<PAGE> 1
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 July 31, 1999
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: 000-25601
------------------------------
BROCADE COMMUNICATIONS SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
DELAWARE 77-0409517
(State or other jurisdiction (I.R.S. employer
of incorporation or organization) identification no.)
------------------------------
1901 GUADALUPE PARKWAY
SAN JOSE, CA 95131
(408) 542-1500
(Address, including zip code, of Registrant's
principal executive offices and 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 [ ]
The number of shares outstanding of the Registrant's Common Stock on August 31,
1999 was 26,676,332 shares.
Page 1 of 24 pages.
<PAGE> 2
BROCADE COMMUNICATIONS SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED JULY 31, 1999
INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Balance Sheets as of July 31, 1999 and October 31, 1998 3
Condensed Statements of Operations for the Three Months and Nine Months
Ended July 31, 1999 and 1998 4
Condensed Statements of Cash Flows for the Nine Months
Ended July 31, 1999 and 1998 5
Notes to Condensed Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations 10
Item 3. Quantitative and Qualitative Disclosures About Market Risks 21
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 22
Item 2. Changes in Securities and Use of Proceeds 22
Item 3. Defaults Upon Senior Securities 22
Item 4. Submission of Matters to a Vote of Security Holders 22
Item 5. Other Information 22
Item 6. Exhibits and Reports on Form 8-K 23
SIGNATURES 24
</TABLE>
======================================================================
This Form 10-Q contains forward-looking statements (as defined in the
Private Securities Litigation Reform Act of 1995), including but not
limited to statements regarding Brocade's expectations, hopes or
intentions regarding the future. Actual results and trends could differ
materially from those discussed in the forward-looking statements. In
addition, past trends should not be perceived as indicators of future
performance. Among the factors that could cause actual results to differ
from the forward-looking statements are those detailed elsewhere in this
Report in Management's Discussion and Analysis of Financial Condition
and Results of Operations and in Brocade's Securities and Exchange
Commission reports.
======================================================================
Page 2 of 24 pages.
<PAGE> 3
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
BROCADE COMMUNICATIONS SYSTEMS, INC.
CONDENSED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
July 31, October 31,
1999 1998
-------- -----------
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 10,360 $ 10,420
Short-term investments 65,976 -
-------- --------
Total cash, cash equivalents and short-term investments 76,336 10,420
Accounts receivable, net 11,269 3,430
Inventories 2,628 1,744
Prepaid expenses and other 1,623 220
-------- --------
Total current assets 91,856 15,814
Property and equipment, net 5,454 5,323
Other assets 115 164
-------- --------
Total assets $ 97,425 $ 21,301
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable $ 6,950 $ 3,247
Accrued liabilities 6,617 3,061
Deferred revenue 6,591 543
Current portion of capital lease obligations 540 784
Current portion of debt - 1,231
Borrowings under line of credit - 1,672
-------- --------
Total current liabilities 20,698 10,538
-------- --------
Long-term liabilities:
Long-term portion of capital lease obligations 121 478
Long-term portion of debt - 1,731
Redeemable convertible preferred stock - 35,261
Warrants to purchase redeemable convertible preferred stock - 648
-------- --------
Total long-term liabilities 121 38,118
-------- --------
Stockholders' equity (deficit):
Common stock, $.001 par value, 50,000 shares authorized:
Issued and outstanding: 26,490 and 5,195 at July 31, 1999
and October 31, 1998, respectively 26 5
Additional paid-in capital 116,676 2,220
Warrants 60 -
Deferred stock compensation (3,720) (300)
Notes receivable from stockholders (6,530) (450)
Accumulated deficit (29,906) (28,830)
-------- --------
Total stockholders' equity (deficit) 76,606 (27,355)
-------- --------
Total liabilities and stockholders' equity $ 97,425 $ 21,301
======== ========
The accompanying notes are integral part of these condensed financial statements.
</TABLE>
Page 3 of 24 pages.
<PAGE> 4
BROCADE COMMUNICATIONS SYSTEMS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
------------------- -------------------
July 31, July 31, July 31, July 31,
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net revenues $20,051 $ 4,569 $38,598 $ 18,839
Cost of revenues 9,921 4,351 18,679 12,720
------- ------- ------- --------
Gross margin 10,130 218 19,919 6,119
------- ------- ------- --------
Operating expenses:
Research and development 4,148 5,016 9,782 11,311
Sales and marketing 3,691 1,444 7,777 3,820
General and administrative 1,000 1,979 2,415 3,242
Amortization of deferred stock
compensation 280 - 1,657 -
------- ------- ------- --------
Total operating expenses 9,119 8,439 21,631 18,373
------- ------- ------- --------
Income (loss) from operations 1,011 (8,221) (1,712) (12,254)
Interest income, net 633 114 669 277
------- ------- ------- --------
Income (loss) before income taxes 1,644 (8,107) (1,043) (11,977)
Provision for income taxes 33 - 33 -
------- ------- ------- --------
Net income (loss) $ 1,611 $(8,107) $(1,076) $(11,977)
======= ======= ======= ========
Basic net income (loss) per share $ 0.09 $ (2.45) $ (0.12) $ (3.98)
======= ======= ======= ========
Diluted net income (loss) per share $ 0.06 $ (2.45) $ (0.12) $ (3.98)
======= ======= ======= ========
Shares used in the calculation
of basic net income (loss) per share 17,836 3,308 9,117 3,007
======= ======= ======= ========
Shares used in the calculation of diluted net
income (loss) per share 27,507 3,308 9,117 3,007
======= ======= ======= ========
Pro forma diluted net income (loss) per share $ 0.06 $ (0.46) $ (0.05) $ (0.70)
======= ======= ======= ========
Shares used in the calculation of pro forma
diluted net income (loss) per share 27,507 17,636 20,312 17,189
======= ======= ======= ========
The accompanying notes are integral part of these condensed financial statements.
</TABLE>
Page 4 of 24 pages.
<PAGE> 5
BROCADE COMMUNICATIONS SYSTEMS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
JULY 31,
--------------------
1999 1998
-------- -------
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (1,076) $(11,977)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization 1,476 1,741
Loss on disposition of equipment 248 -
Provision for doubtful accounts receivable 251 -
Noncash compensation expense 1,738 1,199
Changes in assets and liabilities:
Accounts receivable (8,837) 940
Inventories (884) (3,852)
Prepaid expenses and other (607) 96
Accounts payable and accrued liabilities 7,259 1,756
Deferred revenue 6,048 -
-------- -------
Net cash provided by (used in) operating activities 5,616 (10,097)
-------- --------
Cash flows from investing activities:
Proceeds from (purchases) maturities of short-term investments (65,976) 15,920
Purchases of property and equipment (1,855) (3,483)
-------- ---------
Net cash (used in) provided by investing activities (67,831) 12,437
-------- ---------
Cash flows from financing activities:
Proceeds from the issuance of common stock, net 65,878 30
Proceeds from the issuance of preferred stock, net 1,512 4,902
Line of credit borrowings -- 1,000
Line of credit repayments (1,672) (328)
Payments on capital lease obligations (601) (501)
Proceeds from notes payable 247 1,909
Repayments of notes payable (3,209) (435)
-------- ---------
Net cash provided by financing activities 62,155 6,577
-------- ---------
Net (decrease) increase in cash and cash equivalents (60) 8,917
Cash and cash equivalents at beginning of period 10,420 2,552
-------- ---------
Cash and cash equivalents at end of period $ 10,360 $ 11,469
======== =========
The accompanying notes are an integral part of these condensed consolidated financial statements
</TABLE>
Page 5 of 24 pages.
<PAGE> 6
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(Information for the three and nine months ended
July 31, 1999 and 1998 is unaudited)
1. BASIS OF PRESENTATION
The condensed financial statements included herein have been prepared by
Brocade Communications Systems, Inc. ("Brocade"), without audit, pursuant to the
rules and regulations of the Securities and Exchange Commission. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted pursuant to such rules and regulations. In the opinion of
management, the disclosures are adequate to make the information not misleading.
The condensed balance sheet as of October 31, 1998 has been derived from the
audited financial statements as of that date, but does not include all
disclosures required by generally accepted accounting principles. These
financial statements and notes should be read in conjunction with the audited
financial statements and notes thereto, included in Brocade's Registration
Statement on Form S-1 filed with the Securities and Exchange Commission.
The unaudited condensed financial statements reflect all adjustments,
consisting only of normal recurring adjustments, necessary for a fair
presentation of financial position, results of operations and cash flows for the
periods indicated. The results of operations for the three and nine months ended
July 31, 1999 are not necessarily indicative of the results that may be expected
for future quarters or the year ending October 31, 1999.
2. NET INCOME (LOSS) PER SHARE
Basic and diluted net income (loss) per share are presented in conformity
with Financial Accounting Standards No. 128, "Earning Per Share," ("SFAS No.
128") for all periods presented. Pursuant to the Securities and Exchange
Commission Staff Accounting Bulletin No. 98, common stock and convertible
preferred stock issued or granted for nominal consideration prior to the
anticipated effective date of an initial public offering must be included in the
calculation of basic and diluted net income (loss) per share as if such stock
had been outstanding for all periods presented. To date, Brocade has not had any
issuances or grants for nominal consideration.
In accordance with SFAS No. 128, basic net income (loss) per share has been
computed using the weighted-average number of shares of common stock outstanding
during the period, less shares subject to repurchase. Basic and diluted pro
forma net income (loss) per share, have been computed as described above and
also give effect, under Securities and Exchange Commission guidance, to the
conversion of the convertible preferred stock (using the if-converted method)
from the original date of issuance.
The following table presents the calculation of basic and diluted and pro
forma basic and diluted net income (loss) per common share (in thousands, except
per share data) (unaudited):
Page 6 of 24 pages.
<PAGE> 7
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED)
(Information for the three and nine months ended
July 31, 1999 and 1998 is unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
------------------- -----------------
<S> <C> <C> <C> <C>
1999 1998 1999 1998
------ ------ ------ --------
Basic and diluted net income (loss) per share:
Net income (loss) $ 1,611 $ (8,107) $ (1,076) $(11,977)
======== ======== ======== ========
Weighted-average shares of common stock outstanding 20,210 5,257 11,287 5,149
Less: weighted-average shares subject to repurchase (2,374) (1,949) (2,170) (2,142)
-------- -------- -------- --------
Weighted-average shares used in computing basic
net income (loss) per share 17,836 3,308 9,117 3,007
Dilutive effect of common share equivalents 9,671 -- -- --
-------- -------- -------- --------
Weighted-average shares used in computing diluted
net income (loss) per share 27,507 3,308 9,117 3,007
======== ======== ======== ========
Basic net income (loss) per share $ 0.09 $ (2.45) $ (0.12) $ (3.98)
======== ======== ======== ========
Diluted net income (loss) per share $ 0.06 $ (2.45) $ (0.12) $ (3.98)
======== ======== ======== ========
Pro forma basic and diluted net income (loss) per share:
Net income (loss) $ 1,611 $ (8,107) $ (1,076) $(11,977)
======== ======== ======== ========
Weighted-average shares of common stock outstanding 20,210 5,257 11,287 5,149
Less: weighted-average shares subject to repurchase (2,374) (1,949) (2,170) (2,142)
-------- -------- -------- --------
Weighted-average shares used in computing basic
net income (loss) per share 17,836 3,308 9,117 3,007
Pro forma adjustment to reflect weighted effect of
assumed conversion of convertible preferred stock 4,862 14,328 11,195 14,182
-------- -------- -------- --------
Weighted-average shares used in computing pro forma
basic net income (loss) per share 22,698 17,636 20,312 17,189
Dilutive effect of common share equivalents 4,809 -- -- --
-------- -------- -------- --------
Weighted-average shares used in computing pro forma
diluted net income (loss) per share 27,507 17,636 20,312 17,189
======== ======== ======== ========
Pro forma basic net income (loss) per share $ 0.07 $ (0.46) $ (0.05) $ (0.70)
======== ======== ======== ========
Pro forma diluted net income (loss) per share $ 0.06 $ (0.46) $ (0.05) $ (0.70)
======== ======== ======== ========
</TABLE>
3. CASH, CASH EQUIVALENTS, AND SHORT-TERM INVESTMENTS
All highly liquid investment securities with original maturities of three
months or less are considered cash equivalents, while investment securities with
original maturities of more than three months but less than one year are
considered short-term investments.
As of July 31, 1999 all short-term investments are classified as
available-for-sale and the fair market value of such investments approximated
cost. As such, unrealized holding gains and losses were insignificant.
Page 7 of 24 pages.
<PAGE> 8
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED)
(Information for the three and nine months ended
July 31, 1999 and 1998 is unaudited)
4. COMPREHENSIVE INCOME (LOSS)
Brocade adopted Statement of Financial Accounting Standards No. 130,
"Reporting Comprehensive Income", ("SFAS No. 130") on November 1, 1997. SFAS No.
130 defines comprehensive income as the changes in equity of an enterprise
except those resulting from stockholder transactions. Accordingly, comprehensive
income (loss) includes certain changes in equity that are excluded from net
income (loss). Specifically, SFAS No. 130 requires unrealized holding gains and
losses on available-for-sale securities to be included in accumulated other
comprehensive income (loss). Unrealized holding gains (losses) for all periods
presented are not significant and accordingly, comprehensive income (loss) for
all periods presented approximated net income (loss).
5. INITIAL PUBLIC OFFERING
On May 28, 1999, Brocade completed its initial public offering of 3,737,500
shares of common stock (including the exercise of the underwriters
over-allotment option) and realized net proceeds of $65.1 million. Concurrent
with the closing of the initial public offering, 9,534,005 shares of convertible
preferred stock were converted into 14,625,255 shares of common stock.
6. INVENTORIES
Inventories are stated at the lower of cost or market, on a first in, first
out method and are comprised substantially of finished goods as of July 31,
1999.
7. COMMON STOCK
Effective May 14, 1999, Brocade was reincorporated in the State of Delaware.
In connection with the re-incorporation, Brocade is authorized to issue
50,000,000 shares of common stock, $.001 par value and 5,000,000 shares of
undesignated preferred stock, $.001 par value.
In April 1999, Brocade's stockholders approved the following:
a) the adoption of Brocade's 1999 Employee Stock Purchase Plan (the "Purchase
Plan"). A total of 200,000 shares of common stock have been reserved for
issuance under the Purchase Plan. The Purchase Plan permits eligible
employees to purchase shares of common stock through payroll deductions at
85% of the fair market value of the common stock, as defined in the Purchase
Plan.
b) the adoption of Brocade's 1999 Stock Plan (the "1999 Plan"), the combination
of Brocade's 1995 Equity Incentive Plan, 1998 Equity Incentive Plan and 1998
Executive Equity Incentive Plan into the 1999 Plan, and the addition of
300,000 newly reserved shares of common stock thereunder. The 1999 Plan
provides for the grant of incentive on nonqualified stock options to
employees.
c) the adoption of Brocade's 1999 Director Option Plan (the "Director Plan").
The Director Plan provides for the grant of common stock options to
non-employee directors. A total of 200,000 shares of common stock have been
reserved for issuance under the Director Plan.
Page 8 of 24 pages.
<PAGE> 9
BROCADE COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED)
(Information for the three and nine months ended
July 31, 1999 and 1998 is unaudited)
8. BUSINESS SEGMENTS
Brocade is organized and operates as one business segment, the design,
development, manufacture, marketing and selling of switching solutions for
Storage Area Networks ("SANs").
For the nine months ended July 31 1999, revenues from seven customers
accounted for 88% of total net revenues. The level of sales to any customer may
vary from quarter to quarter however, we expect that significant customer
concentration will continue for the foreseeable future. Loss of any one of these
customers could have a material adverse impact on Brocade's financial condition
or results of operations.
9. RECENT ACCOUNTING PRONOUNCEMENTS
In December 1998, the AICPA issued SOP No. 98-9, "Modification of SOP 97-2,
Software Revenue Recognition, With Respect to Certain Transactions" ("SOP No.
98-9"). SOP No. 98-9 amends SOP No. 97-2 and SOP No. 98-4 by extending the
deferral of the application of certain provisions of SOP No. 97-2 amended by SOP
No. 98-4 through fiscal years beginning on or before March 15, 1999. All other
provisions of SOP No. 98-9 are effective for transactions entered into in fiscal
years beginning after March 15, 1999. Brocade has not had significant software
sales to date and management does not expect the adoption of SOP No. 98-9 to
have a significant impact on Brocade's financial position or results of
operations.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"),
which supercedes and amends a number of existing standards and is required to be
adopted in fiscal years beginning after June 15, 1999. Because Brocade currently
holds no derivative financial instruments and does not currently engage in
hedging activities, the adoption of SFAS No. 133 is not expected to have a
material impact on Brocade's financial condition or results of operations.
Page 9 of 24 pages.
<PAGE> 10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following information should be read in conjunction with the condensed
interim financial statements and the notes thereto included in Item 1 of this
Quarterly Report and with Management's Discussion and Analysis of Financial
Condition and Results of Operations contained in Brocade's Prospectus filed with
the Securities and Exchange Commission on May 24, 1999.
FORWARD-LOOKING INFORMATION IS SUBJECT TO RISK AND UNCERTAINTY
This Quarterly Report contains "forward-looking" statements that relate to
future events or future financial performance. While we believe that the
expectations reflected in the forward-looking statements are reasonable, we
cannot guarantee future results, levels of activity, performance or
achievements. Brocade's actual results could differ materially from those
anticipated and discussed herein. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed below under "Risk
Factors", and to other risk factors detailed in Brocade's Prospectus filed with
the Securities and Exchange Commission. All forward-looking statements included
in this document are based on information available to Brocade on the date
hereof. Brocade assumes no obligation to update any such forward-looking
statements.
OVERVIEW
Brocade is a leading provider of switching solutions for Storage Area
Networks ("SANs"). We sell our SAN switching solutions through leading storage
systems and server original equipment manufacturers, including Compaq Computer,
Data General Corporation, Dell Computer, IBM, McData Corporation, NEC, Sequent
Computer Systems, SGI and StorageTek. These original equipment manufacturers and
our system integrator customers combine our switching solutions with other
system elements and services for enterprise data centers.
From our inception in August 1995 through April 1997, our operating
activities related primarily to developing our research and development
capabilities, building an ASIC design infrastructure, developing, prototyping
and testing our SilkWorm products, staffing our administrative, marketing and
sales organizations and establishing relationships with original equipment
manufacturers. In the third quarter of fiscal year 1997, we commenced volume
shipments of our SilkWorm switch. Since our inception we have incurred
significant losses and as of July 31, 1999, we had an accumulated deficit of
$29.9 million.
Our revenue is derived primarily from sales of our SilkWorm family of
products. We currently sell substantially all of our products through several
major original equipment manufacturers. For the nine months ended July 31 1999,
revenues from seven customers accounted for 88% of total net revenues. The level
of sales to any customer may vary from quarter to quarter however, we expect
that significant customer concentration will continue for the foreseeable
future. Loss of any one of these customers could have a material adverse impact
on Brocade's financial condition or results of operations.
As noted above, we currently sell a large percentage of our products through
several major original equipment manufacturers. The initial evaluation and
product qualification cycle with original equipment manufacturers typically
takes six to twelve months and includes technical evaluation, integration,
testing, product launch planning and execution. Our sales strategy also includes
recruiting system integrators with a Fortune 500 data center presence and the
technical resources to design, implement and support SANs. To date, our sales
have been primarily in the United States. However, we have launched sales and
marketing efforts in Europe and have a distributor in Japan.
Revenue is recognized when products are shipped to customers, unless at the
time of shipment product returns cannot be estimated or significant support
services are required to successfully launch the customer's products. In the
three months ended July 31, 1999, several customers were implementing SANs,
including our product, for their end-users for the first time. In addition,
several customers were implementing new versions of our product for the first
time. Given the recent adoption of the SAN model and Brocade's solution, and
because substantial Brocade services are required to support the customer's
product launch, the revenue related to shipments to these customers has been
deferred pending successful customer product launches. The deferred revenue will
be recognized on a customer by customer basis as they successfully complete
their product launches. Similarly, revenue is deferred for new products that
have not completed the beta test phase. As of July 31, 1999, $6.6 million of
revenue was deferred. This deferred revenue consisted principally of revenue
associated with shipments of our new SilkWorm 2000 family of products that were
made in the three months ended July 31, 1999. It is expected that a portion of
this deferred revenue will be recognized in the fourth quarter of fiscal year
1999 and in the first half of fiscal year 2000. We believe that, as the SAN
market matures, this revenue deferral method for new customers may not be
necessary. We do not provide our customers with product return programs. We do
provide a reserve for warranty returns based on warranty history.
Our average unit selling prices in the three and nine month periods ended
July 31, 1999, have decreased from the same periods in the previous fiscal year.
We expect continued declines in our average unit selling price due to
anticipated increases in per customer sales volume, the impact of competitive
pricing pressures, and the introduction of our new SilkWorm 2000 product.
However, in the near future, we do not anticipate that our gross margins will be
affected by declines in average unit selling prices, due to anticipated product
cost reductions.
Page 10 of 24 pages.
<PAGE> 11
In July 1998, we outsourced our manufacturing and the majority of our supply
chain management operations. Accordingly, a significant portion of our cost of
revenues consists of payments to our contract manufacturer, Solectron. We
conduct quality assurance, manufacturing engineering, documentation control and
repairs at our facility in San Jose, California.
Research and development expenses consist primarily of salaries and related
personnel expenses, fees paid to consultants and outside service providers,
prototyping expenses related to the design, development, testing and
enhancements of our ASICs and software, and the costs of computer support
services. We believe that continued investment in research and development is
critical to our strategic product and cost-reduction objectives. As a result, we
expect these expenses to increase in absolute dollars in the future.
Selling and marketing expenses consist primarily of salaries, commissions
and related expenses for personnel engaged in marketing, sales, and customer
engineering support functions, as well as costs associated with promotional and
travel expenses. We believe that continued investment in sales and marketing is
critical to our strategy to expand our relationships with leading original
equipment manufacturers, to expand our presence in the systems integrator
channel, and to maintaining our leadership position in the SAN market. As a
result, we expect these expenses to increase in absolute dollars in the future.
General and administrative expenses consist primarily of salaries and
related expenses for executive, finance and human resources personnel,
recruiting expenses, professional fees and other corporate expenses. We expect
general and administrative expenses to increase in absolute dollars as we add
personnel and incur additional costs related to the growth of our business.
In connection with the grant of certain stock options to employees, we
recorded deferred compensation of $5.1 million in the nine months ended July 31,
1999, representing the difference between the deemed value of our common stock
for accounting purposes and the option exercise price of these options at the
date of grant. Deferred compensation is presented as a reduction of
stockholder's equity and amortized ratably over the vesting period of the
applicable options. We amortized $280,000 and $1.7 million, respectively during
the three and nine months ended July 31, 1999. We will expense the balance
ratably over the remainder of the vesting period of the options.
RESULTS OF OPERATIONS
The following table sets forth, for the periods presented, the percentage of
net revenues represented by each line item in Brocade's condensed statements of
operations:
<TABLE>
<CAPTION>
PERCENTAGE OF PERCENTAGE OF
TOTAL REVENUE TOTAL REVENUE
------------------ -----------------
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
<S> <C> <C> <C> <C>
1999 1998 1999 1998
---- ---- ---- ----
Net revenues 100% 100% 100% 100%
Cost of revenues 49 95 48 68
---- ---- ---- ----
Gross margin 51 5 52 32
---- ---- ---- ----
Operating expenses:
Research and development 21 110 25 60
Sales and marketing 18 32 20 20
General and administrative 5 43 6 17
Amortization of deferred stock
compensation 1 - 4 -
---- ---- ---- ----
Total operating expenses 45 184 56 98
---- ---- ---- ----
Income (loss) from operations 5 (180) (4) (65)
Interest income, net 3 3 2 1
---- ---- ---- ----
Income (loss) before income taxes 8 (177) (3) (64)
Provision for income taxes - - - -
---- ---- ---- ----
Net income (loss) 8% (177)% (3)% (64)%
==== ==== ==== ====
</TABLE>
Page 11 of 24 pages.
<PAGE> 12
Net Revenues. Net revenues increased from $4.6 million for the third quarter
of fiscal year 1998 to $20.1 million for the third quarter of fiscal year 1999,
and from $18.8 million for the nine months ended July 31, 1998 to $38.6 million
for the nine months ended July 31, 1999. These increases were due primarily to
increased unit sales of our products through an increased customer base and
reflect the ramp-up of sales to significant original equipment manufacturer
customers. Net revenues for the nine months ended July 31, 1999 excluded $6.6
million in deferred revenue associated with shipments to new customers and
shipments of our new SilkWorm 2000 family of products.
For the nine months ended July 31 1999, revenues from seven customers
accounted for 88% of total net revenues. The level of sales to any customer may
vary from quarter to quarter however, we expect that significant customer
concentration will continue for the foreseeable future. Loss of any one of these
customers could have a material adverse impact on Brocade's financial condition
or results of operations.
Gross Margin. Gross margin as a percentage of net revenues increased from
4.8% for the third quarter of fiscal year 1998 to 50.5% for the third quarter of
fiscal year 1999, and from 32.5% for the nine months ended July 31, 1998 to
51.6% for the nine months ended July 31, 1999. These increases were due to lower
component and manufacturing costs, the allocation of fixed manufacturing costs
over a greater revenue base and a higher percentage of software revenue. In
addition, for the three and nine month periods of fiscal year 1998, our gross
margins were adversely affected by the write-off of obsolete inventory and the
write-off of certain inventory and equipment related to a change in contract
manufacturers.
Research and Development Expenses. Research and development expenses
decreased 17% from $5.0 million for the third quarter of fiscal year 1998 to
$4.1 million for the third quarter of fiscal year 1999. For the nine months
ended July 31, 1999, research and development expenses were $9.8 million, a 14%
decrease from $11.3 million for the nine months ended July 31, 1998. These
decreases were due primarily to the fact that for the three and nine months
ended July 31, 1998, research and development expenses reflect restructuring
charges of $0.7 million associated with the cancellation of development and
simulation projects.
Sales and Marketing Expenses. Sales and marketing expenses for the third
quarter of fiscal year 1999 increased 156% from the third quarter of fiscal year
1998, and 104% between the comparable nine-month periods. These increases were
due to an increase in direct selling costs associated with the increase in net
revenues and to the hiring of additional sales and marketing personnel.
General and Administrative Expenses. General and administrative expenses
decreased 50%, from $2.0 million for the third quarter of fiscal year 1998 to
$1.0 million for the third quarter of fiscal year 1999, and 26% between the
comparable nine-month periods. These decreases were due principally to the fact
that fiscal 1998 expenses were impacted by costs related to a fiscal year 1998
third quarter business restructuring, totaling $1.2 million. The decreases were
offset, in part, by increased costs associated with increased staffing and other
expenses necessary to manage and support our increased scale of operations.
Amortization of Deferred Compensation. In the first nine months of
fiscal year 1999, we recorded total deferred compensation of $5.1 million in
connection with stock option grants. We are amortizing this amount over the
vesting periods of the applicable options. Resulting amortization expense was
$0.3 million for the third quarter of fiscal year 1999 and $1.7 million for the
nine months ended July 31, 1999.
Interest Income, net. Interest income consisted primarily of interest
earnings on our cash, cash equivalents and short-term investments. Net interest
income increased to $0.6 million for the third quarter of fiscal year 1999 from
$0.1 million for the third quarter of fiscal year 1998, and to $0.7 million for
the nine months ended July 31, 1999 from $0.3 million for the nine months ended
July 31, 1998. These increases were due primarily from interest earned on the
funds associated with the closing of our initial public offering in May 1999.
LIQUIDITY AND CAPITAL RESOURCES
We have funded our operations to date primarily through the sale of
preferred stock, for aggregate proceeds of approximately $37 million, capital
equipment lease lines and bank debt. Additionally, in May 1999, Brocade
raised $65.1 million in its initial public offering.
Our principal source of liquidity as of July 31, 1999, consisted of
$76.3 million in cash, cash equivalents and short-term investments, and our bank
credit facility. The credit facility includes a revolving line of credit
providing borrowings up to the lesser of $4.0 million or 80% of eligible
accounts receivable and an equipment loan agreement providing for financing up
to $5.0 million. During the three months ended July 31, 1999 we paid off all
debt associated with our credit facility and accordingly as of July 31, 1999,
there were no amounts outstanding under the credit facility
Net cash provided by operating activities was $5.6 million for the nine
months ended July 31, 1999 compared to net cash used in operating activities of
$10.1 million for the nine months ended July 31, 1998. The change from period to
period was due primarily to a decrease in net loss and favorable changes in the
balances of operating assets and liabilities, most notably, deferred revenue.
Page 12 of 24 pages.
<PAGE> 13
Net cash used in investing activities for the nine months ended July 31,
1999 was $67.8 million compared to net cash provided by investing activities of
$12.4 million for the nine months ended July 31, 1998. The period to period
change was due mainly to purchases of short investments in the nine months ended
July 31, 1999, compared to net maturities and sales of short-term investments in
the nine months ended July 31, 1998.
Net cash provided by financing activities was $62.2 million and $6.6
million for the nine months ended July 31, 1999 and 1998, respectively. For the
nine months ended July 31, 1999, the primary source of cash generation from
financing activities was the sale of common stock in our initial public
offering. This was offset, in part, by repayments of borrowings under our credit
facility. For the nine months ended July 31, 1999, the primary source of cash
generation from financing activities was net borrowings under our credit
facility.
We believe that our existing cash, cash equivalents and short-term
investment balances, credit facility, and cash flow expected to be generated
from future operations, will be sufficient to meet our capital requirements at
least through the next twelve months, although we could be required, or could
elect, to seek additional funding prior to that time. Our future capital
requirements will depend on many factors, including the rate of revenue growth,
the timing and extent of spending to support product development efforts and
expansion of sales and marketing, the timing of introductions of new products
and enhancements to existing products, and market acceptance of our products.
There can be no assurances that additional equity or debt financing, if
required, will be available on acceptable terms or at all.
Year 2000 Compliance
Impact of the Year 2000 Computer Problem. The year 2000 computer problem
refers to the potential for system and processing failures of date-related data
as a result of computer-controlled systems using two digits rather than four to
define the applicable year. For example, computer programs that have
time-sensitive software may recognize a date represented as "00" as the year
1900 rather than the year 2000. This could result in a system failure or
miscalculations causing disruptions of operations, including among other things,
a temporary inability to process transactions, send invoices, or engage in
similar normal business activities.
To date, we have not experienced any year 2000 issues with any of our
internal systems or our products, and we do not expect to experience any.
Our Year 2000 Program. We have based our year 2000 compliance program on the
program adopted by the U.S. Government Accounting Office. Our program is divided
into six phases; awareness, assessment, renovation, validation, implementation
and monitoring. The program covers our information technologies systems,
non-information technology systems and embedded technology. We have completed
the awareness phase, substantially completed the assessment phase and are
starting the renovation phase. We expect to be completed with the implementation
phase by the end of our fourth fiscal quarter of 1999.
State of Readiness of Our Products. We have been testing our existing
products for use in the year 2000 and beyond, and believe that using our
products as documented should not cause any Year 2000 related issues. While we
believe our products are year 2000 compliant, it is impractical for us to test
our products in every computer environment or with all available combinations of
our products with components supplied by our customers or other third party
suppliers. As a result, there may be situations where the combination of our
products working with components supplies by other third parties could result in
year 2000 issues.
State of Readiness of Our Internal Systems. Our business may be affected by
year 2000 issues related to non-compliant internal systems developed by us or by
third-party vendors. We are requesting written assurances from our third-party
vendors for all of our material systems that such systems are year 2000
compliant. To date, we have identified one internal system that will require an
upgrade to be year 2000 compliant and one enterprise system that utilizes a
database system that will require an upgrade to be year 2000 compliant. These
upgrades are currently available. In addition, several of our administrative and
engineering systems rely on an operating system that will require an upgrade to
be year 2000 compliant, which is currently available. Most of our productivity
systems and personal computers utilize Microsoft Windows 95 and 98 operating
systems and Microsoft NT 4.0. While the Microsoft Windows 95 and 98 environments
have available year 2000 upgrades, to date Microsoft has not provided what we
consider a usable 2000 upgrade for the NT 4.0 environment. We believe that
Microsoft will provide this upgrade in a timely manner to avoid any year 2000
problems. We believe we will be able to implement all available upgrades by the
end of our fourth fiscal quarter of 1999. No projects have been deferred due to
the year 2000 issue.
Page 13 of 24 pages.
<PAGE> 14
State of Readiness of Our Facilities. The operation of our facilities also
depends upon the computer-controlled systems of third parties such as suppliers
and service providers. We believe that absent a systematic failure outside our
control, such as a prolonged loss of electrical or telephone service, year 2000
problems of these third parties will not have a material impact on our
operations. Our facilities use limited embedded technology and any failure of
that technology is not expected to have a material impact on our operations.
State of Readiness of Key Third Parties. Our third party suppliers are
sensitive to the need to be year 2000 compliant. As part of the assessment phase
of our year 2000 program we a requesting written assurance from our third party
suppliers that they are year 2000 compliant. Some of our third party suppliers
have indicated that they are year 2000 compliant. However, others are in a year
2000 compliance review process. Therefore, at this time, they are not in a
position to provide us with year 2000 compliance assurance. If we identify a
material year 2000 compliance issue with a third party supplier, we will work
with that supplier to resolve the issue or source the parts or services from a
supplier that is year 2000 compliant.
Use of Independent Verification. We have not used external agencies or
partners to verify or validate year 2000 readiness. We do not feel that the
scope of our program warrants this time and expense.
Cost. Based on our assessment to date, we do not anticipate that costs
associated with remediating our internal systems will exceed $250,000.
Worst Case Year 2000 Scenario. While it is impossible to evaluate every
aspect of year 2000 compliance, we believe our year 2000 worst case scenario
would be the failure of a sole or limited source supplier to be year 2000
compliant. The failure of one of these suppliers to be year 2000 compliant could
seriously interrupt the flow of materials into the manufacturing process and
therefore delay the manufacture and sale of our products. However, due to the
general uncertainty inherent in the year 2000 computer problem resulting from
the uncertainty of the year 2000 readiness of third party suppliers and vendors,
we are unable to determine at this time whether the consequences of year 2000
failures will have a material impact on our business.
Additional Risks. Any failure by us to make our products year 2000 compliant
could result in a decrease in sales of our products, an increase in allocation
of resources to address year 2000 problems of our customers without additional
revenue commensurate with such dedication of resources, or an increase in
litigation costs relating to losses suffered by our customers due to such year
2000 problems. Failures of our internal systems could temporarily prevent us
from processing orders, issuing invoices, and developing products, and could
require us to devote significant resources to correcting such problems.
Recent Accounting Pronouncements
In December 1998, the AICPA issued SOP No. 98-9, "Modification of SOP 97-2,
Software Revenue Recognition, With Respect to Certain Transactions" ("SOP No.
98-9"). SOP No. 98-9 amends SOP No. 97-2 and SOP No. 98-4 by extending the
deferral of the application of certain provisions of SOP No. 97-2 amended by SOP
No. 98-4 through fiscal years beginning on or before March 15, 1999. All other
provisions of SOP No. 98-9 are effective for transactions entered into in fiscal
years beginning after March 15, 1999. Brocade has not had significant software
sales to date and management does not expect the adoption of SOP No. 98-9 to
have a significant impact on Brocade's financial position or results of
operations.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"),
which supercedes and amends a number of existing standards and is required to be
adopted in fiscal years beginning after June 15, 1999. Because Brocade currently
holds no derivative financial instruments and does not currently engage in
hedging activities, the adoption of SFAS No. 133 is not expected to have a
material impact on Brocade's financial condition or results of operations.
Qualitative and Quantitative Disclosure about Market Risk
Our interest income is sensitive to changes in the general level of U.S.
interest rates, particularly since the majority of our investments are in
short-term instruments. Due to the nature of our short-term investments, we have
concluded that there is no material market risk exposure. Therefore, no
quantitative tabular disclosures are required.
Page 14 of 24 pages.
<PAGE> 15
RISK FACTORS
WE HAVE AN ACCUMULATED DEFICIT OF $29.9 MILLION AND EXPECT TO INCUR FUTURE
LOSSES
We have incurred significant losses since inception. As a result, as of July
31, 1999, we had an accumulated deficit of $29.9 million. Although our revenues
have grown in recent quarters and we achieved profitability in the three months
ended July 31, 1999, we cannot be certain that we will be able to sustain these
growth rates or that we will realize sufficient revenues to maintain
profitability. We also expect to incur significant product development, sales
and marketing and administrative expenses and, as a result, we will need to
generate significant revenues to achieve and maintain profitability.
In addition, Brocade was founded in August 1995 and has a limited operating
history. Therefore, we cannot forecast future operating results based on our
historical results. We would expect our business, and if our revenues do not
meet our projections, operating results and financial condition to be materially
adversely affected. We plan our operating expenses based in part on future
revenue projections. Our ability to accurately forecast our quarterly revenue is
limited because our products have a long sales cycle that makes it difficult to
predict the quarter in which sales will occur. This forecasting process is made
more difficult because many of our customer agreements provide that customers
may delay scheduled delivery dates and cancel orders within specified time
frames without significant penalty. Moreover, most of our expenses are fixed in
the short term and we may not be able to reduce spending if our revenues are
lower than we had projected. If this were to occur we would expect to incur
additional losses.
WE EXPECT OUR QUARTERLY REVENUES AND OPERATING RESULTS TO FLUCTUATE FOR A
NUMBER OF REASONS WHICH COULD CAUSE OUR STOCK PRICE TO FLUCTUATE
Our quarterly revenues and operating results have varied significantly in
the past and are likely to vary significantly in the future due to a number of
factors, any of which may cause our stock price to fluctuate. The primary
factors that may affect us include the following:
<TABLE>
<S> <C>
- fluctuations in demand for SilkWorm family of products and services;
- the timing of customer orders and product implementations, particularly
large orders from and product implementations of our original equipment
manufacture customers;
- - our ability to develop, introduce, ship and support new products and
product enhancements;
- - announcements and new product introductions by our competitors;
- - the expected decline in the prices at which we can sell our
SilkWorm family of products to our customers;
- - our ability to obtain sufficient supplies of sole or limited sourced
components, including application specific integrated circuits, or ASICs,
gigabit interface converters, or GBICs, and power supplies, for our
SilkWorm family of products;
- - increases in the prices of the components we purchase;
- - our ability to attain and maintain production volumes and quality
levels for our SilkWorm family of products;
- - the mix of our SilkWorm and SilkWorm Express switches sold
and the mix of distribution channels through which they are sold;
- - increased expenses, particularly in connection with our strategy to
continue to expand our relationships with key original equipment
manufacturers and system integrators;
- - widespread adoption of SANs as an alternative to existing data storage
and management systems;
- - decisions by end-users to reallocate their information resources to
other purposes, including year 2000 preparedness; and
- - deferrals of customer orders in anticipation of new products, services or
product enhancements introduced by us or our competitors.
</TABLE>
Accordingly, you should not rely on the results of any past period as an
indication of our future performance. It is likely that in some future period,
our revenues and operating results may be below expectations of public market
analysts or investors. If this occurs, our stock price may drop.
Page 15 of 24 pages.
<PAGE> 16
OUR SUCCESS IS DEPENDENT UPON THE DEVELOPMENT OF THE EMERGING MARKET FOR SANS
AND SAN SWITCHING PRODUCTS
Our SilkWorm family of Fibre Channel switching products is used exclusively
in storage area networks, or SANs. Accordingly, widespread adoption of SANs as
an integral part of data-intensive enterprise computing environments is critical
to our future success. In addition, our success depends upon market acceptance
of our SAN switching solutions as an alternative to the use of hubs or other
interconnect devices in SANs. The market for SANs and SAN switching products
have only recently begun to develop and are rapidly evolving. Because these
markets are new, it is difficult to predict their potential size or future
growth rate. In addition, SANs are often implemented in connection with
deployment of new storage systems and servers and we are therefore dependent to
some extent on this market. Potential end-user customers who have invested
substantial resources in their existing data storage and management systems may
be reluctant or slow to adopt a new approach, like SANs. Our success in
generating revenue in these emerging markets will depend, among other things, on
our ability to educate potential original equipment manufacturers and system
integrator customers, as well as potential end-users, about the benefits of SANs
and SAN switching technology and our ability to maintain and enhance our
relationships with leading original equipment manufacturers and system
integrators. In addition, our products are designed to conform to the Fibre
Channel interconnect protocol and certain other industry standards. Some of
these standards may not be widely adopted, and competing standards may emerge
that will be preferred by original equipment manufacturers or end users.
WE CURRENTLY ONLY OFFER OUR SILKWORM PRODUCT FAMILY AND MUST DEVELOP NEW AND
ENHANCED PRODUCTS THAT ACHIEVE WIDESPREAD MARKET ACCEPTANCE
We currently derive substantially all of our revenue from sales of our
SilkWorm family of products. We expect that revenue from this product family
will continue to account for a substantial portion of our revenue for the
foreseeable future. Therefore, widespread market acceptance of these products is
critical to our future success. Some of our products have been only recently
introduced and therefore, the demand for and market acceptance of our products
is uncertain. Factors that may affect the market acceptance of our products
include market acceptance of SAN switching products, the performance, price and
total cost of ownership of our products, the availability and price of competing
products and technologies, and the success and development of our original
equipment manufacturers and system integrators. Many of these factors are beyond
our control.
Our future success depends upon our ability to address the rapidly changing
needs of our customers by developing and introducing high quality, cost
effective products, product enhancements and services on a timely basis and by
keeping pace with technological developments and emerging industry standards. We
have new product launches and upgrades to our existing products planned for
fiscal year 2000. Our future revenue growth will be dependent on the success of
these new product launches. We have in the past experienced delays in product
development and such delays may occur in the future. In addition, as we
introduce new or enhanced products, we will have to manage successfully the
transition from older products in order to minimize disruption in our customers'
ordering patterns, avoid excessive levels of older product inventories and
ensure that enough supplies of new products can be delivered to meet our
customers' demands. Our failure to develop and introduce successfully new
products and product enhancements, which are not broadly accepted, would reduce
our revenues.
WE DEPEND ON A FEW KEY ORIGINAL EQUIPMENT MANUFACTURER CUSTOMERS AND THE LOSS OF
ANY OF THEM COULD SIGNIFICANTLY REDUCE OUR REVENUES
We depend on a few key original equipment manufacturer customers. For
example, in the nine month period ended July 31, 1999 sales to seven customers
accounted for 88% of our total revenues. We anticipate that our operating
results will continue to depend on sales to a relatively small number of
original equipment manufacturers. Therefore, the loss of any of our key original
equipment manufacturers, or a significant reduction in sales to these original
equipment manufacturers could significantly reduce our revenues.
FAILURE TO EXPAND OUR DISTRIBUTION CHANNELS AND MANAGE OUR DISTRIBUTION
RELATIONSHIPS COULD SIGNIFICANTLY REDUCE OUR REVENUES
Our success will depend on our continuing ability to develop and manage
relationships with significant original equipment manufacturers and system
integrators, as well as on the sales efforts and success of these customers. Our
customers may evaluate our products for up to a year before they begin to market
and sell them and assisting those customers through the evaluation process may
require significant sales and marketing and management efforts on our part,
particularly if we have to qualify our products with multiple customers at the
same time. In addition, once our products have been qualified, our agreements
with our customers have no minimum purchase commitments. We cannot assure you
that we will be able to expand our distribution channels, manage our
distribution relationships successfully or that our customers will market our
products effectively. Our failure to manage successfully our distribution
relationships or the failure of our customers to sell our products could reduce
our revenues.
Page 16 of 24 pages.
<PAGE> 17
THE LOSS OF SOLECTRON CORPORATION, OUR SOLE MANUFACTURER, OR THE FAILURE TO
FORECAST ACCURATELY DEMAND FOR OUR PRODUCTS OR MANAGE SUCCESSFULLY OUR
RELATIONSHIP WITH SOLECTRON, WOULD NEGATIVELY IMPACT OUR ABILITY TO MANUFACTURE
AND SELL OUR PRODUCTS
Solectron, a third party manufacturer for numerous companies, manufactures
all of our products at its Milpitas, California facility on a purchase order
basis. We currently do not have a long-term supply contract with Solectron and,
therefore, Solectron is not obligated to supply products to us for any specific
period, in any specific quantity, except as may be provided in a particular
purchase order. We generally place orders with Solectron up to four months prior
to scheduled delivery of products to our customers. Accordingly, if we
inaccurately forecast demand for our products, we may be unable to obtain
adequate manufacturing capacity from Solectron to meet our customers' delivery
requirements or we may accumulate excess inventories.
We plan to regularly introduce new products and product enhancements, which
will require that we coordinate our efforts with those of our suppliers and
Solectron to rapidly achieve volume production. While we have not, to date,
experienced supply problems with Solectron, we have experienced delays in
product deliveries from one of our former contract manufacturers. If we should
fail to effectively manage our relationships with our suppliers and Solectron,
or if Solectron experiences delays, disruptions, capacity constraints or quality
control problems in its manufacturing operations, our ability to ship products
to our customers could be delayed and commencing volume production is expensive
and time consuming. If we are required or choose to change contract
manufacturers, we may lose revenue and damage our customer relationships.
WE ARE DEPENDENT ON SOLE SOURCE AND LIMITED SOURCE SUPPLIERS FOR CERTAIN KEY
COMPONENTS INCLUDING ASICS AND POWER SUPPLIES
We currently purchase several key components from single or limited sources.
We purchase ASICs and power supplies from single sources, and printed circuit
boards and GBICs from limited sources. In addition we license certain software
that is incorporated into our Brocade Fabric Operating System from Wind River
Systems, Inc. If we are unable to buy these components on a timely basis, we
will not be able to manufacture our products. We use a rolling six-month
forecast based on anticipated product orders to determine our component
requirements. If we overestimate our component requirements, we may have excess
inventory, which would increase our costs. If we underestimate our component
requirements, we may have an inadequate inventory, which could interrupt our
manufacturing. In addition, lead times for materials and components we order
vary significantly and depend on factors such as the specific supplier, contract
terms and demand for a component at a given time. We also may experience
shortages of certain components from time to time, which also could delay our
manufacturing.
THE COMPETITION IN OUR MARKETS MAY LEAD TO REDUCED SALES OF OUR PRODUCTS,
REDUCED PROFITS AND REDUCED MARKET SHARE
The markets for our SAN switching products are competitive, and are likely
to become even more competitive. Increased competition could result in pricing
pressures, reduced sales, reduced margins, reduced profits, reduced market share
or the failure of our products to achieve or maintain market acceptance. Our
products face competition from multiple sources. Some of our competitors and
potential competitors have longer operating histories, greater name recognition,
access to larger customer bases, or substantially greater resources than we
have. As a result, they may be able to respond more quickly than we can to new
or changing opportunities, technologies, standards or customer requirements. For
all of the foregoing reasons, we may not be able to compete successfully against
our current and future competitors.
THE PRICES OF OUR PRODUCTS ARE DECLINING WHICH COULD REDUCE OUR REVENUES AND
GROSS MARGINS
The average unit price of our products continues to decrease. We anticipate
that the average unit price of our products may continue to decrease in the
future in response to changes in product mix, competitive pricing pressures,
increased sales discounts, new product introductions by us or our competitors or
other factors. If we are unable to offset these factors by increasing our sales
volumes, our revenues will decline. In addition , to maintain our gross margins,
we must develop and introduce new products and product enhancements, and we must
continue to reduce the manufacturing costs of our products.
UNDETECTED SOFTWARE OR HARDWARE ERRORS COULD INCREASE OUR COSTS AND REDUCE OUR
REVENUES
Networking products frequently contain undetected software or hardware
errors when first introduced or as new versions are released. Our products are
complex and errors may be found from time to time in our new or enhanced
products. In addition, our products are combined with products from other
vendors. As a result, when problems occur, it may be difficult to identify the
source of the problem. These problems may cause us to incur significant warranty
and repair costs, divert the attention of our engineering personnel from our
product development efforts and cause significant customer relations problems.
Moreover, the occurrence of hardware and software errors, whether caused by our
or another vendor's SAN products, could delay or prevent the development of the
SAN market.
Page 17 of 24 pages.
<PAGE> 18
IF WE LOSE KEY PERSONNEL OR ARE UNABLE TO HIRE ADDITIONAL QUALIFIED PERSONNEL,
WE MAY NOT BE SUCCESSFUL
Our success depends to a significant degree upon the continued contributions
of our key management, engineering and sales and marketing personnel, many of
whom would be difficult to replace. In particular, we believe that our future
success is highly dependent on Gregory L. Reyes, our President and Chief
Executive Officer, Kumar Malavalli, our Vice President, Technology and Paul R.
Bonderson, Jr., our Vice President, Engineering. We do not have employment
contracts with, or key person life insurance on, any of our key personnel. We
also believe that our success depends to a significant extent on the ability of
our management to operate effectively, both individually and as a group. In
April 1999, we hired a new Chief Financial Officer, and certain other members of
our management team, including Mr. Reyes, have only recently joined us.
We believe our future success will also depend in large part upon our
ability to attract and retain highly skilled managerial, engineering, sales and
marketing, and finance and operations personnel. Competition for these personnel
is intense, especially in the San Francisco Bay Area. In particular, we have
experienced difficulty in hiring qualified ASIC, software, system and test, and
customer support engineers and there can be no assurance that we will be
successful in attracting and retaining these individuals. The loss of the
services of any of our key employees, the inability to attract or retain
qualified personnel in the future or delays in hiring required personnel,
particularly engineers and sales personnel, could delay the development and
introduction of and negatively impact our ability to sell our products. In
addition, companies in our industry whose employees accept positions with
competitors frequently claim that their competitors have engaged in unfair
hiring practices. We cannot assure you that we will not receive such claims in
the future as we seek to hire qualified personnel or that such claims will not
result in material litigation. We could incur substantial costs in defending
ourselves against these claims, regardless of their merits.
WE MUST CONTINUE TO IMPROVE OUR OPERATIONAL SYSTEMS AND CONTROLS TO MANAGE
FUTURE GROWTH
We plan to continue to expand our operations significantly to pursue
existing and potential marketing opportunities. This growth places a significant
demand on our management and our operational resources. In order to manage
growth effectively, we must implement and improve our operational systems,
procedures and controls on a timely basis.
WE PLAN TO INCREASE OUR INTERNATIONAL SALES ACTIVITIES SIGNIFICANTLY, WHICH WILL
SUBJECT US TO ADDITIONAL BUSINESS RISKS
We plan to expand our international sales activities significantly. In
fiscal year 1999 and 2000, we intent to focus on expanding our international
sales activities in Western Europe. Our international sales growth in these
countries will be limited if we are unable to establish relationships with
international distributors, establish additional foreign operations, expand
international sales channel management, hire additional personnel and develop
relationships with international service providers. Even if we are able to
successfully expand international operations, we cannot be certain that we will
be able to maintain or increase international market demand for our products.
Our international operations, including our sales activities in Western Europe,
are subject to a number of risks, including:
- - supporting multiple languages;
- - recruiting sales and technical support personnel with the skills to
support our products;
- - increased complexity and costs of managing international operations;
- - protectionist laws and business practices that favor local competition;
- - dependence on local vendors;
- - multiple, conflicting and changing governmental laws and regulations;
- - longer sales cycles;
- - difficulties in collecting accounts receivable;
- - reduced or limited protections of intellectual property rights; and
- - political and economic instability.
To date, none of our international revenues and costs have been denominated
in foreign currencies. As a result, an increase in the value of the U.S. dollar
relative to foreign currencies could make our products more expensive and thus
less competitive in foreign markets. A portion of our international revenues
will be denominated in foreign currencies in the future, including the Euro,
which will subject us to risks associated with fluctuations in those foreign
currencies.
Page 18 of 24 pages.
<PAGE> 19
WE MAY BE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY WHICH WOULD NEGATIVELY
AFFECT OUR ABILITY TO COMPETE
We rely on a combination of patent, copyright, trademark and trade secret
laws and restrictions on disclosure to protect our intellectual property rights.
We also enter into confidentiality or license agreements with our employees,
consultants and corporate partners, and control access to and distribution of
our software, documentation and other proprietary information. Despite our
efforts to protect our proprietary rights, unauthorized parties may attempt to
copy or otherwise obtain and use our products or technology. Monitoring
unauthorized use of our products is difficult, and we cannot be certain that the
steps we have taken will prevent unauthorized use of our technology,
particularly in foreign countries where the laws may not protect our proprietary
rights as fully as in the United States.
OTHERS MAY BRING INFRINGEMENT CLAIMS AGAINST US WHICH COULD BE TIME CONSUMING
AND EXPENSIVE TO DEFEND
In recent years, there has been significant litigation in the United States
involving patents and other intellectual property rights. We were previously the
subject of a lawsuit alleging infringement of intellectual property rights.
Although this dispute was resolved and the lawsuit dismissed, and we are not
currently involved in any other intellectual property litigation, we may be a
party to litigation in the future to protect our intellectual property or as a
result of an alleged infringement of others' intellectual property. These claims
and any resulting lawsuit could subject us to significant liability for damages
and invalidation of our proprietary rights. These lawsuits, regardless of their
success, would likely be time-consuming and expensive to resolve and would
divert management time and attention. Any potential intellectual property
litigation also could force us to do one or more of the following:
- stop selling, incorporating or using our products or services that use the
challenged intellectual property;
- - obtain from the owner of the infringed intellectual property right a license
to sell or use the relevant technology, which license may not be available
on reasonable terms, or at all; and
- - redesign those products or services that use such technology.
If we are forced to take any of the foregoing actions, we may be unable to
manufacture and sell our products, which would reduce our revenues.
WE ARE THE SUBJECT OF A PENDING LEGAL PROCEEDING
We have been sued by one of our former contract manufacturers in the Santa
Clara County, California Superior Court. We believe that we have strong defenses
against the claims alleged in the lawsuit. Accordingly, we intend to defend this
suit vigorously. However, the litigation process is inherently uncertain and we
may not prevail. Our defense of this litigation, regardless of its eventual
outcome, has been, and will likely continue to be, time-consuming, costly and a
diversion for our personnel. A failure to prevail could result in us having to
pay monetary damages of up to $2.9 million and reimburse the plaintiff for some
or all of its attorneys' fees.
WE MAY ENGAGE IN FUTURE ACQUISITIONS THAT DILUTE OUR STOCKHOLDERS AND CAUSE US
TO INCUR DEBT OR ASSUME CONTINGENT LIABILITIES
As part of our strategy, we expect to review opportunities to buy other
businesses or technologies that would complement our current products, expand
the breadth of our market or enhance our technical capabilities, or that may
otherwise offer growth opportunities. While we have no current agreements or
negotiations underway, we may buy businesses, products or technologies in the
future. In the event of any future purchases, we could:
- - issue stock that would dilute our current stockholders' percentage
ownership;
- - incur debt; or
- - assume liabilities.
These purchases also involve numerous risks, including:
- - problems combining the purchased operations, technologies or products;
- - unanticipated costs;
- - diversion of management's attention from our core
business;
- - adverse effects on existing business relationships with suppliers
and customers;
- - risks associated with entering markets in which we have no or
limited prior experience; and
- - potential loss of key employees of purchased organizations.
We cannot assure you that we will be able to successfully integrate any
businesses, products, technologies or personnel that we might purchase in the
future.
Page 19 of 24 pages.
<PAGE> 20
OUR FAILURE AND THE FAILURE OF OUR SUPPLIERS AND CUSTOMERS TO BE YEAR 2000
COMPLIANT COULD HARM OUR BUSINESS.
The year 2000 computer issue creates risks for us. Failure of our products
to recognize correctly date information when the year changes to 2000 could
result in significant decreases in market acceptance of our products, increases
in warranty claims and legal liability for defective software. We have not
tested our products in every possible computer environment, and therefore such
products may not be fully year 2000 compliant. Year 2000 preparations by our
customers could also slow down purchases of our products.
Our internal year 2000 compliance review is focused on reviewing our
internal computer information and security systems for year 2000 compliance, and
developing and implementing remedial programs to resolve year 2000 issues in a
timely manner. Additionally, we are contacting our third party suppliers and
requesting their written assurances that their systems are year 2000 compliant.
To date our year 2000 costs have been primarily driven by the cost of our
personnel conducting the year 2000 compliance review. We estimate such costs to
date are $75,000.
If our suppliers, vendors, major distributors, and partners fail to correct
their year 2000 problems, these failures could result in an interruption in, or
a failure of, our normal business activities or operations. If a Year 2000
problem occurs it may be difficult to determine which vendor's products have
caused the problem. These failures could interrupt our operations and damage our
relationships with our customers. Due to the general uncertainty inherent in the
year 2000 problem resulting from the readiness of third-party suppliers and
vendors, we are unable to determine at this time whether year 2000 failures harm
us.
We believe our year 2000 worst case scenario would be the failure of a sole
or limited source supplier to be year 2000 compliant. The failure of one of
these suppliers to be year 2000 compliant could seriously interrupt our
manufacturing process, which could substantially reduce our revenues.
Our customers' purchasing plans could be affected by year 2000 issues if
they need to expend significant resources to fix their existing systems. This
situation may reduce funds available to purchase our products. Therefore, some
customers may wait to purchase our products until after the year 2000, which
may reduce our revenue.
OUR PRODUCTS MUST COMPLY WITH EVOLVING INDUSTRY STANDARDS AND GOVERNMENT
REGULATIONS
The market for SAN products is characterized by the need to support industry
standards as they emerge, evolve and achieve acceptance. To remain competitive,
we must continue to introduce new products and product enhancements that meet
these industry standards. All components of the SAN must utilize the same
standards in order to operate together. Our products comprise only a part of the
entire SAN and we depend on the companies that provide other components of the
SAN, many of whom are significantly larger than we are, to support the industry
standards as they evolve. The failure of these providers to support these
industry standards could adversely affect the market acceptance of our products.
In addition, in the United States, our products must comply with various
regulations and standards defined by the Federal Communications Commission and
Underwriters Laboratories. Internationally, products that we develop will also
be required to comply with standards established by authorities in various
countries. Failure to comply with existing or evolving industry standards or to
obtain timely domestic or foreign regulatory approvals or certificates could
materially harm our business.
PROVISIONS IN OUR CHARTER DOCUMENTS, CUSTOMER AGREEMENTS AND DELAWARE LAW COULD
PREVENT OR DELAY A CHANGE IN CONTROL OF BROCADE AND MAY REDUCE THE MARKET PRICE
OF OUR COMMON STOCK
Provisions of our certificate of incorporation and bylaws may discourage,
delay or prevent a merger or acquisition that a stockholder may consider
favorable. These provisions include:
- - authorizing the issuance of preferred stock without stockholder approval;
- - providing for a classified board of directors with staggered, three-year
terms;
- - prohibiting cumulative voting in the election of directors;
- - requiring super-majority voting to effect certain amendments to our
certificate of incorporation and bylaws;
- - limiting the persons who may call special meetings of stockholders; and
- - prohibiting stockholder action by written consent.
Certain provisions of Delaware law also may discourage, delay or prevent
someone from acquiring or merging with us. Further, our agreement with certain
of our customers require us to give prior notice of a change in of control of
Brocade and grant certain manufacturing rights following the change of control.
Page 20 of 24 pages.
<PAGE> 21
OUR STOCK PRICE MAY BE VOLATILE AND YOU MAY NOT BE ABLE TO RESELL YOUR SHARES AT
OR ABOVE THE INITIAL PUBLIC OFFERING PRICE
There has been no public market for our common stock prior to the Brocade's
initial public offering in May 1999. The initial public offering price for our
common stock was determined through negotiations between the underwriters and
us. This initial public offering price may vary from the market price of our
common stock after the offering. The market price of the common stock may
fluctuate significantly in response to the following factors, some of which are
beyond our control:
- - actual or anticipated fluctuations in our quarterly results;
- - changes in financial estimates by securities analysts;
- - changes in market valuations of other technology companies;
- - announcements by us or our competitors of significant technical innovations,
contracts, acquisitions, strategic partnerships, joint ventures or capital
commitments;
- - losses of major original equipment manufacturer customers;
- - additions or departures of key personnel; and
- - sales of common stock in the future.
In addition, the stock market has experienced extreme volatility that often
has been unrelated to the performance of particular companies. These market and
industry fluctuations may cause our stock price to fall regardless of our
performance.
OUR BUSINESS MAY BE HARMED BY CLASS ACTION LITIGATION DUE TO STOCK PRICE
VOLATILITY
In the past, securities class action litigation often has been brought
against a company following periods of volatility in the market price of its
securities. We may in the future be the target of similar litigation. Securities
litigation could result in substantial costs and divert management's attention
and resources.
WE MAY BE UNABLE TO MEET OUR FUTURE CAPITAL REQUIREMENTS WHICH WOULD LIMIT OUR
ABILITY TO GROW
We believe that the net proceeds of our initial public offering, credit
facilities and cash flow expected to be generated from future operations, will
be sufficient to meet our capital requirement at least through the next 12
months. In the event we need to raise additional funds we may not be able to do
so on favorable terms, if at all. Further, if we issue equity securities,
stockholders may experience additional dilution or the new equity securities may
have rights, preferences or privileges senior to those of existing holders of
common stock. If we cannot raise funds, on acceptable terms, we may not be able
to develop or enhance our products, take advantage of future opportunities or
respond to competitive pressures or unanticipated requirements.
SUBSTANTIAL FUTURE SALES OF OUR COMMON STOCK IN THE PUBLIC MARKET MAY DEPRESS
OUR STOCK PRICE
Our current stockholders hold a substantial number of shares, which they
will be able to sell in the public market in the near future. A large percentage
of our outstanding common shares are restricted securities as defined in Rule
144 of the Securities Act of 1933. Sales of a substantial number of shares of
our common stock after the restriction periods ends could cause our stock price
to fall. In addition, the sale of these shares could impair our ability to raise
capital through the sale of additional equity securities.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
The majority of Brocade's operations are based in the U.S. and,
accordingly, a majority of our transactions are denominated in U.S. dollars. Our
interest income is sensitive to changes in the general level of U.S. interest
rates, however, due to the nature of our short-term investments, we have
concluded that there is no material market risk exposure.
Page 21 of 24 pages.
<PAGE> 22
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Brocade's former contract manufacturer has filed suit against Brocade,
alleging that Brocade is liable for breaching certain contracts with the
contract manufacturer. The suit claims damages in excess of $3.0 million plus
interest, an unspecified amount of consequential and incidental damages, and
costs and attorney's fees. Brocade has filed a cross complaint against the
contract manufacturer for various credits Brocade claims on its account with the
contract manufacturer. It is management's opinion that any liability on
Brocade's account is limited to accrued and unpaid invoices and that this amount
is subject to various offsets Brocade claims in its cross-complaint.
From time to time Brocade is subject to various claims which arise in the
ordinary course of business. While management does not believe that the ultimate
disposition of these claims will have a material adverse effect on the financial
position of Brocade, claims of this nature are subject to inherent uncertainties
and thus, there can be no assurance that these claims will be resolved favorably
to Brocade.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
In connection with its initial public offering in May of 1999, Brocade filed
a Registration Statement on Form S-1, SEC File No. 333-74711 (the "Registration
Statement"), which was declared effective by the Commission on May 24, 1999.
Pursuant to the Registration Statement, Brocade registered 3,737,500 shares of
its common stock, $.001 par value per share, including 487,500 shares sold to
the underwriters upon the exercise of their over-allotment option. The aggregate
offering price of the shares registered was $71.0 million, $5.0 million of which
was applied towards the underwriters discounts and commissions. Other expenses
related to the offering were $1.5 million. The net proceeds to Brocade from the
sale of common stock in the initial public offering were $65.1 million,
including $0.5 million from the exercise of warrants prior to the initial public
offering. The managing underwriters of the offering were Morgan Stanley Dean
Witter, BT Alex Brown and Dain Rauscher Wessels.
Brocade used the net proceeds from the offering to reduce it short and
long-term debt by $4.0 million and invested the remaining amount in short-term,
investment grade, interest-bearing securities. The use of the proceeds from the
offering does not represent a material change in the use of proceeds described
in the prospectus.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
In the quarter ended July 31, 1999, the following matters were submitted to
the security holders of Brocade:
a) the adoption of Brocade's 1999 Employee Stock Purchase Plan (the "Purchase
Plan"). A total of 200,000 shares of common stock have been reserved for
issuance under the Purchase Plan. The Purchase Plan permits eligible
employees to purchase shares of common stock through payroll deductions at
85% of the fair market value of the common stock, as defined in the Purchase
Plan.
b) the adoption of Brocade's 1999 Stock Plan (the "1999 Plan"), the combination
of Brocade's 1995 Equity Incentive Plan, 1998 Equity Incentive Plan and 1998
Executive Equity Incentive Plan into the 1999 Plan, and the addition of
300,000 newly reserved shares of common stock thereunder. The 1999 Plan
provides for the grant of incentive and nonqualified stock options to
employees.
c) the adoption of Brocade's 1999 Director Option Plan (the "Director Plan").
The Director Plan provides for the grant of common stock options to
non-employee directors. A total of 200,000 shares of common stock have been
reserved for issuance under the Director Plan.
The number of stockholders giving their consent was 103, representing 85% of the
shares outstanding at the time.
ITEM 5. OTHER INFORMATION
None
Page 22 of 24 pages.
<PAGE> 23
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS.
-------------- -----------------------------------------------------------
27.1 Financial Data Schedule.
- ----------------------
(b) REPORTS ON FORM 8-K. No reports on Form 8-K were filed by Registrant
during the three months ended July 31, 1999.
Page 23 of 24 pages.
<PAGE> 24
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Dated: September 15, 1999 BROCADE COMMUNICATIONS SYSTEMS, INC.
(Registrant)
/S/ MICHAEL J. BYRD
------------------------------------------
MICHAEL J. BYRD
Vice President, Finance and
Chief Financial Officer
Page 24 of 24 pages.
<PAGE> 25
INDEX TO EXHIBITS
Exhibit
Number Description
- ------- -----------
27.1 Financial Data Schedule
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THE SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM Q3 FY99 FORM
10-Q FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<RESTATED>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> OCT-31-1999
<PERIOD-START> NOV-01-1998
<PERIOD-END> JUL-31-1999
<CASH> 10,360
<SECURITIES> 65,976
<RECEIVABLES> 11,269
<ALLOWANCES> 0
<INVENTORY> 2,628
<CURRENT-ASSETS> 91,856
<PP&E> 5,454
<DEPRECIATION> 0
<TOTAL-ASSETS> 97,425
<CURRENT-LIABILITIES> 20,698
<BONDS> 0
0
0
<COMMON> 116,702
<OTHER-SE> (40,096)
<TOTAL-LIABILITY-AND-EQUITY> 97,425
<SALES> 38,598
<TOTAL-REVENUES> 38,598
<CGS> 18,679
<TOTAL-COSTS> 18,679
<OTHER-EXPENSES> 21,631
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (1,043)
<INCOME-TAX> 33
<INCOME-CONTINUING> (1,076)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (1,076)
<EPS-BASIC> (0.12)
<EPS-DILUTED> (0.12)
</TABLE>