UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

 

 

Commission file number: 001-31216

 

McAfee, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

 

Registrant’s telephone number, including area code:

(408) 988-3832

 

 

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

 

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

 

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

 

 

As of April 30, 2009, 155,372,744 shares of the registrant’s common stock, $0.01 par value, were outstanding.

 

 

MCAFEE, INC. AND SUBSIDIARIES

 

FORM 10-Q

 

March 31, 2009

 

 

CONTENTS

 

 

 

MCAFEE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

MCAFEE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

MCAFEE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 

McAfee, Inc. and our wholly owned subsidiaries (“we”, “us” or “our”) are a global dedicated security technology company that secures systems and networks from known and unknown threats. We empower home users, businesses, government agencies, service providers and our partners with the ability to block attacks, prevent disruptions, and continuously track and improve their security and compliance. We operate our business in five geographic regions: North America; Europe, Middle East and Africa (“EMEA”); Japan; Asia-Pacific, excluding Japan; and Latin America.

 

 

The accompanying condensed consolidated financial statements include our accounts as of March 31, 2009 and December 31, 2008 and for the three months ended March 31, 2009 and March 31, 2008. All intercompany accounts and transactions have been eliminated in consolidation. These condensed consolidated financial statements have been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The December 31, 2008 condensed consolidated balance sheet was derived from audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. However, we believe that all disclosures are adequate to make the information presented not misleading. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto, included in our annual report on Form 10-K for the year ended December 31, 2008.

 

In the opinion of our management, all adjustments (which consist of normal recurring adjustments, except as disclosed herein) necessary to fairly present our financial position, results of operations and cash flows for the interim periods presented have been included. The results of operations for the three months ended March 31, 2009 are not necessarily indicative of the results to be expected for the full year or for any future periods.

 

Significant Accounting Policies

 

Marketable Securities

 

All marketable securities are classified as available-for-sale securities. Available-for-sale securities are carried at fair value with resulting unrealized gains and losses, net of related taxes, reported as a component of accumulated other comprehensive income. Premium and discount on debt securities recorded at the date of purchase are amortized and accreted, respectively, to interest income using the effective interest method. Short-term marketable securities are those with remaining maturities at the balance sheet date of less than one year. Long-term marketable securities have remaining maturities at the balance sheet date of one year or greater. Realized gains and losses on sales of all such investments are reported in earnings and computed using the specific identification cost method.

 

We assess the value of our available-for-sale marketable securities on a regular basis to assess whether an other-than-temporary decline in the fair value has occurred. Factors which we use to assess whether an other-than-temporary decline has occurred include, but are not limited to, the likely reason for the unrealized loss, period of time the fair value was below amortized cost, changes in underlying collateral, changes in ratings, market trends and conditions, and our intent and ability to hold until we recover such losses. Any “other-than-temporary decline” in value is reported in earnings and a new cost basis for the marketable security is established. In the three months ended March 31, 2009, we recorded additional impairment on previously impaired marketable securities totaling $0.7 million for continued declines in fair value. We had no other-than-temporary impairment of marketable securities in the three months ended March 31, 2008.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Inventory

 

Inventory, which consists primarily of finished goods held at our warehouse and other fulfillment partner locations and finished goods sold to our channel partners but not yet sold through to the end-user, is stated at lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first in, first out basis. Inventory balances are included in other current assets on our condensed consolidated balance sheets and were $14.5 million as of March 31, 2009 and $10.2 million as of December 31, 2008.

 

Deferred Costs of Revenue

 

Deferred costs of revenue, which consist primarily of costs related to revenue-sharing and royalty arrangements, and the direct cost of materials that are associated with product and subscription revenues deferred over a service period, including arrangements that are deferred due to lack of the vendor-specific objective evidence (“VSOE”) of fair value on an undelivered element, are included in the prepaid expenses line item and other assets line item on our condensed consolidated balance sheets. We generally recognize such deferred costs as revenue is recognized. At March 31, 2009, our deferred costs were $213.5 million compared to $184.6 million at December 31, 2008.

 

Reclassifications

 

During the three months ended March 31, 2009, we reclassified sales order operation department expenses previously reported in general and administrative expenses to sales and marketing expenses. This reclassification improves the transparency of the cost of our sales process and does not affect our total operating costs, income from operations or net income. The following table sets forth, for all periods presented, the reclassification to conform to our current period presentation and the stock compensation expense included in the reclassification (in thousands):

 

 

In the condensed consolidated statement of cash flows for the three months ended March 31, 2008, we have reclassified $61.9 million within investing activities to properly reflect partial pay downs received on asset-backed investments, calls and redemptions as “proceeds from maturities of marketable securities” rather than “proceeds from sales of marketable securities”.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Fair Value Measurements

 

On January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value, and expands disclosure requirements regarding fair value measurement. We hold financial assets, such as available-for-sale securities and foreign currency contracts, subject to valuation under SFAS 157. The following table details the fair value measurements within the fair value hierarchy of our financial assets (in thousands):

 

 

 

 

In February 2008, the Financial Accounting Standard Board (“FASB”) issued FASB Staff Position (“FSP”) No. 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”), which delayed the effective date of SFAS 157 for all non-financial assets and non-financial liabilities that are not remeasured at fair value on a recurring basis (at least annually). FSP 157-2 was effective for us beginning January 1, 2009 and did not have an impact on our consolidated financial position, results of operations or cash flows in the three months ended March 31, 2009. We expect FSP 157-2 to have an impact on us going forward.

 

In April 2009, the FASB issued three related Staff Positions: (i) FSP No. 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability have Significantly Decreased and Identifying Transactions That Are Not Orderly” (“FSP 157-4”), (ii) SFAS No. 115-2 and SFAS No. 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (“FSP 115-2 and FSP 124-2”), which will be effective for interim and annual periods ending after June 15, 2009, and (iii) SFAS No. 107-1 and APB No. 28-1, “Interim Disclosures about Fair Value of Financial Instruments”, (“FSP 107-1 and APB 28-1”), which will be effective for interim periods ending after June 15, 2009. FSP 157-4 provides guidance on how to determine the fair value of assets and liabilities under SFAS 157 when there has been a significant decline in market activity and volume and reemphasizes that the objective of a fair value measurement remains an exit price. If we were to conclude that there

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

has been a significant decrease in the volume and level of activity of the asset or liability in relation to normal market activities, quoted market values may not be representative of fair value and we may conclude that a change in valuation technique or the use of multiple valuation techniques may be appropriate. FSP 115-2 and FSP 124-2 modify the requirements for recognizing other-than-temporarily impaired debt securities and revise the existing impairment model for such securities, by modifying the current intent and ability indicator in determining whether a debt security is other-than-temporarily impaired. FSP 107-1 and APB 28-1 enhance the disclosure of instruments under the scope of SFAS 157 for interim periods. We are currently evaluating the impact that these Staff Positions will have on our consolidated financial position, results of operations or cash flows when adopted in the three months ended June 30, 2009.

 

Recent Accounting Pronouncements

 

Instruments Granted in Share-Based Payment Transactions

 

In June 2008, the FASB issued EITF 03-06-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” (“EITF 03-06-1”). EITF 03-06-1 provides that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are “participating securities” and shall be included in the computation of earnings per share pursuant to the two-class method in SFAS No. 128, “Earnings per Share”. EITF 03-06-1 was effective for us beginning January 1, 2009 and did not have an impact on our consolidated results of operations as our stock-based awards are not eligible to receive dividends.

 

Useful Life of Intangible Assets

 

In April 2008, the FASB issued FSP No. 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP 142-3”). FSP 142-3 amends the factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized intangible assets under FASB Statement No. 142, “Goodwill and Other Intangible Assets” and the period of expected cash flows used to measure the fair value under FASB Statement No. 141, “Business Combinations”. FSP 142-3 was effective for us beginning January 1, 2009 and did not have an impact on our consolidated financial position, results of operations or cash flows.

 

Derivative Instruments and Hedging Activities

 

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133” (“SFAS 161”). SFAS 161 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), to expand disclosures about an entity’s derivative instruments and hedging activities, but does not change SFAS 133’s scope of accounting. SFAS 161 was effective for us beginning January 1, 2009. As a result, we have included additional disclosures for our derivative financial instruments in Note 5.

 

Noncontrolling Interests

 

In December 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”). SFAS 160 amends Accounting Research Bulletin No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 was effective for us beginning January 1, 2009. The adoption of SFAS 160 did not have an impact on our consolidated financial position, results of operations or cash flows.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Business Combinations

 

In December 2007, the FASB revised SFAS No. 141, “Business Combinations” (“SFAS 141(R)”), to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. SFAS 141(R) changes the accounting for business combinations by requiring that an acquiring entity measures and recognizes identifiable assets acquired and liabilities assumed at the acquisition date fair value with limited exceptions. The changes include the treatment of acquisition related transaction costs, the valuation of any noncontrolling interest at the acquisition date fair value, the recording of acquired contingent liabilities at acquisition date fair value and the subsequent re- measurement of such liabilities after acquisition date, the recognition of capitalized in-process research and development, the accounting for acquisition-related restructuring cost accruals subsequent to the acquisition date and the recognition of changes in the acquirer’s income tax valuation allowance (see Note 4). SFAS 141(R) was effective for us beginning January 1, 2009. SFAS 141(R) impacts our condensed consolidated financial statements, but the nature and magnitude of the specific effects depends upon the nature, terms and size of acquisitions we consummate. At March 31, 2009, $20.2 million of the $88.6 million liability for unrecognized tax benefits relate to tax positions of acquired entities taken prior to our acquisition. Liabilities settled for lesser or greater amounts will affect the income tax expense in the period of adjustment.

 

Revision to Contingencies under 141(R)

 

In April 2009, the FASB issued FSP No. 141(R)-1, “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies” (“FSP 141(R)-1”). FSP 141(R)-1 amends the provisions in Statement 141(R) for the initial recognition and measurement, subsequent measurement and accounting, and disclosures for assets and liabilities arising from contingencies in business combinations. The FSP eliminates the distinction between contractual and non-contractual contingencies, including the initial recognition and measurement criteria in Statement 141(R) and instead carries forward most of the provisions in SFAS 141 for acquired contingencies. FSP 141(R)-1 is effective for contingent assets and contingent liabilities acquired in business combinations for which the acquisition date is on or after January 1, 2009. We expect FSP 141(R)-1 will have an impact on our condensed consolidated financial statements, but the nature and magnitude of the specific effects will depend upon the nature, term and size of the acquired contingencies from future acquisitions.

 

 

We record compensation expense for stock-based awards issued to employees and outside directors in exchange for services provided based on the estimated fair value of the awards on their grant dates. Stock-based compensation expense is recognized over the required service or performance period of the awards. Our stock-based awards include stock options (“options”), restricted stock units (“RSUs”), restricted stock awards (“RSAs”), restricted stock units with performance-based vesting (“PSUs”) and employee stock purchase rights issued pursuant to our Employee Stock Purchase Plan (“ESPP grants”).

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following table summarizes stock-based compensation expense in accordance with the provisions of SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”) (in thousands):

 

 

Amortization of fair value of options.  We recognize the fair value of options issued to employees and outside directors and assumed in acquisitions as stock-based compensation expense over the vesting period of the awards. These charges include stock-based compensation expense for options granted prior to January 1, 2006 but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), and stock-based compensation expense for options granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R).

 

Restricted stock awards and units.  We recognize the fair value of RSAs and RSUs issued to employees as stock-based compensation expense over the vesting period of the awards. Fair value is determined as the difference between the closing price of our common stock on the grant date and the purchase price of the RSAs and RSUs.

 

Restricted stock units with performance-based vesting.  We recognize stock-based compensation expense for the fair value of PSUs issued to employees.

 

The PSUs can have performance-based vesting components that vest only if performance criteria are met for each respective performance period (“performance component”). Additionally, the PSUs can have service-based vesting components that have accelerated vesting provisions if performance criteria are met for each respective performance period (“service component”). The PSUs issued to employees have either performance components or service components or both.

 

If the performance criteria are not met for a performance period, then the related performance components that would have vested are forfeited and the related service components do not accelerate. Certain performance criteria allow for different vested amounts based on the level of achievement of the performance criteria.

 

For certain performance components, we do not communicate the performance criteria to the employees. For these awards, the accounting grant date does not occur until it is known whether the performance criteria are met, and such achievement or non-achievement is communicated to the employees. These awards are marked-to-market at the end of each reporting period through the accounting grant date, and recognized over the expected vesting period, provided we determine it is probable that the performance criteria will be met.

 

For performance components for which the performance criteria have been communicated to the employees, the accounting grant date is deemed to have occurred. Fair value has been measured on the grant date and is recognized over the expected vesting period, provided we determine it is probable that the performance criteria will be met.

 

For the service components, each tranche is accounted for as a separate award and the accounting grant date is deemed to have occurred. Fair value is measured on the grant date, and is recognized over the expected vesting period for each tranche. The expected vesting period for each tranche is based off the service-based vesting period

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

or the accelerated vesting period if the performance period has been set and we determine it is probable that the performance criteria will be met.

 

Employee Stock Purchase Plan.  We recognize stock-based compensation expense for the fair value of ESPP grants. The estimated fair value of ESPP grants is based on the Black-Scholes pricing model. Expense is recognized ratably based on contributions and the total fair value of the ESPP grants estimated to be issued.

 

Benefit related to cash settlement of options.  Certain options held by terminated employees expired during the blackout period, the period between July 2006 and December 21, 2007, as they could not be exercised during the 90-day period subsequent to termination. As of December 31, 2007, we recorded a liability of $5.7 million based on the intrinsic value of these options using our December 31, 2007 closing stock price. We paid $5.2 million in January 2008 to settle these options based on the average closing price of our common stock subsequent to December 21, 2007, the date we became current on our reporting obligations under the Securities Exchange Act of 1934, as amended. For 2008, we recognized a benefit of $0.4 million for the difference between the December 31, 2007 liability and the amount paid in 2008. All of these options were cash settled by March 31, 2008.

 

Tender offer.  In January 2008, after we became current with our reporting obligations under the Securities Exchange Act of 1934, as amended, we filed a Tender Offer Statement with the SEC. The tender offer extended an offer by us to holders of certain outstanding options to amend the exercise price on certain of their outstanding options. The purpose of the tender offer was to amend the exercise price on options to have the same price as the fair market value on the revised measurement dates that were identified during the investigation of our historical option grant practices. As part of this tender offer, we became obliged to pay a cash bonus of $1.7 million, of which $0.4 million was paid to Canadian employees in the three months ended March 31, 2008, and $1.3 million was paid to U.S. employees in the three months ended March 31, 2009, to reimburse optionees who elected to participate in the tender offer for any increase in the exercise price of their options resulting from the amendment. The impact of the cash bonus, as recorded during the three months ended March 31, 2008, resulted in stock-based compensation expense of $0.6 million and a decrease to additional paid-in capital of $1.1 million. We will not recognize any further expense related to the tender offer.

 

The following table summarizes stock-based compensation expense recorded by condensed consolidated statements of income and comprehensive income line item (in thousands):

 

 

We had no stock — based compensation costs capitalized as part of the cost of an asset.

 

At March 31, 2009, the estimated fair value of all unvested options, RSUs, RSAs, PSUs and ESPP grants that have not yet been recognized as stock-based compensation expense was $162.6 million, net of expected forfeitures. We expect to recognize this amount over a weighted-average period of 2.4 years. This amount does not reflect stock-

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

based compensation expense relating to 0.6 million PSUs for which the performance criteria had not been set as of March 31, 2009.

 

 

2009 Acquisition

 

In January 2009, we acquired 100% of the outstanding shares of Endeavor Security, Inc. (“Endeavor”), an intrusion prevention and detection company, for $2.5 million. The Endeavor purchase agreement provides for an earn-out payment totaling $1.0 million contingent upon the achievement of certain Endeavor financial targets during the two-year period subsequent to the close of the acquisition. The fair value of the earn-out of $0.7 million at acquisition has been accrued, for a total purchase price of $3.2 million. We recorded $1.4 million of goodwill, which is not deductible for tax purposes. The results of operations for Endeavor have been included in our results of operations since the date of acquisition.

 

The purchase agreement also provides for a total of $2.0 million in bonus payments to certain employees contingent upon their continued employment for three years post-acquisition.

 

2008 Acquisitions

 

In 2008, we acquired 100% of the outstanding shares of ScanAlert, Inc. (“ScanAlert”) for $54.9 million, 100% of the outstanding shares of Reconnex Corporation (“Reconnex”) for $46.6 million and 100% of the outstanding shares of Secure Computing Corporation (“Secure Computing”) for $490.1 million. The results of operations for these acquisitions have been included in our results of operations since their respective acquisition dates.

 

Our management determined the purchase price allocations for these acquisitions based on estimates of the fair values of the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived at utilizing recognized valuation techniques. We are continuing to assess uncertain tax positions as well as continuing to assess measurement of certain deferred tax assets and liabilities of Secure Computing. In the three months ended March 31, 2009, we had no significant purchase price adjustments.

 

Pro forma results of operations have not been presented for ScanAlert because the effect of this acquisition was not material to our results of operations. The following unaudited pro forma financial information presents our combined results with Secure Computing and Reconnex as if the acquisitions had occurred at the beginning of 2008 (in thousands, except per share data):

 

 

The above unaudited pro forma financial information includes adjustments for amortization of identifiable intangible assets that were acquired, adjustments to interest income, adjustments for incremental stock-based compensation expense related to the unearned portion of Secure Computing’s RSAs and RSUs assumed and converted, eliminations of intercompany transactions and related tax effects. The pro forma financial information excludes the effects of the SafeWord product line sold by Secure Computing in 2008, the effects of the in-process

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

research and development charge for Secure Computing that was expensed immediately upon acquisition and the effects of the goodwill impairment charge recorded by Secure Computing in 2008. No effect has been given to cost reductions or synergies in this presentation. In management’s opinion, the unaudited pro forma combined results of operations are not indicative of the actual results that would have occurred had the acquisitions been consummated at the beginning of three months ended March 31, 2008, nor are they indicative of future operations of the combined companies.

 

 

Forward Exchange Contracts

 

We conduct business globally. As a result, we are exposed to movements in foreign currency exchange rates. From time to time we enter into forward exchange contracts to reduce exposures associated with certain nonfunctional monetary assets and liabilities such as accounts receivable and accounts payable denominated in the Euro, British Pound, and Canadian Dollar. The forward contracts typically range from one to three months in original maturity. We recognize derivatives, which are included in other current assets and other accrued liabilities on the condensed consolidated balance sheet, at fair value. Both the remeasurement of the asset and liability and the change in value of the derivative are recognized in interest and other income on our condensed consolidated statements of income and comprehensive income. On the condensed consolidated statements of cash flows, the derivatives offset the increase or decrease in cash related to the underlying asset or liability. In general, we do not hedge anticipated foreign currency cash flows, nor do we enter into forward contracts for trading or speculative purposes.

 

The forward contracts do not qualify for hedge accounting and accordingly are marked to market at the end of each reporting period with any unrealized gain or loss being recognized in the statement of income as interest and other income.

 

Forward contracts outstanding are presented below (in thousands):

 

 

In the three months ended March 31, 2009 and 2008, we recorded a $1.6 realized loss and a $0.5 million realized gain, respectively, on derivatives. These amounts are recognized in interest and other income on our condensed consolidated statements of income and comprehensive income.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Goodwill by geographic region is as follows (in thousands):

 

 

The goodwill acquired during the three months ended March 31, 2009 is due to the acquisition of Endeavor. The adjustments to goodwill are a result of purchase accounting adjustments for the Secure Computing acquisition.

 

The components of intangible assets are as follows (in thousands):

 

 

The aggregate amortization expenses for the intangible assets listed above totaled $29.4 million and $18.9 million in the three months ended March 31, 2009 and 2008, respectively.

 

Expected future intangible asset amortization expense as of March 31, 2009 is as follows (in thousands):

 

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

We have initiated certain restructuring actions to reduce our cost structure and enable us to invest in certain strategic growth initiatives to enhance our competitive position.

 

During 2009 (the “2009 Restructuring”), we continued our efforts to consolidate and took the following measures: (i) realigned our sales and marketing workforce and (ii) disposed of excess facilities.

 

During 2008 (the “2008 Restructuring”), we took the following measures: (i) eliminated redundant positions related to the SafeBoot Holdings B.V. (“SafeBoot”) and Secure Computing acquisitions, (ii) realigned our sales force and (iii) realigned staffing across various departments.

 

During 2006 (the “2006 Restructuring”), we took the following measures: (i) reduced our workforce and (ii) continued our efforts to consolidate and dispose of excess facilities. The remaining $0.1 million of lease termination costs and severance and other benefits will be paid in 2009.

 

During 2004 and 2003 (the “2004 and 2003 Restructurings”), we took the following measures: (i) reduced our workforce, (ii) consolidated and disposed of excess facilities, (iii) moved our European headquarters to Ireland and vacated a leased facility in Amsterdam, (iv) consolidated operations formerly housed in three leased facilities in Dallas, Texas into our regional headquarters facility in Plano, Texas, (v) relocated employees from the Santa Clara, California headquarters site to our Plano facility as part of the consolidation activities and (vi) sold our Sniffer and Magic product lines in 2004. During the three months ended March 31, 2009, we recorded a $0.2 million decrease to the liability primarily related to changes in previous estimates of sublease income for the Santa Clara lease. We have a $2.5 million accrual balance related to the 2004 and 2003 Restructurings, which will be paid through 2013.

 

Restructuring charges in the three months ended March 31, 2008 totaled $0.1 million, consisting of $2.5 million related to 2008 restructuring charges partially offset by a $2.4 million revision related primarily to previous estimates of base rent and sublease income for the Santa Clara lease which was restructured in 2003, net of accretion.

 

Restructuring in the three months ended March 31, 2009 totaled $5.1 million, consisting of $2.9 million related to the 2009 Restructuring and a $2.2 million additional accrual over the service period for our 2008 elimination of certain positions at Secure Computing.

 

2009 Restructuring

 

Activity and liability balances related to our 2009 restructuring are as follows (in thousands):

 

 

Of the total 2009 restructuring charge, $1.5 million and $1.4 million was recorded in EMEA and North America, respectively. Lease termination costs and severance and other benefits are expected to be paid through 2009.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

2008 Restructuring

 

Activity and liability balances related to our 2008 restructuring are as follows (in thousands):

 

 

Of the total 2009 restructuring charge for severance, $0.2 million, and $2.1 million was recorded in EMEA and North America, respectively. In 2008, the $6.1 million accrual for lease termination costs was recorded on the opening balance sheet for Secure Computing for costs associated with permanently vacated facilities. In the three months ended March 31, 2009, we recorded a $0.6 million purchase price adjustment for additional lease related costs associated with permanently vacated facilities. The 2009 accretion relates to these lease termination costs. Lease termination costs will be paid through 2015 and severance and other benefits will be paid in 2009.

 

 

On December 22, 2008, we entered into a credit agreement with a group of financial institutions (“the Credit Facility”). The Credit Facility provides for a $100.0 million unsecured term loan and a $100.0 million unsecured revolving credit facility with a $25.0 million letter of credit sublimit. The Credit Facility also contains an expansion option permitting us to arrange up to an aggregate of $200.0 million in additional commitments from existing lenders and/or new lenders at the lenders’ discretion.

 

In January 2009, we borrowed $100.0 million against the term loan in the Credit Facility. The principal together with any accrued interest on the term loan is due on December 22, 2009.

 

The credit facility, which is subject to certain quarterly financial covenants, terminates on December 22, 2011, on which date all outstanding principal of, together with accrued interest on, any revolving loans will be due. We may prepay the loans and terminate the commitments at any time, without premium or penalty, subject to reimbursement of certain costs in the case of eurocurrency loans.

 

Loans may be made in U.S. Dollars, Euros or other currencies agreed to by the lenders. Loans will bear interest at our election at the prime rate or at an adjusted LIBOR rate plus a margin (ranging from 2.00% to 2.50%) that varies with our consolidated leverage ratio (a “eurocurrency loan”). Interest on the loans is payable quarterly in arrears with respect to prime rate loans and at the end of an interest period (or at each three month interval in the case of loans with interest periods greater than three months) in the case of eurocurrency loans. Commitment fees range from 0.25% to 0.45% of the unused portion on the credit facility depending on our consolidated leverage ratio.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

In addition, we have a 14 million Euro credit facility with a bank (“the Euro Credit Facility”). The Euro Credit Facility is available on an offering basis, meaning that transactions under the Euro Credit Facility will be on such terms and conditions, including interest rate, maturity, representations, covenants and events of default, as mutually agreed between us and the bank at the time of each specific transaction. The Euro Credit Facility is intended to be used for short-term credit requirements, with terms of one year or less. The Euro Credit Facility can be canceled at any time. No balances were outstanding under the Euro Credit Facility as of March 31, 2009 and December 31, 2008.

 

 

A reconciliation of the numerator and denominator of basic and diluted net income per share is provided as follows (in thousands, except per share amounts):

 

 

 

 

 

Our consolidated provision for income taxes for the three months ended March 31, 2009 and 2008 was $0.6 million and $38.6 million, respectively, reflecting an effective tax rate of 1% and 56%, respectively. The effective tax rate for the three months ended March 31, 2009 differs from the U.S. federal statutory rate (“statutory rate”) primarily due to the benefit of lower tax rates in certain foreign jurisdictions, as well as tax benefits recognized in the first quarter as a result of statute expirations in various jurisdictions. The effective tax rate for the three months ended March 31, 2008 differs from the statutory rate primarily as a result of certain acquisition integration activities, which resulted in an increase of 22 percentage points to our effective tax rate. In October of 2008, we were granted administrative relief by the U.S. Internal Revenue Service from the negative tax consequences associated with certain acquisition integration activities. As a result, we reversed the tax expense in the fourth quarter of 2008.

 

The earnings from our foreign operations in India are subject to a tax holiday. In May 2008, the Indian government extended the period through which the holiday would be effective to March 31, 2010. The tax holiday provides for zero percent taxation on certain classes of income and requires certain conditions to be met. We were in compliance with these conditions as of March 31, 2009.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

We account for uncertainty in income taxes in accordance with FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”). As a result, we apply a more-likely-than-not recognition threshold for all tax uncertainties. FIN 48 only allows the recognition of those tax benefits that have a greater than 50% likelihood of being sustained upon examination by the taxing authorities. We believe it is reasonably possible that, in the next 12 months, the amount of unrecognized tax benefits related to the resolution of federal, state and foreign matters could be reduced by $6.5 million to $9.6 million as audits close and statutes expire.

 

The U.S. Internal Revenue Service is presently conducting an examination of our federal income tax returns for the calendar years 2006 and 2007. We cannot reasonably determine if this examination will have a material impact on our financial statements. We concluded pre-filing discussions with the Dutch tax authorities with respect to the 2004 tax year in January 2009. As a result, a tax benefit of approximately $2.2 million is reflected in the first quarter of 2009. In addition, the statute of limitations related to various domestic and foreign jurisdictions expired in the first quarter of 2009, resulting in a tax benefit of approximately $9.1 million.

 

 

We have one business and operate in one industry. We develop, market, distribute and support computer and network security solutions for large enterprises, governments, and small and medium-sized business and consumer users, as well as resellers and distributors. Management measures operations based on our five operating segments: North America; EMEA; Japan; Asia-Pacific, excluding Japan; and Latin America. Our chief operating decision maker is our chief executive officer.

 

We market and sell anti-virus and security software, hardware and services through our geographic regions. These products and services are marketed and sold worldwide primarily through resellers, distributors, systems integrators, retailers, original equipment manufacturers, internet service providers and directly by us. In addition, we offer on our web site suites of online products and services personalized for the user based on the users’ personal computer configuration, attached peripherals and resident software. We also offer managed security and availability applications to corporations and governments on the internet.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Our chief operating decision maker evaluates performance based on income from operations, which includes only cost of revenue and selling expenses directly attributable to a sale. Historically, the measure of segment income from operations included the allocation of cost of revenues, research and development and certain sales and marketing expenses. We revised the segment information for the three months ended March 31, 2008 to conform to the 2009 presentation for comparative purposes. Summarized financial information concerning our net revenue and income from operations by geographic region is as follows (in thousands):

 

 

Corporate and other includes research and development expenses, cost of revenues and sales and marketing expenses not directly related to the sale of our products and services, general and administrative expenses, stock-based compensation, amortization of purchased technology and other intangibles and restructuring (benefit) charges. These expenses are not attributable to any specific geographic region and are not included in the segment measure of income from operations reviewed by our chief operating decision maker. The difference between income from operations and income before provision for income taxes is reflected on the face of our condensed consolidated statements of income and comprehensive income.

 

 

Settled Cases

 

In July 2006, the United States District Court for the Northern District of California consolidated several purported stockholder derivative suits as In re McAfee, Inc. Derivative Litigation, Master File No. 5:06CV03484 (JF) (the “Consolidated Action”). In September 2006, three identical lawsuits that had been filed in the Superior Court of the State of California, County of Santa Clara, were consolidated in that court (the “State Action”). The Consolidated Action and State Action asserted that we improperly backdated stock option grants for a period ending in May 2006. In December 2007, we reached a tentative settlement with the plaintiffs in both Actions. The Court preliminarily approved the settlement in October 2008 and granted final approval in February 2009. We paid $13.8 million in the three months ended March 31, 2009 for this previously accrued settlement.

 

In the three months ended March 31, 2009, we recorded a benefit of $6.5 million related to reimbursements from insurance for legal fees we incurred related to cost of defense incurred in connection with our stock option

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

investigation that commenced in May 2006. This benefit is reflected in the general and administrative line on our condensed consolidated statement of income.

 

Open Cases

 

While we cannot predict the likelihood of future claims or inquiries, we expect that new matters may be initiated against us from time to time. The results of claims, lawsuits and investigations also cannot be predicted, and it is possible that the ultimate resolution of these matters, individually and in the aggregate, may have a material adverse effect on our business, financial condition, results of operations or cash flows.

 

In December 2008, Information Protection and Authentication of Texas, LLC, (“IPAT”) filed a complaint in the Eastern District of Texas against us, alleging infringement of two IPAT patents. Although the patents relate to firewall technology, no specific McAfee products have been identified in the suit and no specific infringement allegations have yet been made. In January 2009, IPAT filed suit against many PC manufacturers in the Southern District of Florida alleging infringement of the same two patents.

 

In January 2007, a former executive filed an arbitration demand with the American Arbitration Association in Dallas, Texas, seeking the arbitration of claims associated with his employment; we have filed counterclaims. The arbitration hearing took place in March 2009 and we expect a final award by the arbitrator on or before June 30, 2009. Until the final award has been issued our liability, if any, cannot be reasonably estimated and, therefore, no provision has been recorded in our financial statements.

 

In June 2006, Finjan Software, Ltd. filed a complaint in the United States District Court for the District of Delaware against Secure Computing, alleging Webwasher Secure Content Management suite and CyberGuard TSP infringe three Finjan patents. In March 2008, a jury found that Secure Computing wilfully infringed certain claims of three Finjan patents and awarded $9.2 million in damages. This was recorded as an assumed liability in the allocation of the purchase price for Secure Computing. We acquired Secure Computing in November 2008 and intend to vigorously challenge the verdict and Finjan’s pending motions for an injunction and enhanced damages.

 

In July 2001, certain investment bank underwriters and McAfee, along with certain of our officers and directors were named in a putative class action for alleged violation of federal securities laws. (United States District Court for the Southern District of New York, In re McAfee.com Corp. Initial Public Offering Securities Litigation, 01 Civ.7034 (SAS). This is one of a number of cases challenging underwriting practices in the initial public offerings of more than 300 companies, coordinated for pretrial as In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). The McAfee complaint alleges improper underwriting activities not disclosed in registration statements for McAfee.com’s IPO, and seeks unspecified damages. The parties have reached a global settlement, subject to court approval. Insurers will pay the full McAfee settlement share. Neither the Company nor its officer and director defendants will bear any financial liability. McAfee, its officers and directors were dismissed from the case through a tolling agreement, and such agreement is pending court approval. If the litigation continues, we believe we have meritorious defenses and plan to vigorously defend.

 

In addition, we are engaged in certain legal and administrative proceedings incidental to our normal business activities and believe that these matters will not have a material adverse effect on our financial position, results of operations or cash flows.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

We offer a 90 day warranty on our hardware and software products and record a liability for the estimated future costs associated with warranty claims, which is based upon historical experience and our estimate of the level of future costs. A reconciliation of the change in our warranty obligation as of March 31, 2009 and December 31, 2008 follows (in thousands):

 

 

The following is a summary of certain guarantee and indemnification agreements as of March 31, 2009:

 

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

If we believe a liability associated with any of the aforementioned indemnifications becomes probable and the amount of the liability is reasonably estimable or the minimum amount of a range of loss is reasonably estimable, then an appropriate liability will be established.

 

Forward-Looking Statements; Trademarks

 

This Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are statements that look to future events and consist of, among other things, statements about our anticipated future income including the amount and mix of revenue among type of product, category of customer, geographic region and distribution method and our anticipated future expenses and tax rates. Forward-looking statements include our business strategies and objectives and include statements about the expected benefits of our strategic alliances and acquisitions, our plans for the integration of acquired businesses, our continued investment in complementary businesses, products and technologies, our expectations regarding product acceptance, product and pricing competition, continuation of our stock repurchase program, cash requirements and the amounts and uses of cash and working capital that we expect to generate, as well as statements involving trends in the security risk management market and statements including such words as “may,” “believe,” “plan,” “expect,” “anticipate,” “could,” “estimate,” “predict,” “goals,” “continue,” “project,” and similar expressions or the negative of these terms or other comparable terminology. These forward-looking statements speak only as of the date of this Report on Form 10-Q and are subject to business and economic risks, uncertainties and assumptions that are difficult to predict, including those discussed in “Risk Factors” in Part II, Item 1A in this quarterly report and in Item 1, “Business,” Item 1A, “Risk Factors” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K for the fiscal year ended December 31, 2008. Therefore, our actual results may differ materially and adversely from those expressed in any forward-looking statements. We cannot assume responsibility for the accuracy and completeness of forward-looking statements, and we undertake no obligation to revise or update publicly any forward-looking statements for any reason.

 

This report includes registered trademarks and trade names of McAfee and other corporations. Trademarks or trade names owned by McAfee and/or its affiliates include, but are not limited to: “McAfee,” “VirusScan,” “Total Protection,” “SafeBoot,” and “ScanAlert.” Any other non-McAfee related products, registered and/or unregistered trademarks contained herein are only by reference and are the sole property of their respective owners.

 

The following discussion should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this report. The results shown herein are not necessarily indicative of the results to be expected for the full year or any future periods.

 

Overview and Executive Summary

 

We are the leading dedicated security technology company that secures systems and networks from known and unknown threats around the world. We empower home users, businesses, government agencies, service providers and our partners with the ability to block attacks, prevent disruptions, enforce policy and continuously track and improve their security and compliance. We apply business discipline and a pragmatic approach to security that is based on four principles of security risk management (identify and prioritize assets; determine acceptable risk; protect against threats; enforce and measure compliance). We incorporate some or all of these principles into our solutions. Our solutions protect systems and networks, blocking immediate threats while proactively providing protection from future threats.

 

Security has emerged as one of the most critical concerns facing businesses and consumers. Security breaches have risen dramatically in the past few years, fueled in part by the proliferation of mobile devices such as laptop computers, cell phones and “smart phones” with email and web-surfing capabilities. For corporations, the increasing frequency of security breaches has coincided with expanding regulatory compliance requirements relating to security and more specifically, to privacy. Failure to comply with these requirements, and with the requirements of internal security policies and procedures, creates an additional level of enterprise risk. For consumers, the increasing frequency of online fraud and security concerns discourages customers from transacting online — for example, visiting and purchasing from e-commerce sites, using online banking services and preparing taxes online. All of these trends point toward a growing demand for effective security solutions.

 

We have one business and operate in one industry, developing, marketing, distributing and supporting computer security solutions for large enterprises, governments, small and medium-sized businesses and consumers either directly or through a network of qualified distribution partners. We derive our revenue from three sources:

(i) service and support revenue, which includes support and maintenance, training, consulting revenue; (ii) subscription revenue, which consists of revenue from customers who purchase licenses for products for the term of the subscription; and (iii) product revenue, which includes revenue from perpetual licenses (those with a one-time license fee) and hardware product sales. In the three months ended March 31, 2009, service and support revenue accounted for 51%, subscription revenue accounted for 41% and product revenue accounted for 8% of total net revenue, respectively.

 

Operating Results and Trends

 

We evaluate our consolidated financial performance utilizing a variety of indicators. Three of the primary indicators that we utilize to evaluate the growth and health of our business are total net revenue, operating income and net income.

 

Net Revenue.  As discussed more fully below, our net revenue in the three months ended March 31, 2009 grew by $78.1 million, or 21%, to $447.7 million from $369.6 million in the three months ended March 31, 2008. Our net revenue is directly impacted by corporate information technology, government and consumer spending levels. Net revenue from our 2008 acquisitions contributed $47.1 million in the three months ended March 31, 2009. Changes in the U.S. Dollar compared to foreign currencies negatively impacted our revenue growth by $14.8 million in the three months ended March 31, 2009 when compared to the three months ended March 31, 2008.

 

Operating Income.  The $1.5 million decrease in operating income in the three months ended March 31, 2009 compared to the three months ended March 31, 2008 was primarily attributable to the following factors: (i) amortization expense increased by $10.5 million as a result of purchased technology and intangibles acquired in recent acquisitions, (ii) restructuring charges increased by $5.0 million due to eliminating redundant positions from our Secure Computing acquisition and reorganization of our sales and marketing workforce and (iii) an increase in salaries and benefits due to an increase in headcount, primarily as a result of our Secure Computing acquisition. These decreases were offset largely by the overall growth of our company, including increased revenue and, to a lesser extent, increased operating costs.

 

Net Income.  The $23.3 million increase in net income in the three months ended March 31, 2009 compared to three months ended March 31, 2008 was primarily attributable to a decrease in our effective tax rate discussed more fully in “Provision for Income Taxes” below, offset by a $10.9 million decrease in interest income attributable to lower yields and lower cash and marketable securities balances.

 

Acquisitions.  We continue to focus our efforts on building a full line of system and network protection solutions and technologies that support our multi-platform strategy of personal computer, internet and mobile security solutions. In the fourth quarter of 2008, we acquired Secure Computing for $490.1 million. With the Secure Computing acquisition, we plan to deliver the industry’s most complete network security solution to organizations of all sizes. We expect that the acquisition of Secure Computing will have a dilutive impact in the remainder of 2009, primarily due to the amortization of intangibles.

 

Net Revenue by Product Groups and Customer Category.  Transactions from our corporate business include the sale of product offerings intended for enterprise, mid-market and small business use. Net revenue from our corporate products increased $59.6 million, or 28%, to $276.0 million during the three months ended March 31, 2009 from $216.4 million in the three months ended March 31, 2008. The year-over-year increase in revenue was due to a $17.6 million increase in revenue from our end point solutions, which includes increased revenue from our system security solutions and new revenue from data encryption products integrated from our SafeBoot acquisition and a $43.7 million increase in revenue from our network offerings, which includes new revenue integrated from our Secure Computing acquisition. These increases were offset in part by a $1.7 million decrease in revenue from our vulnerability and risk management offerings.

Transactions from our consumer business include the sale of product offerings primarily intended for consumer use, as well as any revenue or activities associated with providing an overall safe consumer experience on the internet or cellular networks. Net revenue from our consumer security market increased $18.5 million, or 12%, to $171.7 million in the three months ended March 31, 2009 from $153.2 million in the three months ended March 31, 2008. The increase in revenue from our consumer market in the three months ended March 31, 2009 was primarily attributable to our strengthening relationships with strategic channel partners, such as Acer, Dell, Sony Computer, and Toshiba.

 

Deferred Revenue.  Our deferred revenue balance at March 31, 2009 decreased 2% to $1,269.4 million, compared to $1,293.1 million at December 31, 2008. The decrease was attributable to the strengthening of the U.S. Dollar compared to both the Euro and the Japanese Yen during the three months ended March 31, 2009, which negatively impacted our deferred revenue balance at March 31, 2009. On a local currency basis, our deferred revenue continued to increase as a result of growing sales of maintenance renewals from our expanding customer base and increased sales of subscription-based products. We receive up front payments for maintenance and subscriptions but we recognize revenue over the service or subscription term. Approximately 75 to 85% of our total net revenue during 2008 and the first quarter of 2009 came from prior-period deferred revenue. As with revenue, we believe that deferred revenue is a key indicator of the growth and health of our business.

 

Macro Economic Conditions.  While we have recently experienced strong growth in revenue, economic conditions and financial markets have become increasingly negative, and national and global economies and financial markets have experienced a severe downturn stemming from a multitude of factors, including adverse credit conditions impacted by the sub-prime mortgage crisis, slower economic activity, concerns about inflation and deflation, fluctuating energy costs, decreased consumer confidence, reduced corporate profits and capital spending, adverse business conditions and liquidity concerns and other factors. Economic growth in the U.S. and many other countries slowed in the fourth quarter of 2007, remained slow for 2008 and the first quarter of 2009 and is expected to slow further or to recede in 2009 in the U.S. and abroad. The severity or length of time these economic and financial market conditions may persist is unknown. During challenging economic times and in tight credit markets, many customers may delay or reduce technology purchases. This could result in reductions in sales of our products, longer sales cycles, difficulties in collection of accounts receivable, slower adoption of new technologies and increased price competition. In the first quarter of 2009, we experienced delays in closing certain transactions that we anticipated would close during the quarter. In addition, weakness in the end-user market could negatively affect the cash flow of our distributors and resellers who could, in turn, delay paying their obligations to us. This would increase our credit risk exposure and cause delays in our recognition of revenue on future sales to these customers. Specific economic trends, such as declines in the demand for PCs, servers, and other computing devices, or softness in corporate information technology spending, could have a more direct impact on our business. Any of these events would likely harm our business, including decreasing our revenues, decreasing cash provided by operating activities and negatively impacting our liquidity.

 

Foreign Exchange Fluctuations.  We are unable to predict the extent to which revenue in future periods will be impacted by changes in foreign exchange rates. If international sales become a greater portion of our total sales in the future, changes in foreign currency rates may have a potentially greater impact on our revenue and operating results. The Euro and Japanese Yen are the two predominant non-U.S. currencies that affect our financial statements. As the U.S. Dollar strengthens against foreign currencies, our revenues from transactions outside the U.S. and operating income may be negatively impacted. The U.S. Dollar has recently depreciated against the Japanese Yen. As the U.S. Dollar weakens against foreign currencies, our revenues may be positively impacted. During the three months ended March 31, 2009, on an average quarterly exchange basis, the U.S. Dollar strengthened against the Euro and weakened against the Yen compared to the three months ended March 31, 2008. Overall, the U.S. Dollar strengthening against the Euro had the most significant impact to our financial statements and this has resulted in a decrease in the revenue and expense amounts in certain foreign countries in our statements of income for the three months ended March 31, 2009 as compared to the same prior-year period.

Critical Accounting Policies and Estimates

 

We had no significant changes in our critical accounting policies and estimates during the three months ended March 31, 2009 as compared to the critical accounting policies and estimates disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our annual report on Form 10-K for the year ended December 31, 2008.

 

Results of Operations

 

Net Revenue

 

The following table sets forth, for the periods indicated, a year-over-year comparison of the key components of our net revenue:

 

 

Our net revenue in a specific period is an aggregation of thousands of transactions ranging from high-volume, low-dollar transactions to high-dollar, multiple-element transactions that are individually negotiated. The impact of pricing and volume changes on revenue is complex as substantially all of our transactions contain multiple elements, primarily software licenses and post-contract support (“PCS”). Additionally, approximately 75 to 85% of our revenue in a specific period is derived from prior-period transactions for which revenue has been deferred and is being amortized into income over the period of the arrangement. Therefore, the impact of pricing and volume changes on revenue in a specific period results from transactions in multiple prior periods.

 

The increase in net revenue during the three months ended March 31, 2009 compared to the three months ended March 31, 2008 reflected (i) a $59.6 million, or 28%, increase in our corporate business and (ii) an $18.5 million, or 12%, increase in our consumer business.

Net revenue from our corporate business increased during the three months ended March 31, 2009 compared to the three months ended March 31, 2008 primarily due to a $43.7 million increase in revenues from our network protection offerings, which includes revenue from products integrated from our Secure Computing acquisition, and a $17.6 million increase in revenues from our end point solutions, which includes revenue from data encryption products integrated from our SafeBoot acquisition. These increases were partially offset by a $1.7 million decrease in our vulnerability and risk management offerings. During the three months ended March 31, 2009 compared to the three months ended March 31, 2008, we experienced an increase in both the number and size of larger transactions sold to customers through a solution selling approach, bundling multiple products and services into suite offerings, which positively impacted deferred revenue and will impact our revenue in future periods.

 

Net revenue from our consumer market increased during the three months ended March 31, 2009 compared to the three months ended March 31, 2008 primarily due to (i) online subscriber growth due partly to an increase in our customer base, (ii) increased online renewal subscriptions from both a larger customer base and (iii) increased up-sell to higher level suites with higher price points. We continued to strengthen our relationships with strategic channel partners, such as Acer, Dell, Sony Computer, and Toshiba.

 

Net Revenue by Geography

 

Net revenue outside of North America accounted for approximately 43% and 49% of net revenue in the three months ended March 31, 2009 and 2008, respectively. Net revenue from North America and EMEA has historically comprised between 80% and 90% of our total net revenue.

 

The increase in total net revenue in North America during the three months ended March 31, 2009 compared to the three months ended March 31, 2008 was primarily attributable to (i) a $55.4 million increase in corporate revenue due to increased revenue from our network security offerings, which includes new revenue from products integrated from our Secure Computing acquisition and our end point solutions and (ii) a $9.3 million increase in our consumer revenue. We also experienced an increase in U.S. government spending on our product offerings and larger transactions sold to customers through a solution selling approach.

 

The decrease in net revenue in EMEA during the three months ended March 31, 2009 compared to the three months ended March 31, 2008 was attributable to the negative impact of the U.S. Dollar strengthening against the Euro, which resulted in an approximate $19.0 million impact to EMEA net revenue in the three months ended March 31, 2009 compared to the three months ended March 31, 2008. Excluding the negative impact from the strengthening U.S. Dollar against the Euro, we continued to experience revenue growth in EMEA from both our corporate and consumer offerings.

 

Our Japan, Latin America and Asia-Pacific operations combined have historically comprised less than 20% of our total net revenue, and we expect this trend to continue. Net revenue from Japan was also positively impacted by the weakening U.S. Dollar against the Japanese Yen, which resulted in an approximate $4.4 million contribution to Japan net revenue in the three months ended March 31, 2009 compared to the three months ended March 31, 2008.

 

Service and Support Revenue

 

The increase in service and support revenue in the three months ended March 31, 2009 compared to the three months ended March 31, 2008 was attributable to an increase in support and maintenance primarily due to amortization of previously deferred revenue from support arrangements and to an increase in sales of support renewals to existing and new customers. In addition, we have expanded our support offerings to include premium-level services. Revenue from consulting increased due to more consultants providing integration and implementation services.

 

Although we expect our service and support revenue to continue to increase, our growth rate and net revenue depend significantly on renewals of support arrangements as well as our ability to respond successfully to the pace of technological change and our ability to expand our customer base. If our renewal rate or our pace of new customer acquisition slows, our net revenue and operating results would be adversely affected.

Subscription Revenue

 

The increase in subscription revenue in the three months ended March 31, 2009 compared to the three months ended March 31, 2008 was attributable to (i) increases in our online subscription arrangements due to our continued relationships with strategic partners, such as Acer, Dell, Sony Computer and Toshiba (ii) increases in revenue from our McAfee Total Protection Service for small and mid-market businesses, (iii) increases in royalties from sales by our strategic channel partners and (iv) increases in subscriptions from our Secure Computing acquisition. Subscription revenue continues to be positively impacted by McAfee Consumer Suites, including McAfee VirusScan Plus, McAfee Internet Security, and McAfee Total Protection Solutions, as these suites utilize a subscription-based model.

 

Product Revenue

 

The increase in product revenue for the three months ended March 31, 2009, compared to the three months ended March 31, 2008, was attributable to (i) increased revenue from our network security solutions which have a higher hardware content and, therefore, more upfront revenue realization and (ii) increased revenue from our data protection solutions and upgrade initiatives related to our total protection solutions.

 

Cost of Net Revenue

 

The following table sets forth, for the periods indicated a comparison of cost of net revenue:

 

 

Cost of Service and Support Revenue

 

Cost of service and support revenue consists principally of salaries, benefits and stock-based compensation related to employees, as well as expenses related to professional service subcontractors, customer and technical support, training and consulting services. The cost of service and support revenue increased for the three months ended March 31, 2009 compared to the three months ended March 31, 2008 due to increased professional services costs related to consulting services and increased costs related to customer and technical support. The cost of service and support revenue as a percentage of service and support revenue for the three months ended March 31, 2009 increased compared to the same period in 2008 due primarily to the addition of Secure Computing customer support, training and consulting personnel, mitigated in part by increased service contracts and support renewals.

We anticipate the cost of service and support revenue will increase in absolute dollars driven primarily by additional growth in our consulting services, which provide end users with product design, user training, and deployment support and the expected impact related to the acquisition of Secure Computing.

 

Cost of Subscription Revenue

 

Cost of subscription revenue consists primarily of costs related to the sale of online subscription arrangements, the majority of which include revenue-share arrangements and royalties paid to our strategic partners, and the costs of media, manuals and packaging related to McAfee Consumer Suites, as these suites utilize a subscription-based model. The increase in subscription costs for the three months ended March 31, 2009 compared to the three months ended March 31, 2008 was primarily attributable to an increase in the volume of online subscription arrangements and revenue-share arrangements and royalties paid to our online strategic partners. The cost of subscription revenue as a percentage of subscription revenue decreased slightly for the three months ended March 31, 2009 compared to the same period in 2008 due to lower costs per transaction from sales originating with our strategic partners.

 

We anticipate that the cost of subscription revenue will increase in absolute dollars due to expected increased demand for our subscription-based products with associated royalty and revenue-sharing costs.

 

Cost of Product Revenue

 

Cost of product revenue consists primarily of the cost of media, manuals and packaging for products distributed through traditional channels and, with respect to hardware-based security products, the cost of computer platforms, other hardware and embedded third-party components and technologies. The cost of product revenue for the three months ended March 31, 2009 increased compared to the three months ended March 31, 2008 due primarily to additional product-related transactions related to the acquisition of Secure Computing. Cost of product revenue for the three months ended March 31, 2009 decreased as a percentage of product revenue compared to the same period in 2008, due primarily to increased margins on corporate revenue resulting from a shift in product mix to higher-margin network protection solutions from lower-margin hardware transactions.

 

We anticipate that cost of product revenue will increase in absolute dollars due to mix and size of certain enterprise-related transactions.

 

Amortization of Purchased Technology

 

The increase in amortization of purchased technology in the three months ended March 31, 2009 compared to the three months ended March 31, 2008 was driven by the acquisitions of Secure Computing in November 2008, Reconnex in August 2008, and ScanAlert in January 2008. Amortization for the purchased technology related to these acquisitions was $7.8 million in the three months ended March 31, 2009.

 

We expect amortization of purchased technology to increase in absolute dollars as a result of our 2008 acquisitions when comparing 2009 to 2008.

 

Gross Margin

 

Our gross margins decreased slightly for the three months ended March 31, 2009 compared to the three months ended March 31, 2008 due mostly to increased cost of service and support revenue as a percentage of service and support revenue and increased amortization of purchased technology related to acquisitions made during 2008.

 

Gross margins may fluctuate in the future due to various factors, including the mix of products sold, upfront revenue realization, sales discounts, revenue-sharing and royalty arrangements, material and labor costs, warranty costs and amortization of purchased technology.

 

Stock-based Compensation Expense

 

Stock-based compensation expense consists of expense associated with all stock-based awards made to our employees and outside directors. Our stock-based awards include options, RSUs, RSAs, PSUs and ESPP grants.

 

The following table sets forth, for the periods indicated, a comparison of our stock-based compensation expenses:

 

 

The $12.2 million increase in stock-based compensation expense during the three months ended March 31, 2009 compared to the three months ended March 31, 2008 was primarily attributable to (i) a $5.7 million increase in expense relating to increased grants of PSUs, of which a significant portion were granted in February 2008, (ii) a $4.4 million increase in expense relating to increased grants of RSUs and assumed RSAs and RSUs from the 2008 acquisition of Secure Computing and (iii) a $1.5 million increase in expense relating to reinstating our ESPP in June 2008. See Note 3 to the condensed consolidated financial statements for additional information.

 

Operating Costs

 

Research and Development

 

The following table sets forth, for the periods indicated, a comparison of our research and development expenses:

 

 

 

 

Research and development expenses consist primarily of salary, benefits, and stock-based compensation for our development and a portion of our technical support staff, contractors’ fees and other costs associated with the enhancements of existing products and services and development of new products and services. The increase in research and development expenses in the three months ended March 31, 2009 was primarily attributable to (i) a $12.5 million increase in salary and benefit expense for individuals performing research and development activities due to an increase in headcount primarily from our Secure Computing acquisition and salary increases in April 2008, (ii) a $3.2 million increase in stock-based compensation expense and (iii) increases in various other expenses associated with research and development activities, offset by a $4.4 million decrease due to the net impact of foreign exchange rates, primarily driven by the average U.S. Dollar exchange rate strengthening against the Euro during the three months ended March 31, 2009 compared to the three months ended March 31, 2008.

 

We believe that continued investment in product development is critical to attaining our strategic objectives. We expect research and development expenses will increase in absolute dollars during the remainder of 2009.

 

Sales and Marketing

 

The following table sets forth, for the periods indicated, a comparison of our sales and marketing expenses:

 

 

 

 

Sales and marketing expenses consist primarily of salary, commissions, stock-based compensation and benefits and costs associated with travel for sales and marketing personnel, advertising and promotions. The increase in sales and marketing expenses during the three months ended March 31, 2009 compared to the three months ended March 31, 2008 reflected (i) a $19.8 million increase in salary and benefit expense, including commissions, for individuals performing sales and marketing activities due to an increase in headcount primarily from our Secure Computing acquisition, salary increases in April 2008 and increased commissions, (ii) a $13.7 million increase related to agreements with certain PC OEM partners, (iii) a $5.9 million increase in stock-based compensation expense and (iv) increases in various other expenses associated with sales and marketing activities, offset by (i) a $9.3 million decrease due to the net impact of foreign exchange rates, primarily driven by the average U.S. Dollar exchange rate strengthening against the Euro during the three months ended March 31, 2009 compared to the three months ended March 31, 2008 and (ii) a $5.5 million decrease in marketing and promotion expenses.

 

We anticipate that sales and marketing expenses will increase in absolute dollars primarily due to agreements with our strategic partners, primarily our PC OEM partners, where we have seen growth in volume and an increase in the number of partner agreements, our planned branding initiatives and our additional investment in sales capacity.

 

General and Administrative

 

The following table sets forth, for the periods indicated, a comparison of our general and administrative expenses: