||||||||||||
Cost or Amortized Cost | Unrealized Gains | Unrealized Losses | Aggregate Fair Value | ||||||||||||
Cash | $ | 885 | $ | — | $ | — | $ | 885 | |||||||
Cash equivalents: | |||||||||||||||
Money-market funds | $ | 1,130 | $ | — | $ | — | $ | 1,130 | |||||||
U.S. and foreign corporate debt securities | 54 | — | — | 54 | |||||||||||
Foreign governments and multi-national agency obligations | 2 | — | — | 2 | |||||||||||
Total cash equivalents | $ | 1,186 | $ | — | $ | — | $ | 1,186 | |||||||
Short-term investments: | |||||||||||||||
U.S. Government and agency obligations | $ | 542 | $ | — | $ | — | $ | 542 | |||||||
U.S. and foreign corporate debt securities | 3,236 | 3 | (5 | ) | 3,234 | ||||||||||
Foreign governments and multi-national agency obligations | 23 | — | — | 23 | |||||||||||
Municipal obligations | 930 | 2 | — | 932 | |||||||||||
Asset-backed securities | 53 | — | — | 53 | |||||||||||
Mortgage-backed securities | 221 | — | (1 | ) | 220 | ||||||||||
Total short-term investments | $ | 5,005 | $ | 5 | $ | (6 | ) | $ | 5,004 |
Refer to Note F for further information regarding the fair value of VMware’s cash equivalents and investments.
11
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The realized gains and losses on investments during the three and six months ended June 30, 2015 and 2014 were not material.
Unrealized losses on cash equivalents and investments as of June 30, 2015 and December 31, 2014, which have been in a net loss position for less than twelve months, were classified by investment category as follows (table in millions):
June 30, 2015 | December 31, 2014 | ||||||||||||||
Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | ||||||||||||
U.S. and foreign corporate debt securities | $ | 1,718 | $ | (5 | ) | $ | 1,964 | $ | (5 | ) | |||||
Mortgage-backed securities | 169 | (1 | ) | 107 | (1 | ) | |||||||||
Total | $ | 1,887 | $ | (6 | ) | $ | 2,071 | $ | (6 | ) |
Unrealized losses on cash equivalents and available-for-sale investments, which have been in a net loss position for twelve months or greater, were not material as of June 30, 2015 and December 31, 2014.
Contractual Maturities
The contractual maturities of short-term investments held at June 30, 2015 consisted of the following (table in millions):
Amortized Cost Basis | Aggregate Fair Value | ||||||
Due within one year | $ | 1,363 | $ | 1,363 | |||
Due after 1 year through 5 years | 3,511 | 3,512 | |||||
Due after 5 years through 10 years | 107 | 107 | |||||
Due after 10 years | 224 | 223 | |||||
Total short-term investments | $ | 5,205 | $ | 5,205 |
F. Fair Value Measurements
Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis
Certain financial assets and liabilities are measured at fair value on a recurring basis. VMware determines fair value using the following hierarchy:
• | Level 1 - Quoted prices in active markets for identical assets or liabilities |
• | Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are noted active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities |
• | Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities |
VMware’s fixed income securities are primarily classified as Level 2, with the exception of some of the U.S. Government and agency obligations which are classified as Level 1. Additionally, VMware’s Level 2 classification includes foreign currency forward contracts and notes payable to EMC. At June 30, 2015 and December 31, 2014, VMware’s Level 2 securities were generally priced using 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 does not have any material assets or liabilities that fall into Level 3 of the fair value hierarchy as of June 30, 2015 and December 31, 2014, and there have been no transfers between fair value measurement levels during the three and six months ended June 30, 2015 and 2014.
12
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, available-for-sale securities, and foreign currency forward contracts, that were required to be measured at fair value as of June 30, 2015 and December 31, 2014 (tables in millions):
June 30, 2015 | |||||||||||
Level 1 | Level 2 | Total | |||||||||
Cash equivalents: | |||||||||||
Money-market funds | $ | 990 | $ | — | $ | 990 | |||||
U.S. and foreign corporate debt securities | — | 7 | 7 | ||||||||
Municipal obligations | — | 7 | 7 | ||||||||
Total cash equivalents | $ | 990 | $ | 14 | $ | 1,004 | |||||
Short-term investments: | |||||||||||
U.S. Government and agency obligations | $ | 443 | $ | 212 | $ | 655 | |||||
U.S. and foreign corporate debt securities | — | 3,292 | 3,292 | ||||||||
Foreign governments and multi-national agency obligations | — | 27 | 27 | ||||||||
Municipal obligations | — | 888 | 888 | ||||||||
Asset-backed securities | — | 36 | 36 | ||||||||
Mortgage-backed securities | — | 307 | 307 | ||||||||
Total short-term investments | $ | 443 | $ | 4,762 | $ | 5,205 | |||||
Other assets: | |||||||||||
Marketable available-for-sale equity securities | $ | 15 | $ | — | $ | 15 | |||||
Accrued expenses and other: | |||||||||||
Foreign currency forward contracts | $ | — | $ | (3 | ) | $ | (3 | ) |
December 31, 2014 | |||||||||||
Level 1 | Level 2 | Total | |||||||||
Cash equivalents: | |||||||||||
Money-market funds | $ | 1,130 | $ | — | $ | 1,130 | |||||
U.S. and foreign corporate debt securities | — | 54 | 54 | ||||||||
Foreign governments and multi-national agency obligations | — | 2 | 2 | ||||||||
Total cash equivalents | $ | 1,130 | $ | 56 | $ | 1,186 | |||||
Short-term investments: | |||||||||||
U.S. Government and agency obligations | $ | 353 | $ | 189 | $ | 542 | |||||
U.S. and foreign corporate debt securities | — | 3,234 | 3,234 | ||||||||
Foreign governments and multi-national agency obligations | — | 23 | 23 | ||||||||
Municipal obligations | — | 932 | 932 | ||||||||
Asset-backed securities | — | 53 | 53 | ||||||||
Mortgage-backed securities | — | 220 | 220 | ||||||||
Total short-term investments | $ | 353 | $ | 4,651 | $ | 5,004 | |||||
Other current assets: | |||||||||||
Foreign currency forward contracts | $ | — | $ | 1 | $ | 1 | |||||
Accrued expenses and other: | |||||||||||
Foreign currency forward contracts | $ | — | $ | (1 | ) | $ | (1 | ) |
VMware has elected not to record its notes payable to EMC at fair value, but has measured the notes at fair value for disclosure purposes. As of June 30, 2015 and December 31, 2014, the fair value of the notes payable to EMC was $1,510 million and $1,503 million, respectively. Fair value was estimated based on observable market interest rates (Level 2 inputs).
13
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
VMware offers a deferred compensation plan for eligible employees that allows participants to defer payment for part or all of their compensation. VMware’s results of operations are not significantly affected by this plan since changes in the fair value of the assets substantially offset changes in the fair value of the liabilities. As such, assets and liabilities associated with this plan have not been included in the above tables. Assets and liabilities associated with this plan were both approximately $14 million and $8 million as of June 30, 2015 and December 31, 2014, respectively, and are included in other assets and other liabilities on the condensed consolidated balance sheets.
Assets Measured and Recorded at Fair Value on a Non-Recurring Basis
VMware evaluated the strategic investments in its portfolio accounted for 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 three and six months ended June 30, 2015 and 2014, VMware did not recognize an other-than-temporary impairment charge for a non-recoverable strategic investment.
During the three and six months ended June 30, 2015 and 2014, VMware did not have material realized gains or losses on strategic investments. Strategic investments are included in other assets on the condensed consolidated balance sheets. The carrying value of VMware’s strategic investments was $98 million and $110 million as of June 30, 2015 and December 31, 2014, respectively.
G. Derivatives and Hedging Activities
VMware conducts business on a global basis in multiple foreign currencies, subjecting the Company to foreign currency risk. To mitigate this risk, VMware utilizes hedging contracts as described below, which potentially expose the Company to credit risk to the extent that the counterparties may be unable to meet the terms of the agreement. VMware manages counterparty risk by seeking counterparties of high credit quality, by monitoring credit ratings and credit spreads of, and other relevant public information about its counterparties. VMware does not, and does not intend to, use derivative instruments for trading or speculative purposes.
Cash Flow Hedges
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 have 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 loss on the condensed consolidated balance sheets and is subsequently reclassified to the related operating expense line item on the condensed consolidated statements of income in the same period that the underlying expenses are incurred. During the three and six months ended June 30, 2015 and 2014, 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, net on the condensed consolidated statements of income as incurred.
VMware enters into forward contracts annually, which have maturities of 12 months or less. As of June 30, 2015 and December 31, 2014, VMware had foreign currency forward contracts designated as cash flow hedges with a total notional value of $119 million and $240 million, respectively. The notional value represents the gross amount of foreign currency that will be bought or sold upon maturity of the forward contract.
During the three and six months ended June 30, 2015 and 2014, all cash flow hedges were considered effective.
Foreign Currency Forward Contracts Not Designated as Hedges
VMware has established a program that utilizes foreign currency forward contracts to offset the foreign currency risk associated with net outstanding monetary asset and liability positions. 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, net on the condensed consolidated statements of income.
VMware enters into foreign currency forward contracts on a monthly basis, which typically have a contractual term of one month. As of June 30, 2015 and December 31, 2014, VMware had outstanding forward contracts with a total notional value of $645 million and $697 million, respectively. The notional value represents the gross amount of foreign currency that will be bought or sold upon maturity of the forward contract.
14
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
During the three and six months ended June 30, 2015, VMware recognized a loss of $20 million and gain of $21 million, respectively, relating to the settlement of foreign currency forward contracts. During both the three and six months ended June 30, 2014, VMware recognized a loss of $5 million. Gains and losses are recorded in other income, net on the condensed consolidated statements of income.
The combined gains and losses derived from the settlement of foreign currency forward contracts and the underlying foreign currency denominated assets and liabilities resulted in a net loss of $3 million and $9 million during the three and six months ended June 30, 2015, respectively. The combined gains and losses derived from the settlement of foreign currency forward contracts and the underlying foreign currency denominated assets and liabilities were immaterial during the three and six months ended June 30, 2014. Net gains and losses are recorded in other income, net on the condensed consolidated statements of income.
H. Unearned Revenues
Unearned revenues as of June 30, 2015 and December 31, 2014 consisted of the following (table in millions):
June 30, | December 31, | ||||||
2015 | 2014 | ||||||
Unearned license revenues | $ | 481 | $ | 488 | |||
Unearned software maintenance revenues | 3,894 | 3,905 | |||||
Unearned professional services revenues | 438 | 440 | |||||
Total unearned revenues | $ | 4,813 | $ | 4,833 |
Unearned license revenues are generally recognized upon delivery of existing or future products or services, or 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. The amount of unearned revenues is impacted by timing of both product promotion offers and delivery of the future products offered as part of a product promotion. In the event the arrangement does not include professional services, unearned license revenues 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 over the contract period. The weighted-average remaining term at June 30, 2015 was approximately 2.0 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
During June 2015, VMware reached an agreement with the Department of Justice (“DOJ”) and the General Services Administration (“GSA”) to pay $76 million to resolve allegations that VMware's government sales practices between 2006 and 2013 had violated the federal False Claims Act. The settlement was paid and recorded as a reduction of VMware's total revenues during the three months ended June 30, 2015.
On March 27, 2015, Phoenix Technologies (“Phoenix”) filed a complaint against VMware in the U.S. District Court for the Northern District of California asserting claims for copyright infringement and breach of contract relating to a version of Phoenix’s BIOS software that VMware licensed from Phoenix. In the lawsuit, Phoenix is seeking injunctive relief and monetary damages. VMware believes that it has meritorious defenses in connection with this lawsuit, and currently a reasonably possible loss or range of loss cannot be estimated.
On March 4, 2015, Christoph Hellwig, a software developer who alleges that software code he wrote is used in a component of the Company's vSphere product, filed a lawsuit against VMware in Germany alleging copyright infringement for failing to comply with the terms of an open source General Public License v.2 (“GPL v.2”) and seeking an order requiring VMware to comply with the GPL v.2 or cease distribution of any affected code within Germany. VMware believes that it has
15
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
meritorious defenses in connection with this lawsuit, and currently a reasonably possible loss or range of loss cannot be estimated.
VMware accrues for a liability at the low end of the range of estimated losses when a determination has been made that a loss is both probable and the amount of the loss can be reasonably estimated. Significant judgment is required in both the determination that the occurrence of a loss is probable and 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.
VMware believes that it has valid defenses against each of the ongoing legal matters disclosed. However, given the unpredictable nature of legal proceedings, an unfavorable resolution of one or more legal proceedings, claims, or investigations could have a material adverse effect on VMware’s condensed consolidated financial statements.
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 discussions with government entities on various matters. VMware does not believe that any liability from any reasonably foreseeable disposition of such claims and litigation, individually or in the aggregate, would have a material adverse effect on its condensed consolidated financial statements.
J. Stockholders’ Equity
VMware Stock Repurchases
On January 27, 2015, VMware’s Board of Directors authorized the repurchase of up to an additional one billion dollars of VMware’s Class A common stock through the end of 2017. Stock will be purchased from time to time, in the open market or through private transactions, subject to market conditions. The new stock repurchase authorization is in addition to VMware’s ongoing one-billion-dollar stock repurchase program, originally announced on August 6, 2014. 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. VMware is not obligated to purchase any shares under its stock repurchase programs. Purchases can be discontinued at any time VMware believes additional purchases are not warranted. All shares repurchased under VMware’s stock repurchase programs are retired.
The following table summarizes stock repurchase authorizations that remain open as of June 30, 2015 (amounts in table in millions):
Authorization Date | Amount Authorized | Expiration Date | Status | |||
January 27, 2015 | $1,000 | December 31, 2017 | Open | |||
August 6, 2014 | $1,000 | December 31, 2016 | Open |
As of June 30, 2015, the cumulative authorized amount remaining for repurchase was $1,110 million.
The following table summarizes stock repurchase activity during the three and six months ended June 30, 2015 and 2014 (aggregate purchase price in millions, shares in thousands):
Three Months Ended | Six Months Ended | ||||||||||||||
June 30, | June 30, | ||||||||||||||
2015 | 2014 | 2015 | 2014 | ||||||||||||
Aggregate purchase price | $ | 412 | $ | 238 | $ | 850 | $ | 407 | |||||||
Class A common shares repurchased | 4,750 | 2,488 | 10,116 | 4,255 | |||||||||||
Weighted-average price per share | $ | 86.71 | $ | 95.73 | $ | 84.02 | $ | 95.67 |
The aggregate purchase price of repurchased shares includes commissions and is classified as a reduction to additional paid-in capital.
16
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
VMware Stock Options
The following table summarizes stock option activity since January 1, 2015 (shares in thousands):
Number of Shares | Weighted- Average Exercise Price (per share) | |||||
Outstanding, January 1, 2015 | 5,869 | $ | 50.54 | |||
Granted | 13 | 84.68 | ||||
Forfeited | (130 | ) | 61.28 | |||
Exercised | (2,085 | ) | 30.67 | |||
Outstanding, June 30, 2015 | 3,667 | 61.60 |
The stock options outstanding as of June 30, 2015 had an aggregate intrinsic value of $99 million based on VMware’s closing price as of June 30, 2015.
VMware Restricted Stock
VMware's restricted stock primarily consists of restricted stock unit (“RSU”) awards granted to employees. RSUs are valued based on VMware's stock price on the date of grant. The shares underlying the RSU awards are not issued until the RSUs vest. Upon vesting, each RSU converts into one share of VMware Class A common stock.
VMware's 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 2.0 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. As of June 30, 2015, the number of PSUs outstanding includes certain PSUs for which performance conditions have concluded but that remain subject to certain service conditions.
The following table summarizes restricted stock activity since January 1, 2015 (units in thousands):
Number of Units | Weighted- Average Grant Date Fair Value (per unit) | |||||
Outstanding, January 1, 2015 | 12,585 | $ | 88.88 | |||
Granted | 5,170 | 87.04 | ||||
Vested | (2,813 | ) | 85.20 | |||
Forfeited | (872 | ) | 86.89 | |||
Outstanding, June 30, 2015 | 14,070 | 87.70 |
The total fair value of VMware restricted stock that vested during the six months ended June 30, 2015 was $240 million. As of June 30, 2015, restricted stock representing 14.1 million shares of VMware’s Class A common stock were outstanding, with an aggregate intrinsic value of $1,206 million based on VMware’s closing price as of June 30, 2015.
As of June 30, 2015, the total unrecognized compensation cost for stock options and restricted stock was $1,009 million and will be recognized through 2019 with a weighted-average remaining period of 1.6 years.
17
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Accumulated Other Comprehensive Income (Loss)
The changes in components of accumulated other comprehensive income (loss) during the six months ended June 30, 2015 and 2014 were as follows (tables in millions):
Unrealized Gain on Available-for-Sale Securities | Unrealized Loss on Cash Flow Hedges | Total | |||||||||
Balance, January 1, 2015 | $ | — | $ | (1 | ) | $ | (1 | ) | |||
Unrealized gain (loss), net of taxes of $0 | 1 | (3 | ) | (2 | ) | ||||||
Balance, June 30, 2015 | $ | 1 | $ | (4 | ) | $ | (3 | ) |
Unrealized Gain on Available-for-Sale Securities | Total | ||||||
Balance, January 1, 2014 | $ | 4 | $ | 4 | |||
Unrealized gain, net of taxes of $2 | 4 | 4 | |||||
Balance, June 30, 2014 | $ | 8 | $ | 8 |
Unrealized gains on VMware’s available-for-sale securities are reclassified to investment income on the condensed consolidated statements of income in the period that such gains are realized.
The effective portion of gains (losses) resulting from changes in the fair value of forward contracts designated as cash flow hedging instruments are reclassified to its related operating expense line item on the condensed consolidated statements of income in the same period that the underlying expenses are incurred. The amounts recorded to their related operating expense line items on the condensed consolidated statements of income during the three and six months ended June 30, 2015 and 2014, were not material.
K. Related Parties
The information provided below includes a summary of the transactions entered into with EMC and EMC’s consolidated subsidiaries (collectively “EMC”). EMC acquired VCE Company LLC (“VCE”) during the fourth quarter of 2014. Transactions with VCE from the date EMC acquired the controlling interest in VCE have been included in the tables below.
Transactions with EMC
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 provides professional services to end users based upon 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. |
• | Pursuant to an ongoing distribution agreement, VMware acts as the selling agent for certain products and services of Pivotal Software, Inc. (“Pivotal”), a subsidiary of EMC, in exchange for an agency fee. Under this agreement, cash is collected from the end user by VMware and remitted to Pivotal, net of the contractual fee. |
• | VMware provides various transition services to Pivotal. Support costs incurred by VMware are reimbursed to VMware and are recorded as a reduction to the costs incurred by VMware. |
18
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Information about VMware’s revenues and receipts from such arrangements with EMC during the three and six months ended June 30, 2015 and 2014 and unearned revenues as of June 30, 2015 and December 31, 2014 consisted of the following (table in millions):
Revenues and Receipts from EMC | Unearned Revenues from EMC | ||||||||||||||||||||||
Three Months Ended | Six Months Ended | ||||||||||||||||||||||
June 30, | June 30, | June 30, | December 31, | ||||||||||||||||||||
2015 | 2014 | 2015 | 2014 | 2015 | 2014 | ||||||||||||||||||
Reseller revenues | $ | 69 | $ | 43 | $ | 131 | $ | 89 | $ | 261 | $ | 290 | |||||||||||
Internal-use revenues | 6 | 5 | 9 | 13 | 14 | 18 | |||||||||||||||||
Professional services revenues | 24 | 18 | 48 | 40 | 3 | 9 | |||||||||||||||||
Agency fee revenues | 3 | 1 | 4 | 2 | — | — | |||||||||||||||||
Reimbursement for transition services | 1 | — | 2 | 2 | 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 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 charged to VMware with a mark-up intended to approximate costs that would have been incurred had VMware contracted for such services with an unrelated third party. These costs are included as expenses on VMware’s condensed consolidated statements of income and primarily include salaries, benefits, travel and rent expenses. EMC also incurs certain administrative costs on VMware’s behalf in the U.S. that are recorded as expenses on VMware’s condensed consolidated statements of income. |
Information about VMware’s costs from such arrangements with EMC for the three and six months ended June 30, 2015 and 2014 consisted of the following (table in millions):
Three Months Ended | Six Months Ended | ||||||||||||||
June 30, | June 30, | ||||||||||||||
2015 | 2014 | 2015 | 2014 | ||||||||||||
Purchases and leases of products and purchases of services | $ | 12 | $ | 12 | $ | 31 | $ | 33 | |||||||
Collaborative technology project costs | 1 | 3 | 3 | 7 | |||||||||||
EMC subsidiary support and administrative costs | 26 | 35 | 54 | 76 |
VMware also purchases EMC products through EMC's channel partners. Purchases of EMC products through EMC's channel partners were $18 million and $26 million during the three and six months ended June 30, 2015, respectively, and $8 million and $11 million during the three and six months ended June 30, 2014, respectively.
Certain Stock-Based Compensation
Effective September 1, 2012, Pat Gelsinger was appointed Chief Executive Officer of VMware. Prior to joining VMware, Mr. Gelsinger was the President and Chief Operating Officer of EMC Information Infrastructure Products. Mr. Gelsinger retains certain of his EMC equity awards that were held as of September 1, 2012 and he continues to vest in such awards. Stock-based compensation related to Mr. Gelsinger’s EMC awards are being recognized on VMware’s condensed consolidated statements of income over the awards’ remaining requisite service periods.
19
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Tax Sharing Agreement with EMC
Pursuant to a tax sharing agreement between VMware and EMC, payments are made between VMware and EMC related to VMware's portion of federal income taxes on EMC's consolidated tax return as well as income taxes for states in which combined state income tax returns are filed. The following table summarizes these payments made between VMware and EMC during the three and six months ended June 30, 2015 and 2014 (table in millions):
Three Months Ended | Six Months Ended | ||||||||||||||
June 30, | June 30, | ||||||||||||||
2015 | 2014 | 2015 | 2014 | ||||||||||||
Payments from VMware to EMC | $ | 43 | $ | — | $ | 92 | $ | 20 |
Payments made by VMware to EMC result from VMware having a tax liability. The amount that VMware pays to EMC for its portion of federal income taxes on EMC’s consolidated tax return differs from the amount VMware would owe on a separate return basis, and the difference is presented as a component of stockholders’ equity. During the three and six months ended June 30, 2015 and 2014, 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 described above, amounts due to and from related parties, net as of June 30, 2015 and December 31, 2014 consisted of the following (table in millions):
June 30, | December 31, | ||||||
2015 | 2014 | ||||||
Due to related parties | $ | (85 | ) | $ | (76 | ) | |
Due from related parties | 77 | 125 | |||||
Due (to) from related parties, net | $ | (8 | ) | $ | 49 | ||
Income tax due (to) from related parties | $ | 6 | $ | (40 | ) |
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 related parties is governed by the tax sharing agreement with EMC.
Notes Payable to EMC
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 six months ended June 30, 2015, $7 million and $13 million, respectively, of interest expense was recognized. During the three and six months ended June 30, 2014, $7 million and $12 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.
20
VMware, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Revenues by geographic area for the three and six months ended June 30, 2015 and 2014 were as follows (table in millions):
Three Months Ended | Six Months Ended | ||||||||||||||
June 30, | June 30, | ||||||||||||||
2015 | 2014 | 2015 | 2014 | ||||||||||||
United States | $ | 742 | $ | 683 | $ | 1,504 | $ | 1,332 | |||||||
International | 779 | 774 | 1,528 | 1,485 | |||||||||||
Total | $ | 1,521 | $ | 1,457 | $ | 3,032 | $ | 2,817 |
Revenues by geographic area are based on the ship-to addresses of VMware’s customers. No individual country other than the United States accounted for 10% or more of revenues for the three and six months ended June 30, 2015 and 2014.
Long-lived assets by geographic area, which primarily include property and equipment, net, as of June 30, 2015 and December 31, 2014 were as follows (table in millions):
June 30, | December 31, | ||||||
2015 | 2014 | ||||||
United States | $ | 834 | $ | 801 | |||
International | 146 | 117 | |||||
Total | $ | 980 | $ | 918 |
No individual country other than the United States accounted for 10% or more of these assets as of June 30, 2015 and December 31, 2014, respectively.
21
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 June 30, 2015 should be read in conjunction with our consolidated financial statements for the year ended December 31, 2014 contained in our Form 10-K filed February 26, 2015.
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
The information technology (“IT”) industry is transforming, moving from a hardware-based traditional model to one of a software-defined infrastructure. We are the leader in virtualization infrastructure solutions utilized by organizations to help transform the way they build, deliver and consume IT resources. We develop and market our product and service offerings within three main product groups and we also leverage synergies across these three product and service areas:
• | SDDC or Software-Defined Data Center |
• | Hybrid Cloud Computing |
• | End-User Computing |
Historically, the majority of our license sales have been from our standalone vSphere product, which is included in our compute product category within our SDDC architecture. However, over the last two years, standalone vSphere product license sales are slowing, while the growth rate of license sales beyond our standalone vSphere product are continuing to increase as we transition to offering a wider range of products and services to enable the entire SDDC. As the transformation of the IT industry continues, we expect that our growth rates will be increasingly derived from sales of our newer products, suites and services solutions across our SDDC portfolio, beyond standalone vSphere. For example, we have experienced continued growth in sales volumes, production use and number of customers who have purchased VMware NSX, our network virtualization solution, throughout 2014 and during the six months ended June 30, 2015. We also continue to see traction of our Virtual SAN product and other newer offerings.
Hybrid cloud computing, comprised of VMware vCloud Air (“vCloud Air”) and VMware vCloud Air Network (“vCAN”) Service Providers Program offerings, continued to experience growth during the three and six months ended June 30, 2015. We plan to continue to expand our hybrid cloud global footprint as well as our service offerings. Due to the nature of these offerings, revenues are recognized over a period of time.
Our end-user computing solutions include our Horizon workplace suites and enterprise mobile management offerings, led by our AirWatch mobile solutions. Currently, our AirWatch business models include an on-premise solution that we offer through the sale of perpetual licenses and an off-premise solution that we offer as software-as-a-service (“SaaS”). AirWatch products and services continued to contribute to the growth of our end-user computing products during the three and six months ended June 30, 2015. Our investments in AirWatch resulted in increased operating expenses during the six months ended June 30, 2015, primarily driven by employee-related costs, including expenses we recognized in connection with installment payments to certain key employees as part of the acquisition, as well as amortization of purchased intangible assets.
Approximately 70% of our sales are denominated in the U.S. dollar, however, we also 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 financial statements, including our revenues, operating expenses, unearned revenues, and the resulting cash flows derived from the U.S. dollar equivalent of foreign currency transactions are impacted by foreign exchange fluctuations. Foreign currency fluctuations have had a negative impact on the growth rate of our revenues during 2015, the amount of unearned revenues recognized derived from sales denominated in foreign currencies, and the U.S. dollar equivalent of foreign currency cash collections. We have also benefited from operating expenses incurred and paid in currencies other than the U.S. dollar.
We generally sell our solutions using enterprise agreements (“EAs”) or as part of our non-EA, or transactional, business. EAs are comprehensive volume license offerings, offered both directly by us and through certain channel partners, that also provide for multi-year maintenance and support.
22
Results of Operations
Revenues
Our revenues during the three and six months ended June 30, 2015 and 2014 were as follows:
Three Months Ended | Six Months Ended | ||||||||||||||||||||||||||||||||||
June 30, | $ Change | % Change | June 30, | $ Change | % Change | ||||||||||||||||||||||||||||||
2015 | 2014 | Actual | Actual | Constant Currency | 2015 | 2014 | Actual | Actual | Constant Currency | ||||||||||||||||||||||||||
Revenues: | |||||||||||||||||||||||||||||||||||
License | $ | 638 | $ | 614 | $ | 24 | 4 | % | 9 | % | $ | 1,214 | $ | 1,175 | $ | 39 | 3 | % | 8 | % | |||||||||||||||
Services: | |||||||||||||||||||||||||||||||||||
Software maintenance | 829 | 737 | 91 | 12 | 1,641 | 1,438 | 203 | 14 | |||||||||||||||||||||||||||
Professional services | 130 | 106 | 24 | 23 | 253 | 204 | 48 | 24 | |||||||||||||||||||||||||||
Total services | 959 | 843 | 115 | 14 | 1,894 | 1,642 | 251 | 15 | |||||||||||||||||||||||||||
GSA settlement | (76 | ) | — | (76 | ) | n/a | (76 | ) | — | (76 | ) | n/a | |||||||||||||||||||||||
Total revenues | $ | 1,521 | $ | 1,457 | $ | 64 | 4 | 8 | $ | 3,032 | $ | 2,817 | $ | 215 | 8 | 10 | |||||||||||||||||||
Revenues: | |||||||||||||||||||||||||||||||||||
United States | $ | 742 | $ | 683 | $ | 59 | 9 | % | $ | 1,504 | $ | 1,332 | $ | 172 | 13 | % | |||||||||||||||||||
International | 779 | 774 | 5 | 1 | 1,528 | 1,485 | 43 | 3 | |||||||||||||||||||||||||||
Total revenues | $ | 1,521 | $ | 1,457 | $ | 64 | 4 | 8 | $ | 3,032 | $ | 2,817 | $ | 215 | 8 | 10 |
In order to provide a comparable framework for assessing how our business performed, adjusted for the impact of foreign currency fluctuations, management analyzes year-over-year license and total revenues growth on a constant currency basis. License and total revenues recognized during the current period derived from non-U.S. dollar based transactions were converted into U.S. dollars using the exchange rates that were effective in the comparable prior year period. The calculated current period license and total revenues, adjusted for foreign currency fluctuations, is compared to the license and total revenues of the comparable prior year period, as reported, in calculating license and total revenue growth in constant currency.
Hybrid cloud, including vCAN and vCloud Air, and our SaaS offerings, including our AirWatch mobile solutions, increased to greater than 6% of our total revenues during the three and six months ended June 30, 2015. We expect our hybrid cloud and SaaS offerings will continue to grow and represent an increasing percentage of total revenues in future periods. vCAN revenues are generally included in license revenues and our SaaS revenues, including vCloud Air and our AirWatch mobile solutions, are included in both license and services revenues.
License Revenues
License revenues during the three and six months ended June 30, 2015 were up 4% and 3%, respectively, compared to the same periods in the prior year. Our license revenues increased primarily as a result of increased sales of our emerging product offerings, including AirWatch mobile solutions, as well as revenues from our hybrid cloud offerings. Sales of products beyond standalone vSphere, including vSphere with Operations Management, also contribute to license revenues growth, partially offset by a decline in our standalone vSphere product license sales. Our license revenues growth rate also continues to be negatively impacted by changes in the value of the U.S. dollar against foreign currencies in which we invoice.
The anticipated continued revenue growth of our hybrid cloud and SaaS offerings are expected to adversely impact the growth rate of our license revenues during the remainder of 2015 as we will recognize less revenue up-front than we would otherwise recognize as part of a multi-year license arrangement. Additionally, we expect changes in foreign currency to continue to have an impact on our license revenues growth rate.
Services Revenues
During the three and six months ended June 30, 2015, 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.
23
Professional services revenues increased during the three and six months ended June 30, 2015 compared to the same periods in 2014, which is attributable to growth in our license sales and an increase in our solution-based selling. As we continue to invest in our partners and expand our ecosystem of third-party professionals with expertise in our solutions to independently provide professional services to our customers, our professional services revenues will vary based on the delivery channels used in any given period as well as the timing of engagements.
GSA settlement
During June 2015, we reached an agreement with the Department of Justice (“DOJ”) and the General Services Administration (“GSA”) to pay $76 to resolve allegations that our government sales practices between 2006 and 2013 had violated the federal False Claims Act. The settlement was paid and recorded as a reduction of our total revenues during the three months ended June 30, 2015.
Unearned Revenues
Our unearned revenues as of June 30, 2015 and December 31, 2014 were as follows:
June 30, 2015 | December 31, 2014 | ||||||
Unearned license revenues | $ | 481 | $ | 488 | |||
Unearned software maintenance revenues | 3,894 | 3,905 | |||||
Unearned professional services revenues | 438 | 440 | |||||
Total unearned revenues | $ | 4,813 | $ | 4,833 |
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. The amount of unearned revenues is impacted by timing of both product promotion offers and delivery of the future products offered as part of a product promotion. In the event the arrangement does not include professional services, unearned license revenues 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 primarily attributable to our maintenance contracts and are generally recognized ratably over the contract period. The weighted-average remaining term at June 30, 2015 was approximately 2.0 years. Unearned professional services revenues result primarily from prepaid professional services, including training, and are generally recognized as the services are delivered. Our total unearned revenues are impacted by the amount and timing of sales as well as fluctuations in the foreign currencies in which we invoice.
Cost of License Revenues, Cost of Services Revenues and Operating Expenses
Our cost of services revenues and operating expenses were primarily impacted by increasing headcount, net of realignment activities discussed below. Headcount during the three and six months ended June 30, 2015 continued to increase due to organic growth. The increased headcount has resulted in higher cash-based employee-related expenses across most of our income statement expense categories when compared to the same period in 2014, and we expect this trend to continue.
24
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. 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 | Six Months Ended | ||||||||||||||||||||||||||||
June 30, | June 30, | ||||||||||||||||||||||||||||
2015 | 2014 | $ Change | % Change | 2015 | 2014 | $ Change | % Change | ||||||||||||||||||||||
Cost of license revenues | $ | 46 | $ | 45 | $ | — | — | % | $ | 95 | $ | 94 | $ | — | — | % | |||||||||||||
Stock-based compensation | — | 1 | — | (20 | ) | 1 | 2 | — | (17 | ) | |||||||||||||||||||
Total expenses | $ | 46 | $ | 46 | $ | — | — | $ | 96 | $ | 96 | $ | — | — | |||||||||||||||
% of License revenues | 7 | % | 8 | % | 8 | % | 8 | % |
Cost of license revenues was relatively flat when comparing three and six months ended June 30, 2015 and 2014.
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. Additionally, our costs of services revenues include costs related to our IT development efforts and depreciation on equipment supporting our service offerings. As we continue to invest in and grow business from our hybrid cloud, SaaS and professional services offerings, we expect our total costs of services revenues to continue to increase.
Three Months Ended | Six Months Ended | ||||||||||||||||||||||||||||
June 30, | June 30, | ||||||||||||||||||||||||||||
2015 | 2014 | $ Change | % Change | 2015 | 2014 | $ Change | % Change | ||||||||||||||||||||||
Cost of services revenues | $ | 194 | $ | 161 | $ | 32 | 20 | % | $ | 375 | $ | 303 | $ | 72 | 24 | % | |||||||||||||
Stock-based compensation | 10 | 11 | (1 | ) | (5 | ) | 22 | 20 | 1 | 6 | |||||||||||||||||||
Total expenses | $ | 204 | $ | 172 | $ | 31 | 18 | $ | 397 | $ | 323 | $ | 74 | 23 | |||||||||||||||
% of Services revenues | 21 | % | 20 | % | 21 | % | 20 | % |
Cost of services revenues increased during the three and six months ended June 30, 2015 compared to the same periods in 2014 primarily driven by the growth in cash-based employee-related expenses of $26 and $56, respectively, due to organic growth in headcount for the three and six months ended June 30, 2015. Our acquisition of AirWatch, which occurred during the three months ended March 31, 2014, also contributed to the growth in cash-based employee-related expenses during the six months ended June 30, 2015. In addition, the growth of our hybrid cloud and SaaS offerings led to an increase in our professional services costs of $15 during the six months ended June 30, 2015. Additionally, increases in equipment, depreciation and facilities-related costs of $13 and $21 during the three and six months ended June 30, 2015, respectively, contributed to the increase in cost of services revenues. These increases were partially offset by the positive impact of $13 and $22 during the three and six months ended June 30, 2015, respectively, from fluctuations in the exchange rate between the U.S. dollar and the foreign currencies in which we incur expenses.
25
Research and Development Expenses
Our research and development expenses include the personnel and related overhead associated with the development of our product software and service offerings.
Three Months Ended | Six Months Ended | ||||||||||||||||||||||||||||
June 30, | June 30, | ||||||||||||||||||||||||||||
2015 | 2014 | $ Change | % Change | 2015 | 2014 | $ Change | % Change | ||||||||||||||||||||||
Research and development | $ | 269 | $ | 251 | $ | 18 | 7 | % | $ | 520 | $ | 484 | $ | 37 | 8 | % | |||||||||||||
Stock-based compensation | 53 | 66 | (12 | ) | (19 | ) | 107 | 126 | (19 | ) | (15 | ) | |||||||||||||||||
Total expenses | $ | 322 | $ | 317 | $ | 6 | 2 | $ | 627 | $ | 610 | $ | 18 | 3 | |||||||||||||||
% of Total revenues | 21 | % | 22 | % | 21 | % | 22 | % |
Research and development expenses increased during the three and six months ended June 30, 2015 compared to the same periods in 2014. The increase was primarily due to growth in cash-based employee-related expenses of $23 and $47 during the three and six months ended June 30, 2015, respectively, due to organic growth in headcount. Our acquisition of AirWatch during the three months ended March 31, 2014, also contributed to the growth in cash-based employee-related expenses during the six months ended June 30, 2015. Additionally, facilities-related costs contributed to the increase of research and development expenses during the three and six months ended June 30, 2015. The increase in research and development expenses during the three and six months ended June 30, 2015 was partially offset by a decrease in stock-based compensation of $12 and $19, respectively, primarily as a result of certain awards becoming fully vested in fiscal year 2014, as well as by the positive impact from fluctuations in the exchange rate between the U.S. dollar and the foreign currencies in which we incur expenses during the three and six months ended June 30, 2015.
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.
Three Months Ended | Six Months Ended | ||||||||||||||||||||||||||||
June 30, | June 30, | ||||||||||||||||||||||||||||
2015 | 2014 | $ Change | % Change | 2015 | 2014 | $ Change | % Change | ||||||||||||||||||||||
Sales and marketing | $ | 522 | $ | 501 | $ | 22 | 4 | % | $ | 1,019 | $ | 934 | $ | 83 | 9 | % | |||||||||||||
Stock-based compensation | 43 | 43 | (2 | ) | (4 | ) | 81 | 84 | (2 | ) | (3 | ) | |||||||||||||||||
Total expenses | $ | 565 | $ | 544 | $ | 20 | 4 | $ | 1,100 | $ | 1,018 | $ | 81 | 8 | |||||||||||||||
% of Total revenues | 37 | % | 37 | % | 36 | % | 36 | % |
Sales and marketing expenses increased during the three and six months ended June 30, 2015 compared to the same periods in 2014, primarily driven by growth in cash-based employee-related expenses of $31 and $94, respectively, due to organic growth in headcount and higher commission expense due to increased sales volume. Our acquisition of AirWatch during the three months ended March 31, 2014, also contributed to the growth in cash-based employee-related expenses during the six months ended June 30, 2015. Also, costs incurred for marketing programs increased by $12 during the six months ended June 30, 2015 compared to the same period in prior year. Additionally, an increase in facilities-related costs of $7 and $10 during the three and six months ended June 30, 2015, respectively, also contributed to the increase in sales and marketing expenses. These increases in expenses during the three and six months ended June 30, 2015 were partially offset by the positive impact of $29 and $52, respectively, from fluctuations in the exchange rate between the U.S. dollar and the foreign currencies in which we incur expenses.
26
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.
Three Months Ended | Six Months Ended | ||||||||||||||||||||||||||||
June 30, | June 30, | ||||||||||||||||||||||||||||
2015 | 2014 | $ Change | % Change | 2015 | 2014 | $ Change | % Change | ||||||||||||||||||||||
General and administrative | $ | 163 | $ | 161 | $ | 2 | 1 | % | $ | 336 | $ | 295 | $ | 40 | 14 | % | |||||||||||||
Stock-based compensation | 17 | 18 | — | (2 | ) | 31 | 35 | (3 | ) | (9 | ) | ||||||||||||||||||
Total expenses | $ | 180 | $ | 179 | $ | 1 | 1 | $ | 367 | $ | 330 | $ | 37 | 11 | |||||||||||||||
% of Total revenues | 12 | % | 12 | % | 12 | % | 12 | % |
General and administrative expenses remained relatively flat during the three months ended June 30, 2015 and increased during the six months ended June 30, 2015 compared to the same periods in 2014. We have made and will continue to make installment payments to certain key employees of AirWatch subject to the achievement of specified future employment conditions. We recognized compensation expense of $41 and $81 during the three and six months ended June 30, 2015, respectively, relating to these installment payments compared to $41 and $60 during the three and six months ended June 30, 2014, respectively. Other cash-based employee-related expenses increased by $5 and $15 during the three and six months ended June 30, 2015, respectively, due to incremental organic growth in headcount. Additionally, the increase in equipment and depreciation costs of $9 and $15 for the three and six months ended June 30, 2015, respectively, contributed to the increase in general and administrative costs. These increases were partially offset by a decrease in litigation costs.
Realignment Charges
Three Months Ended | Six Months Ended | ||||||||||||||||||||||||||||
June 30, | June 30, | ||||||||||||||||||||||||||||
2015 | 2014 | $ Change | % Change | 2015 | 2014 | $ Change | % Change | ||||||||||||||||||||||
Realignment charges | $ | (2 | ) | $ | (1 | ) | $ | — | 30 | % | $ | 21 | $ | (1 | ) | $ | 22 | (1,685 | )% | ||||||||||
% of Total revenues | — | % | — | % | 1 | % | — | % |
During the three months ended March 31, 2015, we eliminated approximately 350 positions across all major functional groups and geographies to streamline our operations. As a result of these actions, $21 of realignment charges were recognized during the six months ended June 30, 2015, which consisted of severance-related costs. An immaterial credit was recognized during the three months ended June 30, 2015. As of June 30, 2015, $2 remained in accrued expenses and other on the condensed consolidated balance sheets and is expected to be paid during 2015.
Income Tax Provision
Our quarterly effective tax rate, including discrete items was 19.3% and 15.5% during the three and six months ended June 30, 2015, respectively. For the three and six months ended June 30, 2014, our effective tax rate, including discrete items was 17.5% and 18.1%, respectively. The change in our quarterly effective tax rate was primarily due to the shift in the mix of our earnings from our lower tax non-U.S. jurisdictions to the U.S. and the amount and timing of recognition of discrete items including a $19 benefit recognized in connection with the GSA settlement which occurred during the quarter.
Our rate of taxation in non-U.S. jurisdictions is lower than our U.S. tax rate. Our non-U.S. earnings are primarily earned by our subsidiaries organized in Ireland, and as such, our annual effective tax rate can be significantly impacted by the mix of our earnings in the U.S. and non-U.S. jurisdictions.
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 combined outstanding Class A and Class B common 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
27
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 non-U.S. jurisdictions where income is earned.
The EMC consolidated group is routinely under audit by the Internal Revenue Service (the “IRS”). All U.S. federal income tax matters have been concluded for years through 2008. The IRS commenced a federal income tax audit for the tax years 2009 and 2010 in the third quarter of 2012, and commenced an audit of tax year 2011 during the first quarter of 2015. The federal income tax audit for the tax years 2009 and 2010 is ongoing.
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 and shifts in the amount of earnings in the U.S. compared with other regions in the world as well as the expiration of statute of limitations and settlement of audits.
Our Relationship with EMC
As of June 30, 2015, EMC owned 43,025,000 shares of Class A common stock and all 300,000,000 shares of Class B common stock, representing 81.1% of our total outstanding shares of common stock and 97.4% of the combined voting power of our outstanding common stock.
The information provided below includes a summary of the transactions entered into with EMC and EMC’s consolidated subsidiaries (collectively “EMC”). EMC acquired VCE Company LLC (“VCE”) during the fourth quarter of 2014. Transactions with VCE from the date EMC acquired the controlling interest in VCE have been included in the tables below.
Transactions with EMC
We and EMC engaged in the following ongoing intercompany transactions, which resulted in revenues and receipts and unearned revenues for us:
• | 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 provide professional services to end users based upon 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 |
• | Pursuant to an ongoing distribution agreement, we act as the selling agent for certain products and services of Pivotal Software, Inc. (“Pivotal”), a subsidiary of EMC, in exchange for an agency fee. Under this agreement, cash is collected from the end user by us and remitted to Pivotal, net of the contractual fee. |
• | We provide various transition services to Pivotal. Support costs incurred by us are reimbursed to us and are recorded as a reduction to the costs incurred by us. |
Information about our revenues and receipts from such arrangements with EMC during the three and six months ended June 30, 2015 and 2014 and unearned revenues as of June 30, 2015 and December 31, 2014 consisted of the following:
Revenues and Receipts from EMC | Unearned Revenues from EMC | ||||||||||||||||||||||
Three Months Ended | Six Months Ended | ||||||||||||||||||||||
June 30, | June 30, | June 30, | December 31, | ||||||||||||||||||||
2015 | 2014 | 2015 | 2014 | 2015 | 2014 | ||||||||||||||||||
Reseller revenues | $ | 69 | $ | 43 | $ | 131 | $ | 89 | $ | 261 | $ | 290 | |||||||||||
Internal-use revenues | 6 | 5 | 9 | 13 | 14 | 18 | |||||||||||||||||
Professional services revenues | 24 | 18 | 48 | 40 | 3 | 9 | |||||||||||||||||
Agency fee revenues | 3 | 1 | 4 | 2 | — | — | |||||||||||||||||
Reimbursement for transition services | 1 | — | 2 | 2 | n/a | n/a |
28
We and EMC engaged in the following ongoing intercompany transactions, which resulted in costs to us:
• | We purchase and lease products and purchase services 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 charged to us with a mark-up intended to approximate costs that would have been incurred had we contracted for such services with an unrelated third party. These costs are included as expenses on our condensed consolidated statements of income and primarily include salaries, benefits, travel and rent expenses. EMC also incurs certain administrative costs on our behalf in the U.S. that are recorded as expenses on our condensed consolidated statements of income. |
Information about our costs from such arrangements with EMC for the three and six months ended June 30, 2015 and 2014 consisted of the following:
Three Months Ended | Six Months Ended | ||||||||||||||
June 30, | June 30, | ||||||||||||||
2015 | 2014 | 2015 | 2014 | ||||||||||||
Purchases and leases of products and purchases of services | $ | 12 | $ | 12 | $ | 31 | $ | 33 | |||||||
Collaborative technology project costs | 1 | 3 | 3 | 7 | |||||||||||
EMC subsidiary support and administrative costs | 26 | 35 | 54 | 76 |
We also purchase EMC products through EMC's channel partners. Purchases of EMC products through EMC's channel partners were $18 and $26 during the three and six months ended June 30, 2015, respectively, and $8 and $11 during the three and six months ended June 30, 2014, respectively.
Certain Stock-Based Compensation
Effective September 1, 2012, Pat Gelsinger was appointed Chief Executive Officer of VMware. Prior to joining VMware, Mr. Gelsinger was the President and Chief Operating Officer of EMC Information Infrastructure Products. Mr. Gelsinger retains certain of his EMC equity awards that were held as of September 1, 2012 and he continues to vest in such awards. Stock-based compensation related to Mr. Gelsinger’s EMC awards are being recognized on our condensed consolidated statements of income over the awards’ remaining requisite service periods.
Tax Sharing Agreement with EMC
Pursuant to a tax sharing agreement between us and EMC, payments are made between us and EMC related to our portion of federal income taxes on EMC's consolidated tax return as well as income taxes for states in which combined state income tax returns are filed. The following table summarizes these payments made between us and EMC during the three and six months ended June 30, 2015 and 2014:
Three Months Ended | Six Months Ended | ||||||||||||||
June 30, | June 30, | ||||||||||||||
2015 | 2014 | 2015 | 2014 | ||||||||||||
Payments from us to EMC | $ | 43 | $ | — | $ | 92 | $ | 20 |
Payments made by us to EMC result from us having a tax liability. The amount that we pay to EMC for our portion of federal income taxes on EMC’s consolidated tax return differs from the amount we would owe on a separate return basis, and the difference is presented as a component of stockholders’ equity. During the three and six months ended June 30, 2015 and 2014, 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.
29
Due To/From Related Parties, Net
As a result of the related-party transactions with EMC described above, amounts due to and from related parties, net as of June 30, 2015 and December 31, 2014 consisted of the following:
June 30, | December 31, | ||||||
2015 | 2014 | ||||||
Due to related parties | $ | (85 | ) | $ | (76 | ) | |
Due from related parties | 77 | 125 | |||||
Due (to) from related parties, net | $ | (8 | ) | $ | 49 | ||
Income tax due (to) from related parties | $ | 6 | $ | (40 | ) |
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 related parties is governed by the tax sharing agreement with EMC.
Notes Payable to EMC
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 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 six months ended June 30, 2015, $7 and $13, respectively, of interest expense was recognized. During the three and six months ended June 30, 2014, $7 and $12, respectively, of interest expense was recognized.
Liquidity and Capital Resources
At June 30, 2015 and 2014, we held cash, cash equivalents and short-term investments as follows:
June 30, | |||||||
2015 | 2014 | ||||||
Cash and cash equivalents | $ | 1,791 | $ | 2,054 | |||
Short-term investments | 5,205 | 4,583 | |||||
Total cash, cash equivalents and short-term investments | $ | 6,996 | $ | 6,637 |
As of June 30, 2015, we held a diversified portfolio of money market funds and fixed income securities totaling $6,209. Our fixed income securities are denominated in U.S. dollars and consist of highly liquid debt instruments of the U.S. Government and its agencies, 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 June 30, 2015, our total cash, cash equivalents and short-term investments were $6,996, of which $5,565 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 the 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. Should we require additional liquidity, we may seek to arrange debt financing or enter into credit facilities.
30
Our cash flows summarized for the three months ended June 30, 2015 and June 30, 2014 were as follows:
Six Months Ended | |||||||
June 30, | |||||||
2015 | 2014 | ||||||
Net cash provided by (used in): | |||||||
Operating activities | $ | 999 | $ | 1,159 | |||
Investing activities | (404 | ) | (2,060 | ) | |||
Financing activities | (875 | ) | 650 | ||||
Net decrease in cash and cash equivalents | $ | (280 | ) | $ | (251 | ) |
Operating Activities
Cash provided by operating activities decreased by $160 during the six months ended June 30, 2015 compared to the same period in 2014 mainly due to the change in unearned revenues as well as the change in income taxes payable as a result of tax payments made to EMC under the tax sharing agreement. Under the tax sharing agreement, we are obligated to pay EMC an amount equal to the tax expense generated by us that EMC may recognize in a given year on its consolidated tax return. During the six months ended June 30, 2015, we paid $92 to EMC under the tax sharing agreement compared to $20 during the six months ended June 30, 2014. Additionally, cash provided by operating activities during the six months ended June 30, 2015 also reflects payments for legal settlements, primarily $76 for the GSA settlement, and increases in payroll and operating expenses resulting from growth in headcount-related expenses driven by the AirWatch acquisition, including installment payments made to certain key employees of AirWatch. These decreases were partially offset by a change in accounts receivable as a result of an increase in cash collections.
The strengthening of the U.S. dollar that started in 2014 negatively impacted the U.S. dollar equivalent of our foreign currency collections. Even if the U.S. dollar stabilizes at its current level for the remainder of 2015, our cash flows from operations will remain negatively impacted during 2015. Also, we expect higher tax payments to impact our cash flows from operations during 2015. Additionally, cash flows from operations will be further impacted by installment payments of approximately $131 to certain key employees of AirWatch for the remainder of 2015.
Investing Activities
Cash used in investing activities is generally attributable to the purchase of available-for-sale securities, business acquisitions, and capital expenditures. Cash provided by investing activities is impacted by the sales and maturities of our available-for-sale securities.
Cash used in investing activities decreased during the six months ended June 30, 2015 compared to the same period in 2014 primarily as a result of our acquisition of AirWatch for $1,068 during the three months ended March 31, 2014.
Financing Activities
Net cash used in financing activities increased during the six months ended June 30, 2015 compared to the same period in 2014 primarily as a result of an increase in our repurchase of common stock. Additionally, during the six months ended June 30, 2014, we benefited from a cash inflow as a result of our notes payable exchange agreement with EMC. Refer to sections below for further information.
Notes Payable to EMC
As of June 30, 2015, $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.
Stock Repurchase Program
From time to time, we repurchase stock pursuant to authorized stock repurchase programs in open market transactions or privately negotiated transactions as permitted by securities laws and other legal requirements. We are not obligated to purchase
31
any shares under our stock repurchase programs. The timing of any repurchases and the actual number of shares repurchased depends on a variety of factors, including our 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 we believe additional purchases are not warranted. All shares repurchased under our stock repurchase programs are retired. On January 27, 2015, our Board of Directors authorized the repurchase of up to an additional one billion dollars of our Class A common stock through the end of 2017. During the six months ended June 30, 2015, we repurchased 10.1 million shares for an aggregate purchase price of $850. As of June 30, 2015, the cumulative authorized amount remaining for repurchase under an authorized program was $1,110. Refer to Note J to the condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for further discussion.
We are increasing our share buyback goal compared to recent years, and as a result, we expect to repurchase approximately $1,250 of our Class A common stock in 2015.
Critical Accounting Policies and Estimates
Our condensed consolidated financial statements are based upon the selection and application of accounting principles generally accepted in the United States of America (“GAAP”) 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 2014 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.
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements, including, without limitation, statements regarding expectations of, or our plans for: the IT industry transformation and our related strategic positioning; maintaining our industry leadership position; the benefits of our products and services to customers and partners; synergies across our SDDC and product areas; sales of licenses that include products beyond VMware vSphere hypervisor continuing to grow; newer products, suites and services solutions driving growth; SaaS revenues and revenues from our hybrid cloud offerings comprising an increasing percentage of our revenues; sales and related cash collections continuing to increase during the remainder of 2015, offset by installment payments to certain key employees of AirWatch as well as higher tax payments; hybrid cloud and SaaS revenues continuing to grow, but negatively impacting the associated license revenues growth rate during the remainder of 2015; the impact of foreign currency fluctuations on financial results, such as revenues, unearned revenues and anticipated and actual cash flows from operations; customer and partner demand for our products and services; variation in and increased total costs of services revenues; the effect on us of the resolutions of pending claims, legal proceedings and investigations, including the Department of Justice and General Services Administration settlement, and other matters described in Note I of the notes to the condensed consolidated financial statements; variation in, and impact of timing of product promotions on, the recognition of unearned revenues; increasing employee headcount and related impact on operating expense; the impact and timing of our realignment plan on our financial results; the impact of shifts in the mix of earnings between U.S. and non-U.S. tax jurisdictions on our estimated annual effective tax rate; the effects of potential developments in U.S. and non-U.S. tax jurisdictions as well as our business strategies on our effective tax rate; the impact of our relationship with EMC Corporation on taxes; the timing and completion of the IRS tax audit of the EMC consolidated group; indefinitely reinvesting our overseas earnings outside of the U.S. and not repatriating them to the U.S.; the sufficiency of our liquidity and capital reserves to fund our operations and business strategy; our ability to generate positive cash flows from operations; the impact of acquisitions, investments and stock repurchases on our overall cash needs; our ability to obtain liquidity, arrange debt financings or enter into credit facilities, should additional liquidity be required; and repurchasing $1,250 million dollars of Class A common stock in 2015.
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. All forward-looking statements in this document are made as of the date hereof, based on information available to us as of the date hereof. We assume no obligation to, and do not currently intend to, update these forward-looking statements.
32
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 three months ended June 30, 2015. See Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” of our 2014 Annual Report on Form 10-K for a detailed discussion of our market risk exposures.
33
ITEM 4. | CONTROLS AND PROCEDURES |
Evaluation of Disclosure Controls and Procedures
We carried out an evaluation required by the Securities Exchange Act of 1934, amended (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, 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 Controls Over Financial Reporting
There were no changes in our internal control over financial reporting during the most recent fiscal quarter ended June 30, 2015 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.
34
PART II
OTHER INFORMATION
ITEM 1. | LEGAL PROCEEDINGS |
Refer to 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 are 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. Specific risk factors related to our relationship with EMC are also included below under the heading “Risks Related to Our Relationship with EMC”.
Risks Related to Our Business
As the markets for our server and desktop virtualization products have 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 will decline.
Our products and services are based on server virtualization and related technologies that have primarily been used for virtualizing on-premise data center servers and form the foundation for private cloud computing. As the market for data center server 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 public, private and hybrid cloud-based computing, including our VMware vCloud Suite, VMware vSphere with Operations Management and VMware vRealize Suite offerings, our Horizon client virtualization offerings and our AirWatch mobile device management offerings. We have been increasing our focus on our hybrid cloud offerings, which include our vCloud Air service offerings, and we have been increasingly offering software as a service (“SaaS”) versions of our on-premises products, including our vRealize and Horizon Suite, and certain AirWatch offerings. These initiatives present new and difficult technological and compliance challenges, and significant investments will be required to develop or acquire solutions to address those challenges. Our success depends on our current and future customers perceiving technological and operational benefits and cost savings associated with the increasing adoption of our private and hybrid cloud solutions as well as our client virtualization and mobile device management solutions. As the market for our server virtualization products matures and the scale of our business increases, our rate of revenue growth will depend largely upon the success of our newer product and service offerings. In addition, to the extent that our newer private and hybrid cloud solutions, as well as our client and network virtualization and mobile device management 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 server virtualization products including our flagship VMware vSphere product line. Decreases in demand for our server virtualization products could adversely affect our results of operations and financial condition.
The large majority of our revenues have come from our server virtualization products. Although we continue to develop other applications for our virtualization technology such as our network virtualization solution, VMware NSX, end-user computing products and hybrid cloud services and expand our offerings into related areas such as our vRealize SDDC management products and vCloud product suites, we expect that our server virtualization products and related enhancements and upgrades will constitute a majority of our revenues for the foreseeable future. Declines and variability in demand for our server 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 server virtualization products on a timely basis, or at all; |
• | technological change that we are unable to address with our server virtualization and private cloud products or that changes the way enterprises utilize our products; and |
35
• | general economic conditions. |
Also, as more and more businesses achieve high levels of virtualization in their data centers, certain markets for our VMware vSphere product line have matured. Our sales of standalone VMware vSphere have declined as a portion of our overall business as we seek to transition our customers to product suites, our newer products and infrastructure-as-a-service offerings. If we fail to introduce compelling new features in future upgrades to our VMware vSphere product line, manage the transition to hybrid cloud platforms, 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, overall demand for products and services based on VMware vSphere may decline.
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 server virtualization products.
We face intense competition that could adversely affect our operating results.
The virtualization, cloud computing, end-user computing and software-defined data center industries are inter-related and rapidly evolving, and we face intense competition across all the markets for our products and services. Many of our current or potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, sales, marketing and other resources than we do.
We face competition from, among others:
Large, diversified enterprise software and hardware companies. These 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. In addition, these competitors could 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 and prospective 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.
Companies offering competing platforms based on open source technologies. Open source technologies for virtualization, containerization and cloud platforms such as Xen, KVM, Docker, Rocket and OpenStack provide significant pricing competition and enable competing vendors to leverage these open source technologies to compete directly with our SDDC initiative. Enterprises and service providers have shown significant interest in building their own clouds based on open source projects such as OpenStack, and other companies have indicated their intention to expand offerings of virtual management and cloud computing solutions as well. Additionally, a number of enterprise IT hardware vendors have released solutions based on OpenStack including HP, IBM and Cisco.
Other industry alliances. Many of our competitors have entered into or extended partnerships or other strategic relationships to offer more comprehensive virtualization and cloud computing solutions than they individually had offered. 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. These alliances may result in more compelling product and service offerings than we offer.
Providers of public cloud infrastructure offerings. We compete with infrastructure-as-a service offerings from various public cloud providers such as Amazon, Microsoft, IBM and Google both directly through our vCloud Air offerings and indirectly, as these cloud providers present alternatives to VMware’s on-premises server virtualization products.
Our partners and members of our developer and technology partner ecosystem. We face 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. Additionally, as formerly distinct sectors of enterprise IT such as software-based virtualization and hardware-based server, networking and storage solutions converge, we also increasingly compete with 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. For example, Nutanix recently announced a new hypervisor solution based on KVM.
36
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.
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. The expansion of our offerings to deliver the SDDC, address IT management and automation, add network and storage virtualization, 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 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 infrastructure-as-a-service (including software-defined networking and vCloud Air) offerings that enable customers to transform their IT systems requires a greater focus on marketing and selling product suites and more holistic solutions, rather than selling on a product-by-product basis. Consequently, we have developed, and must continue to develop, new strategies for marketing and selling our offerings, and the duration of sales cycles for our offerings has increased as our customers’ purchasing decisions become more complex and require additional levels of approval. |
• | 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, such as our VCloud Air hybrid cloud services and our SaaS offerings, 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. Moreover, as customers transition to our hybrid cloud and SaaS products and services, our revenue growth rate may be adversely impacted, during the period of transition as we will recognize less revenue up-front than we would otherwise recognize as part of a multi-year license arrangement. |
• | The success of our hybrid cloud offerings, including vCloud Air, and our SaaS offerings, will depend on the successful global implementation of the offering and building effective go-to-market strategies. We will need to build sales expertise and infrastructure to support the new offering that is capable of meeting customer requirements for security, reliability and regulatory compliance. Our vCloud Air hybrid cloud offering involves significant capital investment as well as technology risk, and may not be accepted by customers. Further, our newer hybrid cloud and SaaS offerings 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 vCloud Air hybrid cloud 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 |
37
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 hybrid cloud 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 virtualized end-user computing industry has continued to expand. Other companies are entering, and are developing competing standards for, the end-user computing space, such as Microsoft, Amazon and Citrix, and such companies are likely to introduce their own initiatives that may compete with or not be compatible with our 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. |
• | The cloud computing industry is in early stages of expansion. Other companies are entering, and are developing competing standards for the cloud computing space, such as Microsoft, IBM, Cisco, Google and Amazon, as well as numerous vendor offerings based on the OpenStack project. These companies are likely to introduce their own initiatives that may compete with or not be compatible with our cloud initiatives, which could potentially 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 cloud computing and SaaS, 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, because competitive product and service offerings in these sectors have gained 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 continuing to do 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. |
• | In connection with some of our product initiatives, including our hybrid cloud and mobile services, we expect that our customers may increasingly use our services to store and process personal information and other regulated data, increasing our potential exposure to cybersecurity breaches and data loss. |
• | As we continue to develop and expand our hybrid cloud and SaaS offerings, we will need to continue to evolve our processes to meet a number of regulatory, intellectual property and contractual and service compliance challenges as we seek to transform significant portions of our business from a products- to a services-based organization and as our customers increasingly utilize our services to house their data and rely upon our services for their own continuous operations. These challenges include compliance with licenses for open source and third party software embedded in our hybrid cloud and SaaS offerings, maintaining compliance with export control and privacy regulations, protecting our services from external threats, maintaining the continuous service levels and data security expected by our customers, preventing the inappropriate use of our services and adapting our go-to-market efforts to clarify the increasing complexity in our product and service offerings for our customers. |
• | 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 hybrid cloud and SaaS offerings rely 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 hybrid cloud offerings, adversely impact our plans to expand the vCloud Air and SaaS services and damage our reputation.
Our hybrid cloud and SaaS 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 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
38
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 hybrid cloud 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 agreements (“EAs”) that customers will commit to, reducing the level of our non-EA 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 revenues 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 to the degree that the economic recovery is anemic or not sustained, they may be better positioned to continue investment in competitive technologies.
Our revenues, unearned revenues, cash flows from operating activities and financial results may be adversely impacted by fluctuation of foreign currency exchange rates. Although foreign currency hedges can offset some of the risk related to foreign currency fluctuations, we will continue to experience foreign currency gains and losses in certain instances where it is not possible or cost effective to hedge our foreign currency exposures.
Our revenues, unearned revenues and cash flows from operating activities may be adversely impacted as a result of fluctuations in the exchange rates between the U.S. dollar and foreign currencies. We invoice and collect in certain non-U.S. dollar denominated currencies, thereby conducting a portion of our transactions in currencies other than the U.S. dollar. Although this practice may alleviate credit risk from our distributors during periods when the U.S. dollar strengthens, it shifts the risk of currency fluctuations to us and may negatively impact our revenues, unearned revenues, anticipated cash flows and financial results due to fluctuations in foreign currency exchange rates, particularly the euro, the British pound, the Japanese yen, the Australian dollar and the Chinese renminbi relative to the U.S. dollar. While variability in operating margin may be reduced due to invoicing in certain of the local currencies in which we also recognize expenses, increased exposure to foreign currency fluctuations will introduce additional risk for variability in revenue-related components of our consolidated financial statements and in our cash provided by operating activities. During the first six months of 2015 and fiscal year 2014 approximately 28% and 30%, respectively, of our sales were invoiced and collected in certain non-U.S. dollar denominated currencies.
We enter into foreign currency forward contracts to hedge a portion of our net outstanding monetary assets and liabilities against movements in certain foreign exchange rates. Although we expect the gains and losses on our foreign currency forward contracts to generally offset the majority of the gains and losses associated with the underlying foreign-currency denominated assets and liabilities that we hedge, our hedging transactions may not yield the results we expect. Additionally, we expect to continue to experience foreign currency gains and losses in certain instances where it is not possible or cost effective to hedge our foreign currency exposures. For example, we experienced a measurable negative impact to our revenues, unearned revenues as well as cash flows from operating activities in the fourth quarter of 2014 and the first half of 2015 due to exchange rate fluctuations and we expect a further negative impact throughout 2015 even if currency exchange rates stabilize at their current levels. The further weakening of foreign currency exchange rates against the U.S. dollar would likely result in additional adverse impact on our revenues, unearned revenues and cash flows from operating activities.
39
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 has proven to be a disruptive technology that is altering 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 last two weeks 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 (which have been increasing in length) 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; |
40
• | 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; |
• | seasonal factors such as the end of fiscal period budget expenditures by our customers and the timing of holiday and vacation periods; |
• | renewal rates and the amounts of the renewals for EAs as original EA 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; |
• | our ability to accurately predict the degree to which customers will elect to purchase our subscription-based offerings in place of licenses to our on-premises offerings; and |
• | the recoverability of benefits from goodwill and acquired intangible assets, and the potential impairment of these assets. |
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 and SaaS businesses expand 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 and SaaS offerings. Similarly, we rely upon distributors, resellers, system vendors and systems integrators to sell our products and services 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 and SaaS offerings, thereby damaging the reputation and perceived reliability and security of our products and |
41
services and potentially making the data systems of our customers vulnerable to further data loss and cyber incidents; and
• | personally identifiable or confidential data of our customers, employees and business partners could be stolen or lost. |
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.
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 50% and 53%, respectively, of our total revenues during the six months ended June 30, 2015 and 2014. 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 European institutions. Our international operations subject us to a variety of risks, including:
• | the difficulty of managing and staffing international offices and the increased travel, infrastructure and legal compliance costs associated with multiple international locations; |
• | increased exposure to foreign currency exchange rate risk; |
• | difficulties in enforcing contracts and collecting accounts receivable, and longer payment cycles, especially in emerging markets; |
• | difficulties in delivering support, training and documentation in certain foreign markets; |
• | tariffs and trade barriers and other regulatory or contractual limitations on our ability to sell or develop our products and services in certain foreign markets; |
• | economic or political instability and security concerns in countries that are important to our international sales and operations; |
• | macroeconomic disruptions, such as monetary and credit crises, that can threaten the stability of local and regional financial institutions and decrease the value of our international investments; |
• | the overlap of different tax structures or changes in international tax laws; |
• | reduced protection for intellectual property rights, including reduced protection from software piracy, in some countries; |
• | difficulties in transferring funds from certain countries; and |
• | difficulties in maintaining appropriate controls relating to revenue recognition practices. |
For example, the Chinese government is working to implement new network security standards that will require IT systems being sold into certain key sectors to be certified as “secure and controllable”. As part of that effort, in December 2014, standards were implemented in the banking sector requiring IT companies selling to Chinese banks to submit their software and other technology to intrusive security testing, include indigenous Chinese intellectual property and encryption technology in their software and disclose source code and other proprietary information to the Chinese government. Implementation of these standards was subsequently suspended in light of concerns communicated by banks and other parties. However, the authorities have indicated that revised standards may be announced in the future. If we are not able to, or choose not to, comply with any such future banking standards and other standards the Chinese government might implement in the future to cover other market sectors within China, our business in China may suffer.
Additionally, if we fail to comply with legal and regulatory requirements covering the foreign activities of U.S. corporations, such as export control requirements and the Foreign Corrupt Practices Act, as well as with local regulatory requirements in non-U.S. jurisdictions, we may be exposed to significant fines and penalties and reputational harm. These risks will increase as we expand our operations to locations with a higher incidence of corruption and fraudulent business practices. Our success will depend, in large part, on our ability to anticipate and effectively manage these and other risks associated with our international operations. We expect a significant portion of our growth to occur in foreign countries, which can add to the
42
difficulties in maintaining adequate management and compliance systems and internal controls over financial reporting, and increase challenges in managing an organization operating in various countries.
In addition, potential fallout from recent disclosures related to the U.S. Internet and communications surveillance could also make foreign customers reluctant to purchase cloud computing products and services from U.S.-based companies and impair our growth rate in foreign markets.
Our failure to manage any of these risks successfully could negatively affect our reputation, limit our growth, harm our operations and reduce our international sales.
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, at a dollar value at least equal to the original agreement, 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 21% of our total revenues during both the six months ended June 30, 2015 and fiscal year ended December 31, 2014. Our future plans include significant 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 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. The growing complexity and variety of our product and service offerings can also increase sales cycles. These factors can have a particular impact on the timing and length of our EA 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 EAs.
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 two weeks 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; |
• | 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. |
43
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 and increasingly offer SaaS versions of our products, such as our vRealize, Horizon and AirWatch SaaS offerings, 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; |
• | 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; |
44
• | 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, including the industry-wide transition to cloud-based computing, our cash flows and results of operations could be negatively impacted. For example, as 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 revenues from subscriptions are recognized for our services over the term of the subscription, downturns or upturns in sales may not be immediately reflected in our results.
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.
Failure to effectively manage our product and service lifecycles could materially adversely affect our business, financial condition, operating results and cash flow.
As part of the natural lifecycle of our products and services, we periodically inform customers that products or services will be reaching their end of life or end of availability and will no longer be supported or receive updates and security patches. To the extent these products or services remain subject to a service contract with the customer, we offer to transition the customer to alternative products or services. Failure to effectively manage our product and service lifecycles could lead to customer dissatisfaction and contractual liabilities, which could materially adversely affect our business, financial condition, operating results and cash flow.
Our success depends on the interoperability of our products and services with those of other companies.
The success of our products 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. To the extent that hardware, software and cloud hosting vendors perceive that their products and services compete with ours or those of our controlling stockholder, EMC Corporation (“EMC”), they may have an incentive to withhold their cooperation, decline to share access or sell to us their proprietary APIs, protocols or formats, or engage in practices to actively limit the functionality, compatibility
45
and certification of our products. In addition, vendors may fail to certify or support or continue to certify or support our products for their systems. If any of the foregoing occurs, our product development efforts may be delayed or foreclosed and it may be difficult and more costly for us to achieve functionality and service levels that would make our services attractive to end users, any of which could negatively impact our business and operating results.
We rely on distributors, resellers, system vendors and systems integrators to sell our products and services, and our failure to effectively develop, manage or prevent disruptions to our distribution channels and the processes and procedures that support them could cause a reduction in the number of end users of our products and services.
Our future success is highly dependent upon maintaining and increasing the number of our relationships with distributors, resellers, system vendors and systems integrators. Because we rely on distributors, resellers, system vendors and systems integrators, we may have little or no contact with the ultimate users of our products and services, thereby making it more difficult for us to establish brand awareness, ensure proper delivery and installation of our products and services, service ongoing customer requirements, estimate end-user demand and respond to evolving customer needs.
Recruiting and retaining qualified channel partners and training them in the use of our technology and product offerings requires significant time and resources. In order to develop and expand our distribution channel, we must continue to expand and improve our processes and procedures that support our channel, including our investment in systems and training, and those processes and procedures may become increasingly complex and difficult to manage. The time and expense required for sales and marketing organizations of our channel partners to become familiar with our product and service offerings, including our new product and service developments, may make it more difficult to introduce those products and services to end users and delay end-user adoption of our product and service offerings.
We generally do not have long-term contracts or minimum purchase commitments with our distributors, resellers, system vendors and systems integrators, and our contracts with these channel partners do not prohibit them from offering products or services that compete with ours. Our competitors may be effective in providing incentives to existing and potential channel partners to favor products and services of our competitors or to prevent or reduce sales of our products and services. Certain system vendors now offer competing virtualization products pre-installed on their server products and services. Additionally, our competitors could attempt to require key distributors to enter into exclusivity arrangements with them or otherwise apply their pricing or marketing leverage to discourage distrib