Item 1A. Risk Factors
The announcement and pendency of Brocade’s agreement to be acquired by Broadcom Limited (“Broadcom”) and Broadcom’s planned divestiture of Brocade’s Internet Protocol (“IP”) Networking business has had and may continue to have an adverse effect on Brocade’s business and operating results.
On November 2, 2016, Brocade entered into a merger agreement with Broadcom under which Broadcom agreed to acquire Brocade. In connection with the announcement of the proposed acquisition, Broadcom announced its intention to retain Brocade’s Storage Area Networking (“SAN”) business and divest Brocade’s IP Networking business. Brocade’s pending acquisition by Broadcom, and Broadcom’s announcement of its plans to divest Brocade’s IP Networking business, has had and may continue to have an adverse effect on Brocade’s revenue in the near term if its customers delay, defer, or cancel purchases pending completion of the transactions. In addition, Broadcom’s announcement on February 22, 2017, that it plans to divest Brocade’s wireless and campus businesses to ARRIS International plc following Broadcom’s acquisition of Brocade may create additional uncertainty. Current and prospective customers of Brocade’s products and services, including its SAN and IP Networking solutions, have been and may continue to be reluctant to purchase Brocade solutions due to potential uncertainty about the direction of its offerings and the support and service of its offerings following consummation of the transactions. Brocade is subject to additional risks in connection with the announcement and pendency of the proposed transactions, including:
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difficulties maintaining existing and/or establishing business relationships, including relationships with significant customers, contract manufacturers, component suppliers, channel partners, and other business partners;
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disruption to Brocade’s business, including increased costs and diversion of management time and resources that could otherwise have been devoted to other opportunities that may have been beneficial to Brocade;
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the restrictions imposed on Brocade’s business and operations pursuant to certain covenants set forth in the merger agreement, which may prevent Brocade from pursuing certain opportunities, responding to competitive pressures and industry developments, or taking certain actions without Broadcom’s approval;
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continued erosion of EBITDA that may lead to noncompliance with debt financial covenants and erosion of domestic cash;
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adverse effects on Brocade’s ability to attract, recruit, retain and motivate current and prospective employees who may be uncertain about their future roles following completion of the proposed transactions, and the possibility that Brocade’s employees could lose productivity as a result of uncertainty regarding their employment following the proposed transactions;
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the pendency and outcome of the legal proceedings that have been or may be instituted against Brocade, its directors, executive officers and others relating to the proposed transactions;
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announcements related to the proposed transactions could result in adjustments to the terms of the warrant transactions (the “Warrant Transactions”) Brocade entered into in connection with the issuance of the 1.375% convertible senior unsecured notes due 2020 (the “2020 Convertible Notes”); and
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the diversion of Brocade’s employees’ and management’s attention due to activities related to the proposed transactions.
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As noted above, on February 22, 2017, Broadcom announced that it plans to divest Brocade’s wireless and campus businesses to ARRIS International plc following Broadcom’s acquisition of Brocade. Uncertainties regarding that transaction and Broadcom’s planned divestiture of other components of Brocade’s IP Networking business, including the completion and timing of any such divestiture, the identity of the buyer or buyers, and the terms and conditions of any such transaction or transactions, have exacerbated and may continue to exacerbate certain of the risks described above in relation to this business.
The failure to complete Brocade’s pending acquisition by Broadcom may adversely affect Brocade’s business and stock price.
Consummation of the acquisition is subject to certain customary closing conditions, including, without limitation: the absence of legal impediments; the expiration or termination of the required waiting periods (as extended pursuant to the request for additional information and documentary materials, commonly referred to as a “second request,” received from the Federal Trade Commission on February 3, 2017) under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended; antitrust regulatory approval in the People’s Republic of China, the European Union and Japan; and review and clearance by the Committee on Foreign Investment in the United States. There can be no assurance that these conditions to the completion of the merger will be satisfied in a timely manner or at all. If the merger is not completed, Brocade’s stock price could fall to the extent its current price reflects an assumption that the acquisition will be completed. Furthermore, if the acquisition is not completed, Brocade may suffer other consequences that could adversely affect its business, operating results and stock price including the following:
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any disruptions to Brocade’s business resulting from the announcement and pendency of the proposed transactions, including adverse changes in its relationships with customers, suppliers, channel partners, other business partners and employees, may continue or intensify in the event the acquisition is not consummated or is significantly delayed;
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Brocade would have incurred significant costs, including professional services fees and other transaction costs, in connection with the proposed transactions that it would be unable to recover;
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Brocade may be subject to negative publicity or be negatively perceived by the investment or business communities;
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Brocade may be subject to legal proceedings related to the transactions contemplated by the merger agreement;
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Brocade may not be able to take advantage of alternative business opportunities or effectively respond to competitive pressures; and
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Brocade may experience a departure of employees.
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The merger agreement with Broadcom limits Brocade’s ability to pursue alternative transactions, which could deter a third party from proposing an alternative transaction.
The merger agreement contains provisions that limit Brocade’s ability to pursue an alternative acquisition transaction. These or other provisions may discourage a potential competing acquirer that might have an interest in acquiring all or a significant part of Brocade from considering or proposing an acquisition.
Litigation challenging the merger agreement may prevent the merger from being consummated at all or within the expected time frame and may result in substantial costs to Brocade.
In December 2016 and January 2017, six putative class-action lawsuits (the “Broadcom acquisition-related matters”) were commenced against, among others, Brocade and its directors in the United States District Court for the Northern District of California. The complaints each allege violations of Sections 14(a) and 20(a) of the Exchange Act and one or more SEC rules arising out of Brocade’s preliminary and definitive proxy statements filed with the SEC on December 6 and December 20, 2016, respectively, relating to the proposed merger. Among other things, the plaintiffs in these actions seek to enjoin the defendants from consummating the proposed merger. Brocade stockholders, as plaintiffs, may initiate further stockholder class-action lawsuits also seeking, among other things, to enjoin consummation of the merger. One of the conditions to the consummation of the merger is that no governmental entity of competent jurisdiction shall have issued an order or decree which prohibits or prevents the consummation of the merger on the terms contemplated in the merger agreement. There can be no assurance that Brocade and the other defendants in these lawsuits will be successful in their defenses. An unfavorable outcome in any such lawsuit could prevent or delay the consummation of the merger and, regardless of the outcome, may result in substantial costs to Brocade and may otherwise negatively affect its business and operations. For additional information regarding the Broadcom acquisition-related matters, see Note
9
, “
Commitments and Contingencies
,” of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q.
The consummation of the proposed Broadcom acquisition could result in substantial obligations becoming payable in respect of the 2020 Convertible Notes, the Warrant Transactions, the 2023 Notes, and the Credit Agreement, which could negatively impact Brocade’s cash flows and financial position.
The proposed acquisition of Brocade by Broadcom would constitute a “Fundamental Change” under the terms of the 2020 Convertible Notes, would constitute a “Change in Control” under the Credit Agreement (the “Credit Agreement”) with Wells Fargo Bank, National Association, and certain other lenders (collectively, the “Lenders”), would result in a termination of the Warrant Transactions, and could result in a “Change of Control Triggering Event” under the 4.625% senior notes due 2023 (the “2023 Notes”). In addition, the consummation of the proposed transaction would result in a temporary adjustment to the conversion rate for the 2020 Convertible Notes. Specifically:
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Holders of the 2020 Convertible Notes have the right to require Brocade to repurchase their convertible notes upon the occurrence of a “Fundamental Change” (as defined in the indenture governing the 2020 Convertible Notes) at a repurchase price of 100% of the principal amount plus accrued and unpaid interest, if any.
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The 2020 Convertible Notes would become convertible for a specified period of time following the consummation of the proposed Broadcom acquisition, which would require Brocade to make cash payments up to the full conversion value of any notes being converted; Brocade could not elect to settle the conversion of the notes with shares of its common stock.
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Holders of the 2023 Notes have the right to require Brocade to repurchase their notes upon the occurrence of a “Change of Control Triggering Event” (as defined in the indenture governing the 2023 Notes), at a repurchase price equal to 101% of the principal amount plus accrued and unpaid interest, if any. The proposed Broadcom acquisition would result in a Change of Control Triggering Event if the acquisition were accompanied or followed within a specified period by certain downgrades of the ratings of the 2023 Notes.
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A “Change of Control” under the Credit Agreement would constitute an event of default and permit the Lenders to cause the acceleration of the repayment of all of the outstanding amounts owed thereunder.
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Upon termination of the Warrant Transactions in connection with the proposed Broadcom acquisition, Brocade would be required to settle such transactions in cash. Further, announcements relating to the proposed acquisition may result in adjustments to the terms of the Warrant Transactions to take into account the economic effect of the proposed acquisition, which could result in greater amounts becoming due upon termination or otherwise have a dilutive effect.
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The foregoing payment obligations would materially impact Brocade’s cash flows and financial position, and Brocade may not have enough available cash or be able to obtain financing on acceptable terms (or at all) at the time to discharge those payment obligations.
Failure to successfully compete in the networking market could prevent Brocade from increasing or maintaining revenue, profitability, and cash flows with respect to its networking solutions.
The networking market is highly competitive and is undergoing significant transitions due to the adoption of new technologies, such as cloud computing, virtualization, software networking, and infrastructure-as-a-service. For example, companies such as Amazon Web Services, Inc., Microsoft Corporation, Cisco Systems, Inc. (“Cisco”) and Hewlett Packard Enterprise Company (“HPE”) all offer cloud computing services for the enterprise market, and some customers may choose to procure networking as a service rather than implement on-site networking solutions. Brocade sells into certain sections of the enterprise market which, over time, could shift their information technology (“IT”) spending substantially or completely to cloud services. If Brocade is unable to build and sustain relationships with companies that will continue to invest in their own on-site networks, Brocade’s revenue and profitability could be adversely affected.
Other shifts in the networking market are also creating competitive challenges for Brocade. For example, data center buying patterns are shifting to converged infrastructures in which computer, network, and storage systems are sold as bundled solutions. If Brocade is unsuccessful in having its products included in those bundled solutions, Brocade’s market share could be adversely affected. Also, Juniper Networks, Inc. (“Juniper”) and HPE have launched new offerings, including “whitebox” switches, which those companies have promoted as a low-cost option for networking equipment purchasers. These and other market dynamics, as well as further commoditization of networking products, could negatively impact Brocade’s business and financial results.
Following its acquisition of Ruckus Wireless, Inc. (“Ruckus”), Brocade has become a vendor of wireless networking products. Previously, Brocade had relied on partner relationships developed with other companies for access to wireless networking technologies, including access to wireless networking products to supplement Brocade’s wireline campus business. Those partner relationships may be adversely affected by the fact that Brocade now competes with those companies’ wireless networking businesses.
Cisco maintains a dominant position in the networking market; however, customers also have many choices in both traditional and emerging networking technology and networking providers. These other competitors in the networking market include A10 Networks, Inc.; Arista Networks, Inc.; Avaya Inc.; Dell, Inc. (now, Dell Technologies Inc. (“Dell Technologies”)); Extreme Networks, Inc.; F5 Networks, Inc.; HPE; Huawei Technologies Co. Ltd.; Juniper; and Nokia Corporation (“Nokia”). Many of Brocade’s competitors have longer operating histories; greater financial, technical, sales, marketing, and other resources; more name recognition; and larger customer-installed bases than Brocade. These companies’ businesses may have better economies of scale, and therefore these companies could also adopt more aggressive pricing policies than Brocade. Some of these companies’ brands are better known by end users than Brocade’s brand, and channel partners often prefer to sell well-known brands to end-user accounts. In addition, some of Brocade’s current and potential competitors have in the past, and could in the future, enhance their business models through acquisitions, divestitures, or new strategic alliances designed to enable them to better compete for customers by offering more comprehensive solutions. For example, in recent years, Dell Technologies acquired EMC Corporation (now, “Dell EMC”), Cavium, Inc. (“Cavium”) acquired QLogic Corporation, and Nokia acquired Alcatel-Lucent. Such industry consolidation may increase competitive dynamics in Brocade’s markets, impact Brocade’s partner ecosystem, and limit certain routes to market for Brocade’s solutions. Also, any one of these competitors could devote more resources to develop, promote, and sell their products, and, therefore, could respond more quickly to changes in customer or market requirements and adopt more aggressive pricing policies. Brocade’s failure to successfully compete in the networking market would harm its business and financial results.
Conditions in the SAN market could adversely affect Brocade’s business, financial results, and growth prospects.
Approximately one-half of Brocade’s fiscal year 2016 revenue was generated from its SAN business. As such, Brocade’s business, financial results, and growth prospects may be impacted significantly by changes in SAN market conditions. For example, total SAN market revenue contracted in calendar year 2015 and through the first three calendar quarters of 2016 due to, among other factors, the increasing efficiency of SAN products, the adoption of other networking protocols, changes in data center architectures, hyper-converged solutions and other new storage technologies, and the other competitive factors described in the risk factor above.
Revenue generated from sales of Brocade’s SAN products is also impacted by the amount of storage capacity deployed by its SAN customers. While the amount of storage capacity deployed is growing, the rate of that growth has declined in recent years.
In addition, revenue generated from sales of Brocade’s SAN products is impacted by the average selling price for those products. While the overall average selling price for Brocade’s SAN products has increased in recent periods, that increase has been largely due to the introduction of new products. Accordingly, that trend may not be sustained if Brocade is unable to continue to successfully introduce and obtain customer acceptance of new SAN products at the same rate, or at all.
The health of the overall SAN market will also depend on continued market participation by other SAN ecosystem vendors, such as Broadcom and Cavium, who produce Fibre Channel host bus adapters for servers and interconnect technology for storage arrays.
If Brocade fails to successfully address these SAN market conditions, Brocade’s business, financial results, and growth prospects may be adversely affected.
A limited number of major original equipment manufacturer (“OEM”) partners comprise a significant portion of Brocade’s revenues; the loss of revenue from, or decreased inventory levels held by, any of these major OEM partners could significantly reduce Brocade’s revenues and adversely affect its financial results.
Brocade’s SAN business depends on recurring purchases from a limited number of large OEM partners for a substantial portion of its revenues, specifically Dell EMC, HPE, and International Business Machines Corporation (“IBM”). As a result, revenues from these large OEM partners have a significant impact on Brocade’s quarterly and annual financial results. For fiscal years 2016, 2015, and 2014, these three OEM partners each represented 10% or more of Brocade’s total net revenues, for a combined total of 36%, 41%, and 46% of total net revenues, respectively. Brocade’s agreements with its OEM partners are typically cancellable and nonexclusive, and have no minimum or specific timing requirements for purchases. Brocade’s OEM partners could increase the amount purchased from Brocade’s competitors, introduce their own technology, or experience lower demand for Brocade SAN products from their end customers.
Also, one or more of Brocade’s OEM partners could elect to divest certain lines of business, split their business, or consolidate or enter into a strategic partnership with one of Brocade’s competitors, such as IBM’s sale of certain lines of business to Lenovo Group Limited, HPE becoming a separate public company, and the acquisition of the former EMC Corporation by Dell Technologies, which could reduce or eliminate Brocade’s revenue opportunities with that OEM partner. In addition, business execution or other operating performance issues experienced by Brocade’s OEM partners has in the past and may in the future adversely affect Brocade’s revenue and financial results. Brocade anticipates that a significant portion of its revenues and operating results from its SAN business will continue to depend on sales to a relatively small number of OEM partners. Brocade’s business and financial results could be harmed by the loss of any one significant OEM partner, a decrease in the level of sales to any one such partner, a change in any one such partner’s go-to-market strategy, or an unsuccessful negotiation on key terms, conditions, or timing of purchase orders placed during a quarter.
Brocade may not realize the anticipated benefits of past or future acquisitions, divestitures, and strategic investments, and the integration of acquired companies or technologies or divestiture of businesses may negatively impact Brocade’s business and financial results.
Brocade has acquired—or made strategic investments in—other companies, products, or technologies, and Brocade may make additional acquisitions and strategic investments in the future. For example, in the third quarter of fiscal year 2016, Brocade acquired Ruckus. The ability of Brocade to realize the anticipated benefits of its acquisitions and strategic investments involves numerous risks, including, but not limited to, the following:
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The target market for the acquired products may not develop within the expected time frame or may evolve in a different technical direction;
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Difficulties in successfully integrating the acquired businesses and realizing any expected synergies, including failure to integrate successfully the sales organizations;
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Failure to communicate to customers the capabilities of the combined company;
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Unanticipated costs, litigation, and other contingent liabilities, including liabilities associated with acquired intellectual property;
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Diversion of management’s attention from Brocade’s daily operations and business;
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Adverse effects on existing business relationships with suppliers and customers, including delays or cancellations of customer purchases, as well as revenue attrition in excess of anticipated levels if existing customers alter or reduce their historical buying patterns;
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Risks associated with entering into markets in which Brocade has limited or no prior experience, including the potential for a lower level of understanding of specific market dynamics;
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Inability to attract and retain key employees;
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Inability to successfully develop new products and services on a timely basis to address the market opportunities of the combined company;
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Inability to compete effectively against companies already serving the broader market opportunities expected to be available to the combined company;
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Inability to qualify the combined company’s products with OEM partners on a timely basis, or at all;
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Inability to successfully integrate financial reporting and IT systems;
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Inability to develop software-oriented back-office systems and processes necessary to sell and support a variety of software-based offerings;
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Failure to successfully manage additional business locations, including the infrastructure and resources necessary to support and integrate such locations;
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Assumption or incurrence of debt and contingent liabilities and related obligations to service such liabilities and potential limitations on Brocade’s operations in order to satisfy financial and other negative operating covenants;
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Additional costs, such as increased costs of manufacturing and service; costs associated with excess or obsolete inventory; costs of employee redeployment, relocation, and retention, including salary increases or bonuses; accelerated amortization of deferred equity compensation, severance payments, reorganization, or closure of facilities; taxes; advisor and professional fees; and termination of contracts that provide redundant or conflicting services; and
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The impact of acquisition- and integration-related costs, goodwill or in-process research and development impairment charges, amortization costs for acquired intangible assets, and acquisition accounting treatment, including the loss of deferred revenue and increases in the fair values of inventory and other acquired assets, on Brocade’s operating results and financial condition.
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Integration and other risks associated with acquisitions can be more pronounced for larger and more complicated transactions. For example, Brocade completed its acquisition of Ruckus in May 2016 and is in the process of combining the businesses and operations of the two companies. The size of the Ruckus acquisition increases both the scope and consequence of the ongoing risks and challenges associated with those efforts. In addition, Brocade’s ability to integrate Ruckus is further challenged by the pending acquisition of Brocade by Broadcom and Broadcom’s intent to divest Brocade’s IP Networking business, which includes Ruckus. Brocade may not successfully address those risks and challenges in a timely manner, or at all. If that occurs, Brocade may not fully realize all of the anticipated benefits of the Ruckus acquisition, and its revenue, expenses, operating results and financial condition could be adversely affected.
Brocade may also divest or reduce its investment in certain businesses or product lines from time to time. Such divestitures involve risks, such as difficulty separating portions of or entire businesses, distracting employees, incurring potential loss of revenue, negatively impacting margins, and potentially disrupting customer relationships. Brocade may also incur significant costs associated with exit or disposal activities, related impairment charges, or both.
Uncertainty about or a slowdown in the domestic and/or international economies has adversely affected, and may increasingly adversely affect, Brocade’s operating results and financial condition.
In recent years, the rate of economic growth in the United States has moderated and in certain other countries, including China, has significantly declined. In addition, uncertainty exists about the future growth of the domestic and international economies. Such uncertainty and slowdowns have resulted in, and may again result in, lower growth or a decline in IT-related spending, and, consequently, lead to lower growth or a decline in the networking market (including high-performance data networking solutions). Historically, IT spending has declined as general economic and market conditions have worsened due to geopolitical uncertainty. In addition, IT spending by international customers may decline if the value of the local currencies weaken against the U.S. dollar. Brocade is particularly susceptible to reductions in IT spending because the purchase of networking solutions is often discretionary and may involve a significant commitment of capital and other resources. The loss or delay of orders from any of Brocade’s more significant customers, such as individual branches or agencies within the U.S. federal government, or customers within the service provider, financial services, education (including technology improvements for schools funded by the U.S. federal government commonly known as the E-Rate program), and health sectors, could also cause Brocade’s revenue and profitability to suffer. For example, Brocade’s revenue and operating results could be negatively impacted if the U.S. federal government experiences delays in procurement due to longer decision-making time frames and/or a shift in IT procurement priorities. Economic uncertainty has caused, and may cause further, reductions in Brocade’s revenue, profitability, and cash flows, along with increased price competition, increased operating costs, and longer fulfillment cycles. Moreover, economic uncertainty may exacerbate many other risks noted elsewhere in this Form 10-Q, which could adversely affect Brocade’s business operations and financial condition.
Brocade’s future revenue growth depends on its ability to successfully introduce and achieve market acceptance of new products, services, and support offerings on a timely basis.
Developing new products, services (including software networking), and support offerings requires significant upfront investments that may not result in revenues for an extended period of time, if at all. Brocade must achieve market acceptance of its new product and support offerings on a timely basis in order to realize the benefits of its investments. However, the market for networking solutions, driven in part by the growth and evolution of the Internet and adoption of new technologies, such as software-defined networking, network functions virtualization, and Wi-Fi-related cloud services, is characterized by rapidly changing technology, accelerated product introduction cycles, changes in customer requirements, and evolving industry standards. In addition, many of Brocade’s new products, services, and support offerings will be directed toward customers, including hyperscale cloud providers and large service providers, with whom Brocade does not have strong existing sales relationships and who may require longer periods of time to evaluate products prior to making purchases. Sales to these customers may be challenging because sales are often based on long-term relationships and network incumbency and the complex system environments maintained by these customers often require interoperation with a variety of other vendors and back-office applications. Brocade’s future success depends largely upon its ability to address the rapidly changing needs of both new and existing customers by: allowing connectivity to other devices and partnering effectively; keeping pace with technological developments and emerging industry standards; and delivering high-quality, reliable, and cost-effective products, product enhancements, and services and support offerings on a timely basis.
Other factors that may affect Brocade’s successful introduction of new products, services, and support offerings include, but are not limited to, Brocade’s ability to:
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Properly predict the market for new products, services, and support offerings, including features, cost-effectiveness, scalability, and pricing—all of which can be particularly challenging for initial product offerings in new markets;
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Differentiate Brocade’s new products, services, and support offerings from its competitors’ offerings;
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Address the interoperability complexities of Brocade’s products with its OEM partners’ server and storage products and Brocade’s competitors’ products;
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Determine which route(s) to market will be most effective; and
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Manage product transitions, including forecasting demand, managing excess and obsolete inventories, addressing product cost structures, and managing different sales and support requirements.
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Failure to successfully introduce competitive products, services, and support offerings on a timely basis may harm Brocade’s business and adversely affect Brocade’s financial results.
If Brocade is unable to successfully transition from older products and corresponding support and service offerings to new products and corresponding support and service offerings on a timely basis, its business and financial results could be adversely affected.
As Brocade introduces new or enhanced products, such as Brocade’s recently introduced Gen 6 Fibre Channel SAN platform and SLX line of routers and data center switches, it must successfully manage the transition from older products to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories, maintain existing support revenue streams, and provide sufficient supplies of new products to meet customer demands. The introduction of new or enhanced products may shorten the life cycle of Brocade’s existing products or replace the sales of some of Brocade’s current products, thereby offsetting the benefit of a successful product introduction. When Brocade introduces new or enhanced products, it faces numerous risks related to product transitions, including the inability to accurately forecast demand, manage excess and obsolete inventories, address new or higher product cost structures, and manage different sales and support requirements due to the type or complexity of the new or enhanced products. In addition, customer evaluation periods or any customer uncertainty regarding the timeline for rolling out new products, or Brocade’s plans for future support of existing products (for example, uncertainty created by Brocade’s pending acquisition by Broadcom and Broadcom’s planned divestiture of Brocade’s IP Networking business), may cause customers to delay purchase decisions or to purchase competing products, which would adversely affect Brocade’s business and financial results.
The prices of Brocade’s IP Networking products have declined in the past and Brocade expects the prices of its products to decline in the future, which could reduce Brocade’s revenues, gross margins, and profitability.
The average selling price for Brocade’s IP Networking products has typically declined in the past and will likely decline in the future as a result of competitive pricing pressures, broader macroeconomic factors, product mix, new product introductions by Brocade or competitors, the entrance of new competitors, and other factors. In particular, if economic conditions deteriorate and create a more cautious capital spending environment in the IT sector, Brocade and its competitors could pursue more aggressive pricing strategies in an effort to maintain or increase revenues. If Brocade is unable to offset a decline in the average selling price of Brocade’s IP Networking products by increasing the volume of products shipped and/or reducing product manufacturing costs, including key components such as optics, Brocade’s revenues, gross margins, and profitability could be adversely affected.
Brocade’s failure to execute on its overall sales strategy or successfully leverage its channel and direct sales capabilities could significantly reduce its revenues and negatively affect its business, financial results, and growth prospects.
Brocade offers networking solutions through a multipath distribution strategy, including distributors, resellers, a direct sales force, and OEMs. However, Brocade’s efforts to increase sales through this multipath distribution strategy may not generate incremental revenue opportunities. Several of Brocade’s major OEM customers, including Dell EMC, IBM, HPE, and Oracle Corporation, have acquired companies that offer IP Networking solutions that are competitive with Brocade offerings. A loss of, or significant reduction in, revenue through one of Brocade’s paths to market would negatively impact its business and financial results.
As the networking industry continues to evolve, partners with which Brocade does not have long-standing relationships, such as cloud service providers that provide routing and infrastructure-as-a-service and global systems integrators that provide complete solutions to end users interested in upgrading to more modern architectures, may become increasingly important. In addition, as more enterprises purchase infrastructure-as-a-service offerings from hyperscale cloud providers and large service providers, sales through some of Brocade’s existing paths to market could decline. If Brocade fails to build or grow successful relationships with these partners and service providers, Brocade’s business and financial results could be adversely affected.
Brocade’s failure to successfully develop new and/or maintain its current channel partner relationships, or the failure of these partners to successfully sell Brocade’s products (for example, by devoting more resources to marketing and supporting Brocade’s competitors’ products and services), could reduce Brocade’s growth prospects significantly. In addition, Brocade’s ability to respond to the needs of its distribution and reseller partners in the future may also depend on third parties producing complementary products and applications for Brocade products to enable these partners to be competitive in the market. In addition, Brocade may not successfully achieve its expanded go-to-market objectives, which include effectively maintaining or expanding sales through its distribution channels, successfully managing distribution and reseller partner relationships, and effectively training and incentivizing its channel partners. If Brocade fails to respond successfully to the needs of these distribution and reseller partners and their customers, Brocade’s business and financial results could be adversely affected.
If Brocade does not manage the risks associated with its wireless networking business properly, its revenue and profitability could be adversely affected.
As described below, certain risks that accompany Brocade’s new wireless networking business differ from those of Brocade’s other businesses.
The success of Brocade’s wireless networking business depends on the continued growth and reliance on Wi-Fi, particularly in the service provider and enterprise markets. The recent growth of the market for Wi-Fi networks is being driven by the increased use of Wi-Fi-enabled mobile devices and the use of Wi-Fi as a preferred connectivity option to support video, voice, and other higher-bandwidth uses. As a result, mobile service providers and enterprises are struggling to address the increasing capacity demands. A number of barriers may prevent service providers or their subscribers from adopting Wi-Fi technology to address the wireless network capacity gap. For example, Wi-Fi operates over an unlicensed radio spectrum, and if the Wi-Fi spectrum becomes crowded, Wi-Fi solutions will be a less attractive option for service providers. In addition, in order for Wi-Fi solutions to adequately address the capacity gap, mobile devices should automatically switch from a cellular data network to the service provider’s Wi-Fi network, when available and appropriate, which does not generally occur. There is no guarantee that service providers and enterprises will continue to utilize Wi-Fi technology, that use of Wi-Fi-enabled mobile devices will continue to increase, or that Wi-Fi will continue to be the preferred connectivity option for the uses described above. If another technology were found to be superior to Wi-Fi by service providers or enterprises, it could adversely affect Brocade’s revenue and profitability.
Brocade’s wireless products are designed to interoperate with cellular networks and mobile devices using Wi-Fi technology. These networks and devices have varied and complex specifications. As a result, Brocade must attempt to ensure that its products interoperate effectively with all of these existing and planned networks and devices. To meet these requirements, Brocade must continue to undertake development and testing efforts that require significant capital and employee resources. Brocade may not accomplish these development efforts quickly or cost-effectively, or at all. If Brocade’s wireless products do not interoperate effectively, orders for Brocade’s wireless products could be delayed or cancelled, potentially resulting in the loss of existing and potential end customers; Brocade could experience significant warranty, support and repair costs; and the attention of Brocade’s engineering personnel could be diverted from its product development efforts. In addition, Brocade’s end customers may require Brocade’s products to comply with new and rapidly evolving security or other certifications and standards. If Brocade’s wireless products are late in achieving or fail to achieve compliance with these certifications and standards, and/or if Brocade’s competitors achieve compliance with these certifications and standards, such end customers may not purchase Brocade’s products, which would adversely affect Brocade’s revenue and profitability.
Brocade’s wireless products have been deployed in many different locations and user environments and are capable of providing connectivity to many different types of Wi-Fi-enabled devices operating a variety of applications. The ability of Brocade’s wireless products to operate effectively can be negatively impacted by many different elements unrelated to its products. For example, a user’s experience may suffer from an incorrect setting in a Wi-Fi device. Although certain technical problems experienced by users may not be caused by Brocade’s products, users often perceive the underlying cause to be a result of poor performance of the wireless network. This perception, even if incorrect, could harm Brocade’s business and reputation.
If Brocade loses key employees or is unable to hire additional qualified employees, its business may be negatively impacted.
Brocade’s success depends, to a significant degree, upon the continued contributions of its employees, including executive officers, engineers, sales representatives, and others, many of whom would be difficult to replace. Departures, appointments, and changes in roles and responsibilities of officers or other key members of management may disrupt Brocade’s business and adversely affect Brocade’s operating results.
Brocade believes its future success depends, in large part, upon its ability to attract highly skilled employees and operate effectively in geographically diverse locations. Brocade has relied heavily on equity awards in the form of stock options and restricted stock units as one means for recruiting and retaining highly skilled employees. The number of shares available for issuance under Brocade’s 2009 Stock Plan is limited, and any increase in the number of shares available under that plan must be approved by Brocade’s stockholders. The extent to which Brocade is able to obtain such stockholder approval depends on a variety of factors, including assessments by stockholders and proxy advisory firms of Brocade’s historical equity award granting practices. The effectiveness of these equity awards in recruiting and retaining employees could be reduced if Brocade has to reduce the size of the equity awards granted to its employees or if there is a sustained decline in the trading price of Brocade’s shares. There are also limited qualified employees in each of Brocade’s markets, and competition for such employees is very aggressive. In particular, Brocade operates in various locations with highly competitive labor markets, including Bangalore, India, and San Jose, California. Brocade may experience difficulty in hiring key management and qualified employees with skills in nearly all areas of Brocade’s business and operations.
The loss of the services of any of Brocade’s key employees, the inability to attract or retain qualified employees in the future, or delays in hiring required employees—particularly sales and engineering employees—could delay the development and introduction of Brocade’s products or services and/or negatively affect its ability to sell products or services.
In addition, the pending acquisition of Brocade by Broadcom, and Broadcom’s planned divestiture of Brocade’s IP Networking business, has had and may continue to have an adverse effect on Brocade’s ability to retain and motivate current employees or attract and retain prospective employees, each of whom may be uncertain about their future roles and relationships following the completion of the transactions. Further, Brocade’s ability to change compensation or take other actions to retain employees is limited under the merger agreement. Attrition of Brocade’s employees will likely have an adverse effect on Brocade’s business.
Brocade has a substantial amount of acquired intangible assets, goodwill, and deferred tax assets on its balance sheet, and if Brocade is required to record impairment charges for these assets, such impairment charges could adversely affect Brocade’s financial results.
Brocade has a substantial amount of acquired intangible assets and goodwill on its balance sheet related to Brocade’s prior acquisitions. Brocade’s determination of the fair value of its long-lived assets relies on management’s assumptions of future revenues, operating costs, and other relevant factors. Brocade’s estimates with respect to the useful life or ultimate recoverability of Brocade’s carrying basis of assets, including acquired intangible assets, could change as a result of changes in strategic focus, competition, or other changes affecting management’s assumptions. If management’s estimates of future operating results change or if there are changes to other assumptions, such as the discount rate applied to future cash flows, then the estimated fair value of Brocade’s reporting units could change significantly, which could result in goodwill impairment charges. The risk of a future goodwill impairment charge is comparatively high for the IP Networking Products reporting unit because, based on the Company’s fiscal year
2016
annual goodwill impairment test, the estimated fair value of that reporting unit’s net assets, which include goodwill, exceeded the carrying value of those net assets by only approximately $181 million. For a sensitivity analysis that quantifies the impact of certain key assumptions used by Brocade on the fair value estimates for the IP Networking Products reporting unit, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” in Part I, Item 2 of this Form 10-Q. If future impairment tests should result in a charge to earnings, Brocade’s financial results would be adversely affected.
Brocade has determined that, more likely than not, it will realize its deferred tax assets based on positive evidence of its historical operations and projections of future income, except for the deferred tax assets related to California and remaining capital loss carryforwards for which a valuation allowance has been applied. In the event that future income by jurisdiction is less than what is currently projected, Brocade may be required to apply a valuation allowance to these deferred tax assets in jurisdictions where realization of such assets is no longer more likely than not, which could result in a charge to earnings that would adversely affect Brocade’s financial results.
Cyberattacks and data security breaches could disrupt Brocade’s operations, negatively impact Brocade’s reputation, and erode customers’ trust.
Cyberattacks and other malicious attacks could lead to data breaches, computer break-ins, malware, viruses, and unauthorized tampering with Brocade’s computer systems, intellectual property, and confidential information of its customers and partners. These attacks could disrupt Brocade’s operations, negatively impact Brocade’s reputation, and erode customers’ trust. Brocade’s IT systems also rely in part upon certain business management and communication tools provided by third-party vendors, and security flaws or outages in such tools could adversely affect Brocade’s operations. Despite implementation of cybersecurity measures by Brocade and its third-party vendors, Brocade or such vendors may not successfully limit attacks by malicious third parties if they attempt to undermine or disrupt those cybersecurity measures.
Additionally, if an actual or perceived cyberattack or data security breach occurs in Brocade’s network or in one of Brocade’s customers’ networks, regardless of whether the breach is attributable to Brocade’s products, the market perception of the effectiveness of Brocade’s products could be harmed. Brocade may suffer reputational harm and Brocade’s customers’ trust may be eroded as a result of a data security breach involving customers’ or employees’ information, which could negatively impact revenue, expenses, and profitability. Customers have become increasingly sensitive to government-sponsored surveillance and may believe that, as a U.S.-based manufacturer, Brocade’s equipment contains “backdoor” code that would allow customer data to be compromised by either governmental bodies or other third parties. As a result, customers may choose not to deploy Brocade networking products, which could negatively impact Brocade’s business and financial results.
Brocade’s revenues, operating results, and cash flows may fluctuate from period to period due to a number of factors, which makes predicting financial results difficult.
IT spending is subject to cyclical and uneven fluctuations, which could cause Brocade’s financial results to fluctuate unevenly and unpredictably. For example, the U.S. federal budget for government IT spending can be highly seasonal and subject to delays, reductions, and uncertainty due to changes in the political and legislative environment. It can also be difficult to predict the degree to which end-customer demand and the seasonality and uneven sales patterns of Brocade’s OEM partners or other customers will affect Brocade’s business in the future, particularly as Brocade releases new or enhanced products. While Brocade’s first and fourth fiscal quarters are typically stronger quarters for SAN products and Brocade’s third and fourth fiscal quarters are typically stronger quarters for IP Networking solutions, future buying patterns may differ from historical seasonality. If the mix of revenue changes, it may also cause results to differ from historical seasonality. Accordingly, Brocade’s quarterly and annual revenues, operating results, cash flows, and other financial and operating metrics may vary significantly in the future, and the results of any prior periods should not be relied upon as an indication of future performance. In addition, the announcement and pendency of Brocade’s agreement to be acquired by Broadcom, Broadcom’s planned divestiture of Brocade’s IP Networking business, or the failure to complete the proposed transactions on a timely basis or at all, could have a material adverse effect on, and cause fluctuations in, Brocade’s operating results.
Failure to accurately forecast demand for Brocade’s products or to successfully manage the production of its products could increase Brocade’s product cost and adversely affect its revenue, margins and profitability.
Brocade provides product forecasts to its contract manufacturers (“CMs”) and places purchase orders with them in advance of the scheduled delivery of products to Brocade’s customers. In preparing sales and demand forecasts, Brocade relies largely on input from its sales force, partners, resellers, and end-user customers. If Brocade is unable to accurately forecast demand, or if Brocade fails to effectively communicate with its distribution partners about end-user demand or other time-sensitive information, Brocade’s ability to successfully manage production could be negatively impacted. Brocade’s ability to accurately forecast demand also may become increasingly limited as Brocade introduces new or enhanced products, begins phasing out certain products, or acquires other companies or businesses. Further, the announcement and pendency of Broadcom’s proposed acquisition of Brocade and planned divestiture of Brocade’s IP Networking business increases the challenge of accurately forecasting customer demand. If these forecasts are inaccurate, Brocade may be unable to obtain adequate manufacturing capacity from its CMs to meet customers’ delivery requirements, which could cause customers to cancel their orders for Brocade products. Inaccurate forecasts also could cause Brocade to accumulate excess inventories or incur costs associated with excess manufacturing capacity. If customers cancel their orders, Brocade’s revenue may be adversely affected. If excess inventories accumulate, Brocade’s gross margins may be negatively impacted by write-downs for excess and/or obsolete inventory. In addition, Brocade will experience higher fixed costs as it expands its CMs’ capabilities for forecasted demand, which could negatively affect Brocade’s margins if demand decreases suddenly and Brocade is unable to reduce these fixed costs.
Additionally, most of Brocade’s manufacturing overhead and expenses are fixed in the short term or incurred in advance of receipt of corresponding revenue, and Brocade may not be able to reduce such expenses sufficiently to offset declining product prices, reduced volumes, or other factors. As a result, Brocade’s gross margins may be adversely affected by fluctuations in manufacturing volumes, component costs, foreign currency exchange rates, the mix of product configurations sold, and the mix of distribution channels through which its products are sold. Brocade’s gross margins may also be adversely affected if product or related warranty costs associated with Brocade’s products are greater than previously experienced.
Brocade has extensive international operations, which expose its business and operations to additional risks.
Brocade has significant international operations, and a significant portion of Brocade’s sales occur in international jurisdictions. In addition, Brocade’s CMs have significant operations in China and other locations outside the United States. Brocade’s international sales of its IP Networking solutions have primarily depended on its distributors and resellers. Maintenance or expansion of international sales or international operations involves inherent risks that Brocade may not be able to control, including, but not limited to, the following:
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Compliance by Brocade and its channel partners and other agents with numerous and often complex U.S. and other applicable government regulations prohibiting certain end-uses and restricting trade with embargoed or sanctioned countries, such as Iran and Russia, and with denied parties;
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Difficulty in conducting due diligence with respect to business partners in certain international markets;
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Exposure to economic instability or fluctuations in international markets, such as China, that could cause reductions in IT spending;
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Exposure to inflationary risks and/or wage inflation in certain countries, such as India;
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Increased exposure to foreign currency exchange rate fluctuations, including currencies such as the British pound, the Chinese yuan, the euro, the Indian rupee, the Japanese yen, the Singapore dollar, and the Swiss franc;
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Exposure to sovereign debt risk and political and economic instability in certain regions of Europe, including Russia and Turkey, and certain countries with newly advanced economies, including China and Brazil;
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Multiple potentially conflicting and changing governmental laws, regulations, technical standards, certification requirements, and practices, including differing environmental, data privacy, export, import, trade, manufacturing, product compliance, tax, labor, and employment laws;
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Compliance by Brocade and its channel partners and other agents with the numerous and often complex U.S. and other applicable government regulations relating to exports and imports, and associated licensing requirements, particularly in the area of encryption technology;
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Reduced or limited protection of intellectual property rights, particularly in jurisdictions that have less-developed intellectual property regimes, such as China and India;
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Commercial laws and business practices that favor local competition;
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In certain international regions, particularly those with rapidly developing economies, it may be common to engage in business practices that are prohibited by anti-bribery laws, such as the U.S. Foreign Corrupt Practices Act and the U.K. Bribery Act;
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Increased complexity, time, and costs of managing international operations;
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Managing research and development and sales teams in geographically diverse locations, including teams divided between the United States, the United Kingdom, and India;
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Effective communications across multiple geographies, cultures, and languages;
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Recruiting sales and technical support personnel with the skills to design, manufacture, sell, and support Brocade’s products in international markets;
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Longer sales cycles and manufacturing lead times;
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Increased complexity and cost of providing customer support and maintenance for international customers;
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Difficulties in collecting accounts receivable;
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Increased complexity of logistics and distribution arrangements; and
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Increased complexity of accounting rules and financial reporting requirements.
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In addition, the June 2016 announcement of the results of the United Kingdom European Union membership referendum (commonly referred to as “Brexit”) advising for the exit of the United Kingdom from the European Union has created economic, financial, and regulatory uncertainty, which may cause Brocade’s customers to closely monitor their costs and reduce their spending on Brocade’s products and services.
Any of these factors could negatively impact Brocade’s business, revenues, and profitability.
If product orders are received late in a fiscal quarter, Brocade may be unable to recognize revenue for these orders in the same quarter, which could adversely affect quarterly financial results.
Brocade’s IP Networking business typically experiences significantly higher levels of customer orders toward the end of a fiscal period. Customer orders received toward the end of the period may not ship within the period due to a lack of available inventory and manufacturing lead times. The inability to ship within the quarter in which the customer orders are received could negatively impact Brocade’s financial results in a particular quarter.
Brocade is subject to—and will continue to be subject to—intellectual property infringement claims and litigation that are costly to defend and/or settle, which could result in significant damages and other costs to Brocade and limit Brocade’s ability to use certain technologies in the future.
Brocade competes in markets in which companies are frequently subject to claims and related litigation regarding patent and other intellectual property rights. Third parties have, from time to time, asserted patent, copyright, trade secret, and/or other intellectual property-related claims against Brocade and/or employees of Brocade. These claims may be, and have in the past been, made against Brocade’s products and services, subcomponents of its products, methods performed by its products or a combination of products, including third-party products, methods used in its operations, or uses of its products by its customers. The claimant may seek various remedies against Brocade, such as money damages, disgorgement of profits, injunctions barring sales of infringing goods, or exclusion orders barring import of products into the U.S., among other possible remedies. Moreover, these claims may concern Brocade’s hiring of a former employee of the third-party claimant. Brocade and companies acquired by Brocade have in the past incurred, and will likely incur in the future, substantial expenses to defend against such third-party claims. In particular, as a result of the acquisition of Ruckus, Brocade now competes in new markets, including the Wireless LAN market, that may result in relatively greater numbers of third-party intellectual property claims. Brocade’s suppliers and customers also may be subject to third-party intellectual property claims with respect to their own products, which could negatively impact the suppliers’ ability to supply Brocade with components or customers’ willingness to purchase products from Brocade. In addition, Brocade may be subject to claims, defenses, and indemnification obligations with respect to third-party intellectual property rights pursuant to Brocade’s agreements with suppliers, OEM and channel partners, or customers. If Brocade refuses to indemnify or defend such claims, for instance, even in situations in which the allegations are meritless, then suppliers, partners, or customers may refuse to do business with Brocade. Parties that assert such intellectual property claims may be unreasonable in their demands, or may simply refuse to settle, which could lead to prolonged periods of litigation, additional burdens on employees or other resources, distraction from Brocade’s business operations, component supply stoppages, expensive settlement payments, and lost sales. Furthermore, there is little or no information publicly available concerning market or fair values for licenses and/or settlement fees, which can lead to overpayment of license or settlement fees. Any of the above scenarios could have an adverse effect on Brocade’s financial position, financial results, cash flows, and future business prospects.
Undetected software or hardware errors could increase Brocade’s costs, reduce its revenues, and delay market acceptance of its products.
Networking products frequently contain undetected software or hardware errors when first introduced or as new versions are released. As Brocade continues to expand its product portfolio to include software-centric products, which may include software licensed from third parties, errors may be found from time to time in these products. In addition, through its acquisitions, Brocade has assumed—and may in the future assume—products previously developed by an acquired company that have not been through the same level of product development, testing, and quality control processes used by Brocade, and may have known and/or undetected errors. Some types of errors may not be detected until the product is installed in a user environment. In addition, Brocade products are often combined with other products, including software from other vendors, and these products often need to interoperate. For IT products that have different specifications, utilize multiple protocol standards, or may be procured from other vendors, it may be difficult to identify the source of any problems. Identifying the source of and remediating these problems may cause Brocade to incur significant warranty and repair costs, divert the attention of engineering personnel from product development efforts, and cause significant customer relations problems, resulting in lower profitability from increased costs and/or decreased revenue. Moreover, the occurrence of hardware and software errors, whether caused by Brocade products or another vendor’s products, could delay market acceptance of new or enhanced Brocade products.
Brocade’s supply chain is dependent on several sole-source and limited-source suppliers and a limited number of major CMs, either one or both of which may significantly impact Brocade’s financial results.
Although Brocade uses standard parts and components for its products where possible, Brocade’s CMs currently purchase, on Brocade’s behalf, several key components used in the manufacture of its products from single- or limited-source suppliers. Brocade’s single-source components include, but are not limited to, its application-specific integrated circuits (commonly referred to as “ASICs”) and its Wi-Fi chipsets. Brocade’s principal limited-source components include memory, certain oscillators, microprocessors, certain connectors, certain logic chips, power supplies, programmable logic devices, printed circuit boards, certain optical components, packet processors, and switch fabric components. Brocade generally acquires these components through purchase orders and has no long-term commitments regarding supply or pricing with such suppliers. If Brocade is unable to obtain these and other components when required, or if Brocade’s suppliers experience component defects, Brocade may not be able to deliver its products to customers in a timely manner and may be required to repair or retrofit products previously delivered to customers, at significant expense to Brocade. In addition, a challenging economic or industry environment could cause some of these sole-source or limited-source suppliers to delay or halt production, go out of business, or be acquired by third parties, which could result in a disruption in Brocade’s supply chain. Brocade’s supply chain could also be disrupted in a variety of other circumstances that may impact its suppliers and partners, including adverse results from intellectual property litigation or natural disasters. Any manufacturing disruption by these sole-source or limited-source suppliers could severely impair Brocade’s ability to fulfill orders and may significantly impact its financial results.
In addition, the loss of any of Brocade’s major CMs, or portions of their capacity, could significantly impact Brocade’s ability to produce its products for an indefinite period of time. Qualifying a new CM and commencing volume production is typically a lengthy and expensive process. A CM may move the production lines for Brocade’s products to new locations or factories, and this may result in delays or disruptions. If Brocade changes any of its CMs or if any of its CMs experience unplanned delays, disruptions, capacity constraints, component parts shortages, or quality control problems in their manufacturing operations, shipment of Brocade’s products to customers could be delayed and result in loss of revenues.
Brocade’s intellectual property rights may be infringed upon or misappropriated by others, and Brocade may not be able to protect or enforce its intellectual property rights.
Brocade’s intellectual property rights may be infringed upon or misappropriated by others, including by competitors, partners, former employees, foreign governments, or other third parties. In some cases, such infringement or misappropriation may be undetectable, or enforcement of Brocade’s intellectual property rights may be impractical. Brocade has filed, and may in the future file, lawsuits against third parties in an effort to enforce its intellectual property rights. Intellectual property litigation is expensive and unpredictable. There can be no assurance that Brocade will prevail in such assertions or enforcement efforts, either on the merits, or with respect to particular relief sought, such as damages or an injunction. Nor can there be any assurance that any awarded damages ultimately will be paid to Brocade. Furthermore, the opposing party may attempt to prove that the asserted intellectual property rights are invalid or unenforceable, and, if successful, may seek recompense for its attorneys’ fees and costs or countersue Brocade as part of its defense. Finally, there can be no assurance that any attempt by Brocade to enforce its intellectual property rights, even if successful in court, will improve Brocade’s sales, diminish the defendant’s sales, or stop the defendant’s allegedly unfair competition.
Brocade relies on a combination of patent, copyright, trademark, and trade secret laws, along with measures such as physical and operational security and contractual restrictions, to protect its intellectual property rights in its proprietary technologies, but none of these methods of protection may be entirely appropriate or adequate to address all risks that could result in a loss of intellectual property rights. Loss or violation of Brocade’s intellectual property rights could adversely affect Brocade’s business and operating results, through a loss of revenue or an increase in expenses.
Brocade relies on licenses from third parties, and the loss or inability to obtain any such license could adversely affect its business.
Many Brocade products are designed to include software or other intellectual property licensed from third parties. There can be no assurance that the necessary licenses will be available on acceptable terms, if at all. Brocade’s inability to obtain certain licenses or other rights on favorable terms, or the termination of existing licenses, could have an adverse effect on Brocade’s business, operating results, and financial condition, including its ability to continue to distribute or support affected products.
In addition, if Brocade has failed, or in the future fails, to adequately manage the use of commercial or “open-source” software in Brocade’s products, or if companies acquired by Brocade fail in such regard, Brocade may be subject to copyright infringement litigation or other claims. Furthermore, Brocade may be required, for commercially licensed software, to pay penalties or undergo costly audits pursuant to the license agreement. In the case of open-source software, Brocade may be required to license proprietary portions of its products on a royalty-free basis, disclose proprietary parts of source code, or commence costly product redesigns that could result in a loss of intellectual property rights, product performance degradation, or a delay in shipping products to customers and result in loss of revenue or increased costs.
Brocade’s planned upgrade of its enterprise resource planning (“ERP”) software solution could result in significant disruptions to its operations.
Brocade is in the process of upgrading its ERP software solution to a newer version. Brocade expects the upgrade to be completed in the first half of fiscal year 2018. Implementation of the upgraded solution will have a significant impact on Brocade’s business processes, information systems, and internal controls. The transition will require significant change management, meaningful investment in capital and personnel resources, and coordination of numerous software and system providers and internal business teams. Brocade may experience difficulties as it manages these changes and transitions to the upgraded systems and processes, including loss or corruption of data, delayed shipments, decreases in productivity as its personnel implement and become familiar with new systems and processes, unanticipated expenses (including increased costs of implementation or costs of conducting business), and lost revenues. Difficulties in implementing the upgraded solution or significant system failures could disrupt Brocade’s operations, divert management’s attention from key strategic initiatives, and have an adverse effect on its capital resources, financial condition, results of operations, or cash flows. In addition, any delays in completing the upgrade process, including any delays associated with Broadcom’s proposed acquisition of Brocade, could exacerbate these transition risks as well as expose Brocade to additional risks in the event that the support for Brocade’s existing ERP software solution is reduced or eliminated.
Business interruptions could adversely affect Brocade’s business operations.
Brocade’s business operations and the operations of its suppliers, CMs, and customers are vulnerable to interruptions caused by acts of terrorism, fires, earthquakes, tsunamis, nuclear reactor leaks, hurricanes, power losses, telecommunications failures, and other events beyond Brocade’s control. For example, a substantial portion of Brocade’s facilities, including its corporate headquarters, are located near major earthquake faults. Brocade does not have multiple-site capacity for all of its services in the event of a business disruption. In the event of a major earthquake, Brocade could experience business interruption resulting from destruction of facilities or other infrastructure and from loss of life. Brocade does not carry earthquake insurance and has not set aside funds or reserves to cover potential earthquake-related losses. Additionally, major public health issues, such as an outbreak of a pandemic or epidemic, may interrupt business operations of Brocade, its CMs, its customers, or its suppliers in those geographic regions affected by that particular health issue. In addition, one of Brocade’s CMs has a major facility located in an area that is subject to hurricanes, and Brocade’s suppliers could face other natural disasters, such as floods, earthquakes, extreme weather, and fires. In the event that a business interruption occurs that affects Brocade, its suppliers, CMs, or customers, shipments could be delayed or cancelled, and Brocade’s business operations and financial results could be harmed.
In addition, Brocade may suffer reputational harm and may not carry sufficient insurance to compensate for financial losses that may occur as a result of any of these events. Any such event could have an adverse effect on Brocade’s business, operating results, and financial condition, and could expose Brocade to significant third-party claims of liability and damages.
Brocade is required to assess its internal control over financial reporting on an annual basis, and any adverse findings from such assessment could result in a loss of investor confidence in its financial reports and significant expense to remediate any internal control deficiencies, and ultimately could have an adverse effect on its stock price.
Brocade is required to assess the effectiveness of its internal control over financial reporting annually, as required by Section 404 of the Sarbanes-Oxley Act of 2002. Brocade’s evaluation of the effectiveness of its internal control over financial reporting as of October 29, 2016, its most recent internal control effectiveness evaluation date, did not include the internal control over financial reporting of Ruckus, a company that Brocade acquired in May 2016. Even though, as of October 29, 2016, Brocade concluded that its internal control over financial reporting was effective, Brocade needs to maintain its processes and systems and adapt them as its business grows and changes, including to reflect its integration of Ruckus, as well as any future acquisitions Brocade may undertake. This continuous process of maintaining and adapting its internal controls and complying with Section 404 is expensive, time consuming, and requires significant management attention. In addition, Brocade cannot be certain that its internal control measures will continue to provide adequate control over its financial processes and reporting or ensure compliance with Section 404.
If Brocade or its independent registered public accounting firm identifies material weaknesses in Brocade’s internal controls, the disclosure of that fact, even if quickly remedied, may cause investors to lose confidence in Brocade’s financial statements and its stock price may decline. Remediation of a material weakness could require Brocade to incur significant expenses and, if Brocade fails to remedy any material weakness, its financial statements may be inaccurate, its ability to report its financial results on a timely and accurate basis may be adversely affected, its access to the capital markets may be restricted, its stock price may decline, and Brocade may be subject to sanctions or investigation by regulatory authorities, including the U.S. Securities and Exchange Commission (“SEC”) or the NASDAQ Stock Market LLC (“NASDAQ”). Brocade may also be required to restate its financial statements from prior periods.
Brocade’s business is subject to increasingly complex and changing legal and regulatory requirements that could adversely affect its business, financial results, and stock price.
Brocade is subject to the changing rules and regulations of federal and state governments, as well as the stock exchange on which Brocade’s common stock is listed. These entities, including the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, the SEC, the Internal Revenue Service (the “IRS”), the Financial Industry Regulatory Authority, Inc., and NASDAQ, have issued a significant number of new regulations over the last several years and continue to develop additional regulations and requirements. Further, Brocade is subject to various rules and regulations of certain foreign jurisdictions. Brocade’s efforts to comply with these requirements have resulted in, and are likely to continue to result in, an increase in expenses and a diversion of management’s time from other business activities.
For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act requires that public companies disclose whether certain minerals, commonly known as “conflict minerals,” are necessary to the functionality or production of a product manufactured or contracted to be manufactured by those companies, and, if so, whether those minerals originated in the Democratic Republic of the Congo or an adjoining country. These requirements could adversely affect (i) Brocade’s revenues, if its partners or customers are dissatisfied with Brocade’s use or efforts to reduce the use of conflict minerals and (ii) the sourcing, availability, and pricing of minerals used in the manufacture of certain components that are incorporated in Brocade products. In addition, Brocade’s supply chain is complex, so Brocade may face reputational challenges with its partners, customers, stockholders, and other stakeholders if the origins of the conflict minerals used in its products cannot be sufficiently verified.
Similarly, Brocade is subject to environmental and other regulations governing product safety, materials usage, packaging, and other environmental impacts in the countries where Brocade products are sold. For example, many Brocade products are subject to laws and regulations that restrict the use of certain substances such as lead, mercury, hexavalent chromium, and cadmium, and that require Brocade to assume responsibility for collecting, treating, recycling, and disposing of products when they have reached the end of their useful lives. For example, in Europe, environmental restrictions apply to products sold in that region, and certain Brocade partners require compliance with these or other more stringent requirements. In addition, recycling, labeling, and related requirements apply to Brocade products sold in Europe and China. If Brocade products do not comply with local environmental laws, Brocade could be subject to fines, civil and criminal sanctions, and contract damage claims. In addition, Brocade could be prohibited from shipping noncompliant products into certain jurisdictions and required to recall and replace any noncompliant products already shipped, which would disrupt Brocade’s ability to ship products and result in reduced revenue, increased warranty expense, increased obsolete or excess inventories, and harm to Brocade’s business and customer relationships.
Brocade’s wireless products are subject to governmental regulations in a variety of jurisdictions. In order to achieve and maintain market acceptance, Brocade’s wireless products must continue to comply with these regulations, as well as a significant number of industry standards. In the United States, Brocade’s products must comply with various regulations defined by the Federal Communications Commission (“FCC”), Underwriters Laboratories, and others. Brocade must also comply with similar international regulations. For example, Brocade’s wireless communication products operate through the transmission of radio signals, and radio emissions are subject to regulation in the United States and in other countries in which Brocade does business. In the United States, various federal agencies including the Center for Devices and Radiological Health of the United States Food and Drug Administration, the FCC, the Occupational Safety and Health Administration, and various state agencies have promulgated regulations that concern radio/electromagnetic emissions standards. Member countries of the European Union have enacted similar standards concerning electrical safety and electromagnetic compatibility and emissions, as well as chemical substances and use standards. As these regulations and standards evolve, and if new regulations or standards are implemented, Brocade will be required to modify its products or develop and support new versions of its products, and Brocade’s compliance with these regulations and standards may become more burdensome. The failure of Brocade’s wireless products to comply, or delays in compliance, with the various existing and evolving industry regulations and standards could prevent or delay introduction of Brocade’s products, which could harm Brocade’s business. End-customer uncertainty regarding future policies may also affect demand for communications products, including Brocade’s wireless products. If existing laws or regulations regarding the use of Brocade’s wireless products or related services are enforced in a manner not contemplated by Brocade’s end customers, it could expose them or Brocade to liability and adversely affect Brocade’s wireless networking business. Moreover, channel partners or end customers may require Brocade, or Brocade may otherwise deem it necessary or advisable, to alter its wireless products to address actual or anticipated changes in the regulatory environment. Brocade’s inability to alter its wireless products to address these requirements and any regulatory changes may adversely affect Brocade’s wireless networking business.
Brocade is subject to laws, rules, and regulations in the United States and other countries relating to the collection, use, and security of personal information and data. Brocade has incurred, and will continue to incur, expenses to comply with privacy and security standards, protocols, and obligations imposed by applicable laws, regulations, industry standards, and contracts. In addition, such data privacy laws, regulations, and other obligations may negatively impact Brocade’s ability to execute transactions and pursue business opportunities. Brocade’s customers may also be subject to such laws and regulations in their use of certain Brocade products and services to collect, store, and process data that may include personal information. Such customers may demand or request additional functionality in Brocade’s products and services that they believe are necessary or appropriate to comply with such laws and regulations, which could cause Brocade to incur significant additional costs or lose business, or which could delay or impede the development of new solutions. The privacy and data protection-related laws, rules, and regulations applicable to Brocade and its customers are also subject to significant change. For example, in October 2015, the Court of Justice of the European Union invalidated a safe harbor framework that allowed Brocade and other U.S. companies to meet certain European legal requirements for transferring personal data from Europe to the United States. In response to this development, Brocade and many of its foreign subsidiaries have entered into an Intra-Group Data Transfer Agreement to enable the transatlantic transfer of employee and customer data. In April 2016, the European Parliament approved the General Data Protection Regulation. This regulation, when effective in May 2018, will impose more stringent data protection requirements on U.S. companies collecting personal data from European Union residents and establish greater penalties for noncompliance. Brocade is in the process of evaluating its business practices to ensure compliance with the General Data Protection Regulation. Any inability to comply with applicable privacy or data protection laws, regulations, or other obligations could result in significant cost and liability, damage Brocade’s reputation, and adversely affect its business.
Changes to Brocade’s provision for income taxes or unfavorable outcomes of tax audits could adversely impact Brocade’s financial condition or results.
Brocade is subject to income and other taxes in the United States, including those required by both state and federal governmental agencies, such as the IRS, and numerous foreign jurisdictions. Brocade’s provision for income taxes could be increased due to changes in tax laws in the jurisdictions in which Brocade does business, including an increase in tax rates or an adverse change in the treatment of an item of income or expense. In this regard, the United States, countries in the European Union, and other countries where Brocade operates have enacted or are proposing changes to relevant tax, accounting, and other laws, regulations, and interpretations, including fundamental changes to tax laws applicable to multinational corporations. In addition, future effective tax rates could be subject to volatility or adversely affected by changes in the geographic mix of earnings in countries with differing statutory rates, changes in the valuation of deferred tax assets and liabilities, and tax effects of stock-based compensation. These potential changes could increase Brocade’s effective tax rate or result in other costs in the future.
Brocade is subject to periodic audits or other reviews by such governmental agencies, and is currently under examination by several state and foreign tax jurisdictions for various years. Audits by governmental tax agencies are subject to inherent uncertainties and could result in unfavorable outcomes, including potential fines or penalties. While Brocade regularly assesses the likely outcomes of these audits in order to determine the appropriateness of its tax provision, the occurrence of an unfavorable outcome in any specific period could have an adverse effect on Brocade’s financial condition or results for that period or future periods. The expense of defending and resolving such an audit may be significant.
Brocade is exposed to various risks related to legal proceedings or claims that could adversely affect its financial condition or results.
Brocade is a party to lawsuits in the normal course of its business. The results of complex legal proceedings are difficult to predict. Responding to lawsuits brought against Brocade, or legal actions initiated by Brocade, can often be expensive, time-consuming, and disruptive to normal business operations. Unfavorable outcomes from these claims and/or lawsuits could adversely affect Brocade’s business, financial results, or financial condition, and Brocade could incur substantial monetary liability and/or be required to change its business practices. In view of the uncertainties, potential risks, and expenses of litigation, Brocade may, from time to time, settle such disputes, even where Brocade had meritorious claims or defenses, by agreeing to settlement agreements that, depending on their terms, may significantly impact Brocade’s financial condition or results. Additional information regarding certain legal proceedings in which Brocade is currently engaged is discussed under “Legal Proceedings” in Part II, Item 1 of this Form 10-Q and in Note
9
, “
Commitments and Contingencies
,” of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q.
Brocade’s stock price may fluctuate, which could cause the value of an investment in Brocade’s shares to decline.
Brocade’s stock price has fluctuated in the past and may be subject to wide fluctuations in the future in response to various factors. Brocade does not have the ability to influence or control many of these factors. In addition to the factors discussed elsewhere in this “Risk Factors” section, factors that could affect Brocade’s stock price include, among others:
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The failure of the pending acquisition of Brocade by Broadcom to be completed on a timely basis or at all;
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Speculation, coverage, or sentiment in the media or investment community regarding the likelihood of completion of the pending acquisition of Brocade by Broadcom;
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Public announcements regarding the status of the pending acquisition of Brocade by Broadcom and/or the status of Broadcom’s planned divestiture of Brocade’s IP Networking business;
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Actual or anticipated changes in Brocade’s operating results;
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Whether Brocade’s operating results or forecasts meet the expectations of securities analysts or investors;
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Actual or anticipated changes in the expectations of securities analysts or investors;
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Recommendations by securities analysts or changes in their earnings estimates;
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The announcement or timing of announcement of Brocade’s quarterly or annual operating results;
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Announcements of actual or anticipated operating results by Brocade’s competitors, Brocade’s OEM partners, and other companies in the IT industry;
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Speculation, coverage or sentiment in the media or the investment community about, or actual changes in, Brocade’s business, strategic position, competitive position, market share, operations, prospects, future stock price performance, or Brocade’s industry in general;
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The announcement of new, planned, or contemplated products; services; commercial relationships; technological innovations; acquisitions; divestitures; or other significant transactions by Brocade or its competitors;
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Brocade’s level of success, or perceived level of success, in integrating acquisitions, including the Ruckus acquisition;
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Adverse changes to Brocade’s relationships with any of its OEM partners;
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Changes in the business strategy or execution of any of Brocade’s OEM partners;
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Departures of key employees;
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Litigation or disputes involving Brocade, Brocade’s industry, or both;
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General economic conditions and trends;
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Sales of Brocade’s stock by Brocade’s officers, directors, or significant stockholders; and
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The timing and amount of dividends and stock repurchases.
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In addition, the stock market in general, and the market for technology companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Accordingly, broad market and industry factors may adversely affect Brocade’s stock price regardless of Brocade’s operating performance. In addition, Brocade’s stock price might also fluctuate in reaction to events that affect other companies in Brocade’s industry even if these events do not directly affect or involve Brocade.
If Brocade’s stock price fluctuates widely, Brocade may become the target of securities litigation. Securities litigation could result in substantial costs and divert Brocade’s management’s attention and resources from Brocade’s business.
Brocade has incurred substantial indebtedness that may decrease its business flexibility and access to capital, and/or increase its borrowing costs, which may adversely affect Brocade’s operations and financial results.
As of
January 28, 2017
, Brocade had approximately
$1.6 billion
in principal amount of outstanding indebtedness, including $575 million of indebtedness under the 2020 Convertible Notes, $300.0 million of unsecured indebtedness under the 2023 Notes, and $760.0 million of indebtedness under the Term Loan Facility described below. In connection with the completion of the Ruckus acquisition in May 2016, Brocade entered into the Credit Agreement pursuant to which the Lenders have provided Brocade with a term loan facility of $800 million (the “Term Loan Facility”) and a revolving credit facility of $100 million (the “Revolving Facility,” and together with the Term Loan Facility, the “Senior Credit Facility”) (see Note
8
, “
Borrowings
,” of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q). Brocade’s substantially increased indebtedness could have the effect, among other things, of reducing Brocade’s flexibility to respond to changing business and economic conditions. In addition, a substantial amount of cash will be required to pay interest, make scheduled principal amortization payments, and repay at maturity Brocade’s indebtedness, which may adversely impact Brocade’s cash resources, reduce Brocade’s business flexibility and reduce the funds otherwise available for working capital, capital expenditures, acquisitions, share repurchases, and other general corporate purposes. Moreover, Brocade’s increased indebtedness may put the company at a competitive disadvantage relative to other companies with lower indebtedness levels.
The Credit Agreement contains financial maintenance covenants, including a maximum total leverage ratio and a minimum interest coverage ratio. The Credit Agreement also contains restrictive covenants that limit, among other things, Brocade’s and certain of its subsidiaries’ ability to incur additional indebtedness or issue certain preferred equity, pay dividends or make other distributions or other restricted payments (including stock repurchases), sell assets other than on terms specified by the Credit Agreement, amend the terms of certain other indebtedness and organizational documents, create liens on certain assets to secure debt, consolidate, merge, sell or otherwise dispose of all or substantially all of their assets, enter into certain transactions with affiliates, or change their lines of business, fiscal years and accounting practices, in each case, subject to certain exceptions. The indenture governing the 2023 Notes contains several negative covenants that restrict the incurrence of debt by Brocade’s subsidiaries, restrict the incurrence of liens on principal properties, and restrict Brocade and its subsidiaries from engaging in certain sale-leaseback transactions. In addition, the indentures governing both the 2020 Convertible Notes and the 2023 Notes impose covenants that restrict Brocade’s ability to effect certain mergers, consolidations, or sales of assets and require Brocade to offer to repurchase the notes upon the occurrence of certain “Fundamental Changes” or “Change of Control Triggering Events.” A “Change in Control” will also trigger an event of default under the Credit Agreement.
The financial and other covenants agreed to by Brocade in connection with such indebtedness could, among other things, reduce Brocade’s flexibility to respond to changing business and economic conditions, increase borrowing costs (if further debt financing is desired), and adversely affect Brocade’s operations and financial results. Brocade’s failure to comply with these covenants would result in a default under the applicable indenture or the Credit Agreement, which could permit the holders to accelerate such debt or demand payment in exchange for a waiver of such default. A default under one debt instrument could also result in cross-defaults under Brocade’s other debt instruments, negatively impact the price and liquidity of Brocade’s debt and equity securities, negatively impact Brocade’s credit ratings, and impair Brocade’s ability to access sources of capital. If any of Brocade’s debt is accelerated, Brocade may not have sufficient funds available to repay such debt.
Agencies rating Brocade’s debt securities may lower Brocade’s credit rating. This could further negatively impact the price and liquidity of Brocade’s debt and equity securities and Brocade’s ability to access sources of capital. In addition, in the event of certain credit rating downgrades, Brocade’s obligations under the Senior Credit Facility, which are currently unsecured, will be required to be secured, subject to certain exceptions, by the equity interests of certain Brocade subsidiaries.
Although interest rates have remained at low levels in recent years, they may increase for various reasons, including an increase in inflation, Federal Reserve Board actions, domestic or international fiscal policies, or domestic or international events impacting financial or capital markets. Higher interest rates or an increase in the credit spread for Brocade’s rating could negatively impact Brocade’s ability to raise additional debt or refinance existing debt. In addition, the indebtedness under the Senior Credit Facility has a floating interest rate, and an increase in interest rates may negatively impact Brocade’s financial results.
Provisions in Brocade’s charter documents, customer agreements, and Delaware law could discourage, delay, or prevent a change of control of Brocade, which could hinder stockholders’ ability to receive a premium for Brocade’s common stock and adversely affect the value of Brocade’s convertible notes.
Provisions of Brocade’s certificate of incorporation and bylaws may discourage, delay, or prevent a merger or mergers that a stockholder may consider favorable. These provisions include, but are not limited to:
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Authorizing the issuance of preferred stock without stockholder approval;
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Prohibiting cumulative voting in the election of directors;
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Limiting who may call special meetings of stockholders and when special meetings of stockholders may be called; and
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Prohibiting stockholder actions by written consent.
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Certain provisions of Delaware law also may discourage, delay, or prevent someone from acquiring or merging with Brocade, and Brocade’s agreements with certain Brocade customers require that Brocade give prior notice of a change of control and grant certain manufacturing rights following a change of control. Brocade’s various change-of-control provisions could prevent or delay a change of control of Brocade, which could hinder stockholders’ ability to receive a premium for Brocade’s common stock and could adversely affect the value of Brocade’s convertible notes.