1
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-Q
------------------------
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM __________ TO __________ .
COMMISSION FILE NUMBER 0-20558
------------------------
NETWORKS ASSOCIATES, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 77-0316593
(STATE OF INCORPORATION) (IRS EMPLOYER IDENTIFICATION NUMBER)
3965 FREEDOM CIRCLE
SANTA CLARA, CALIFORNIA 95054
(408) 988-3832
(ADDRESS AND TELEPHONE NUMBER OF PRINCIPAL EXECUTIVE OFFICES)
------------------------
Indicate by check mark whether 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, and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
136,665,321 shares of the registrant's common stock, $0.01 par value, were
outstanding as of March 31, 2001.
THIS DOCUMENT CONTAINS 47 PAGES.
THE EXHIBIT INDEX IS ON PAGE 43.
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
2
NETWORKS ASSOCIATES, INC.
FORM 10-Q
MARCH 31, 2001
------------------------
CONTENTS
ITEM
NUMBER PAGE
------ ----
PART I: FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets:
March 31, 2001 and December 31, 2000........................ 1
Condensed Consolidated Statements of Operations and
Comprehensive Income (Loss):
Three months ended March 31, 2001 and 2000.................. 2
Condensed Consolidated Statements of Cash Flows:
Three months ended March 31, 2001 and 2000.................. 3
Notes to Condensed Consolidated Financial Statements........ 4
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 13
Item 3. Quantitative and Qualitative Disclosures about Market
Risk...................................................... 21
PART II: OTHER INFORMATION
Item 1. Legal Proceedings........................................... 41
Item 2. Changes in Securities....................................... 41
Item 3. Defaults in Securities...................................... 41
Item 4. Submission of Matters to a Vote of Security Holders......... 41
Item 5. Other Information........................................... 41
Item 6. Exhibits and Reports on Form 8-K............................ 41
SIGNATURES........................................................... 42
EXHIBIT INDEX........................................................ 43
i
3
NETWORKS ASSOCIATES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
(UNAUDITED)
ASSETS
MARCH 31, DECEMBER 31,
2001 2000
---------- ------------
Current assets:
Cash and cash equivalents................................. $ 298,354 $ 275,539
Short term marketable securities.......................... 70,894 85,721
Accounts receivable, net.................................. 80,457 122,315
Prepaid expenses, income taxes and other current assets... 43,024 50,346
Deferred taxes............................................ 96,963 86,771
---------- ----------
Total current assets.............................. 589,692 620,692
Long term marketable securities............................. 267,286 332,893
Fixed assets, net........................................... 75,348 75,499
Deferred taxes.............................................. 118,680 113,489
Intangibles and other assets................................ 220,951 242,275
---------- ----------
Total assets...................................... $1,271,957 $1,384,848
========== ==========
LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $ 33,469 $ 46,816
Accrued liabilities....................................... 213,970 225,317
Deferred revenue.......................................... 163,543 151,566
---------- ----------
Total current liabilities......................... 410,982 423,699
Deferred taxes............................................ 7,161 7,971
Deferred revenue, less current portion.................... 27,779 26,592
Convertible debentures.................................... 399,858 395,969
Other long term debt and liabilities...................... 861 899
---------- ----------
Total liabilities................................. 846,641 855,130
---------- ----------
Commitments and contingencies (Note 9)
Minority Interest........................................... 10,576 11,067
Common stock, $0.01 par value; Authorized: 300,000,000;
Issued: 139,328,528 shares at March 31, 2001 and December
31, 2000;
Outstanding: 136,665,321 shares at March 31, 2001 and
138,089,775 shares at December 31, 2000................... 1,393 1,381
Treasury stock, at cost: 2,663,207 shares at March 31, 2001
and 1,238,753 shares at December 31, 2000................. (65,127) (23,186)
Additional paid-in capital.................................. 687,247 685,423
Cumulative other comprehensive loss -- unrealized gain
(loss) on investments and foreign currency translation.... (39,595) (31,266)
Accumulated Deficit......................................... (169,178) (113,701)
---------- ----------
Total stockholders' equity........................ 414,740 518,651
---------- ----------
Total liabilities, minority interest, and
stockholders' equity............................ $1,271,957 $1,384,848
========== ==========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
1
4
NETWORKS ASSOCIATES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND
COMPREHENSIVE INCOME (LOSS)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
--------------------
2001 2000
-------- --------
Net revenue:
Product................................................... $107,244 $165,112
Services and support...................................... 63,095 49,344
-------- --------
Total net revenue................................. 170,339 214,456
-------- --------
Cost of net revenue:
Product................................................... 23,460 23,738
Services and support...................................... 10,453 8,505
-------- --------
Total cost of net revenue......................... 33,913 32,243
-------- --------
Operating costs and expenses:
Research and development(1)............................... 39,973 41,675
Marketing and sales(2).................................... 110,134 96,765
General and administrative(3)............................. 30,339 20,876
Amortization of intangibles............................... 15,845 14,430
-------- --------
Total operating cost and expenses................. 196,291 173,746
-------- --------
Income (loss) from operations..................... (59,865) 8,467
Interest and other income and expense, net................ 1,362 4,602
Gain (loss) on investments, net........................... -- 40,373
-------- --------
Income (loss) before provision for income taxes
and minority interest........................... (58,503) 53,442
Provision for income taxes (income tax benefit)............. (10,440) 25,540
-------- --------
Net income (loss) before minority interest........ (48,063) 27,902
Minority interest in loss of consolidated subsidiaries...... 702 1,123
-------- --------
Net income (loss)................................. $(47,361) $ 29,025
======== ========
Other comprehensive income (loss):
Unrealized gain (loss) on investments, net................ $ (8,013) $ 5,630
Foreign currency translation loss......................... (316) (1,965)
-------- --------
Comprehensive income (loss)............................... $(55,690) $ 32,690
======== ========
Net income (loss) per share -- basic...................... $ (0.35) $ 0.21
======== ========
Shares used in per share calculation -- basic............. 137,140 138,877
======== ========
Net income (loss) per share -- diluted.................... $ (0.35) $ 0.20
======== ========
Shares used in per share calculation -- diluted........... 137,140 144,372
======== ========
---------------
(1) Includes stock-based compensation charge of $91 and $454 for the three
months ended March 31, 2001 and 2000, respectively.
(2) Includes stock-based compensation charge of $144 and $720 for the three
months ended March 31, 2001 and 2000, respectively.
(3) Includes stock-based compensation charge of $1,421 and $392 for the three
months ended March 31, 2001 and 2000, respectively.
The accompanying notes are an integral part of these condensed consolidated
financial statements.
2
5
NETWORKS ASSOCIATES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31,
----------------------
2001 2000
--------- ---------
Cash flows from operating activities:
Net income (loss)......................................... $ (47,361) $ 29,025
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation, amortization, and bad debt expense....... 22,893 24,673
Interest on convertible notes.......................... 4,687 4,465
Realized gain (loss) on investments.................... (3,876) 125
Impairment of strategic investments.................... 5,000 --
Minority interest...................................... (702) (1,123)
Deferred taxes......................................... (17,249) (6,135)
Stock compensation charges............................. 1,656 1,566
Gain on sale of Goto.com investment.................... -- (28,551)
Gain on sale of Network Associates Japan investment.... -- (11,947)
Changes in assets and liabilities:
Accounts receivable.................................. 45,818 7,291
Prepaid expenses, taxes and other.................... 974 (12,004)
Accounts payable and accrued liabilities............. (21,307) 21,685
Deferred revenue..................................... 16,411 3,728
--------- ---------
Net cash provided by operating activities......... 6,944 32,798
--------- ---------
Cash flows from investing activities:
Purchase of marketable securities......................... (107,164) (150,490)
Proceeds from sale of marketable securities............... 183,277 170,216
Purchase of investments................................... -- (4,650)
Proceeds from Goto.com investment......................... -- 36,750
Proceeds from Network Associates Japan investment......... -- 11,947
Acquisitions by subsidiary................................ -- (1,981)
Additions to fixed assets................................. (8,752) (11,144)
--------- ---------
Net cash provided by investing activities......... 67,361 50,648
--------- ---------
Cash flows from financing activities:
Repayment of notes payable................................ -- (67)
Proceeds from issuance of stocks from option plan and
stock purchase plans................................... 4,682 9,440
Repurchase of common stock................................ (53,800) (27,442)
Other..................................................... (548) 1,330
Proceeds from sale of put options......................... -- 7,890
--------- ---------
Net cash used in financing activities............. (49,666) (8,849)
--------- ---------
Effect of exchange rate fluctuations...................... (1,824) (22,069)
--------- ---------
Net increase in cash and cash equivalents................... 22,815 52,528
Cash and cash equivalents at beginning of period............ 275,539 316,784
--------- ---------
Cash and cash equivalents at end of period.................. $ 298,354 $ 369,312
========= =========
Non cash investing activities:
Unrealized gain (loss) on investments..................... $ (8,013) $ 5,630
========= =========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
6
NETWORKS ASSOCIATES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The unaudited, condensed consolidated financial statements have been
prepared by Networks Associates, Inc. (the "Company") without audit in
accordance with instructions to Form 10-Q and Article 10 of Regulation S-X. The
unaudited, condensed consolidated financial statements include the accounts of
the Company and its majority owned subsidiaries. All intercompany accounts and
transactions have been eliminated in consolidation. The Company has two
reportable segments consisting of computer security and management software, and
managed security and availability application services to business users on the
Internet ("Infrastructure") and consumer PC security and management software on
the Internet ("McAfee.com").
In the opinion of management, all adjustments, consisting only of normal
recurring adjustments considered necessary for a fair presentation, have been
included. The results of operations for the three month period ended March 31,
2001 are not necessarily indicative of the results to be expected for the full
year or for any future periods. The accompanying unaudited, condensed
consolidated financial statements should be read in conjunction with the audited
consolidated financial statements contained in the Company's Annual Report on
Form 10-K filed with the Securities and Exchange Commission on April 2, 2001.
The balance sheet at December 31, 2000 has been derived from the audited
financial statements as of and for the year ended December 31, 2000, but does
not include all the information and footnotes required by generally accepted
accounting principles for complete financial statements.
Certain reclassifications have been made to the 2000 unaudited condensed
consolidated financial statements and related notes to conform to the 2001
presentation.
2. BUSINESS SEGMENT INFORMATION
In 2000, the Company established a subsidiary, McAfee.com ,as a separate
business entity. The Company evaluated its product segments in 2001 and
concluded that its reportable segments were computer security and management
software, including managed security and availability applications services on
the Internet ("Infrastructure") and consumer PC security and management software
on the Internet ("McAfee.com"). Management measures profitability for its
business based on these two segments.
The Infrastructure segment consists of anti-virus, network management,
security and help desk software. These products are marketed and sold through a
direct sales force to distributors, retailers, and end users world-wide. In
addition, the Infrastructure segment includes managed security and availability
applications services on the Internet.
The McAfee.com segment is a one-stop destination for consumer PC security
and management needs on the Internet. The McAfee.com web site provides a suite
of online products and services personalized for the user based on the user's PC
configuration, attached peripherals and resident software.
4
7
NETWORKS ASSOCIATES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
Summarized pre-tax financial information concerning the Company's
reportable segments is provided as follows (in thousands):
THREE MONTHS ENDED
MARCH 31,
--------------------------
2001 2000
---------- ------------
Infrastructure:
Net revenues............................. $ 157,523 $ 204,198
Segment operating income (loss).......... (57,147) 16,397
McAfee.com:
Net revenues............................. 12,816 10,258
Segment operating loss................... (2,718) (7,930)
MARCH 31, DECEMBER 31,
2001 2000
---------- ------------
Infrastructure:
Total assets..................... $1,173,873 $1,286,716
McAfee.com:
Total assets..................... 98,084 98,132
3. STOCK OPTION REPRICING AND STOCK REPURCHASE PLAN
On April 22, 1999, the Company offered to substantially all of its
employees, excluding executive officers, the right to cancel certain outstanding
stock options and receive new options with exercise prices at the current fair
market value of the stock. Options to purchase a total of 10.3 million shares
were cancelled and the same number of new options were granted at an exercise
price of $11.063, which was based on the closing price of the Company's common
stock on April 22, 1999. The new options vest at the same rate that they would
have vested under previous option plans. As a result, options to purchase
approximately 3.2 million shares at $11.063 were vested and outstanding at March
31, 2001.
In accordance with Accounting Principles Board Opinion No. 25 "Accounting
for Stock Issued to Employees," the Company incurred an initial stock based
compensation charge in connection with this repricing. This charge was
calculated based on the difference between the exercise price of the new options
and their market value on the date of acceptance by employees. Approximately
$314,000 was expensed in the three months ended March 31, 2001.
In March 2000, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock
Compensation, an interpretation of APB Opinion No. 25" ("Interpretation"). Among
other issues, this Interpretation clarifies (a) the definition of employee for
purposes of applying Opinion 25, (b) the criteria for determining whether a plan
qualifies as a non-compensatory plan, (c) the accounting consequence of various
modifications to the terms of a previously fixed stock option or award, and (d)
the accounting for an exchange of stock compensation awards in a business
combination. This guidance was effective as of July 1, 2000.
As a result of the introduction of this Interpretation, stock options
repriced by the Company on April 22, 1999 are subject to variable plan
accounting treatment from July 1, 2000. Accordingly, the Company has and will
continue to remeasure compensation cost for the repriced options until these
options are exercised, cancelled, or forfeited without replacement. The first
valuation period began with the effective date of the Interpretation which was
July 1, 2000. The valuation has and will be based on any excess of the closing
stock price at the end of the reporting period or date of exercise, forfeiture
or cancellation without replacement, if earlier, over the fair value of the
Company's common stock on July 1, 2000, which was $20.375. The resulting
compensation charge to earnings will be recorded over the remaining vesting
period, using the accelerated
5
8
NETWORKS ASSOCIATES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
method of amortization discussed in FASB Interpretation No. 28. When options are
fully vested, the charge will be recorded to earnings immediately. Depending
upon movements in the market value of the Company's common stock, this
accounting treatment may result in significant additional compensation charges
in future periods.
In addition, variable plan accounting as described above, applied to
options issued to employees of McAfee.com and myCIO.com as a replacement for
Company options which were subject to the repricing described above. As a
result, the Company will record variable charges based on the movements in the
fair value of McAfee.com and myCIO.com common stock from July 1, 2000. Because
myCIO.com employees were reintegrated into the Company's Infrastructure segment,
the Company will record charges for McAfee.com and the Infrastructure segment.
During the three months ended March 31, 2001, the Company did not incur
charges to earnings related to options subject to variable plan accounting as
the Company's stock price was below the July 1, 2000 closing price of $20.375.
As of March 31, 2001 the Company and McAfee.com had options, outstanding and
subject to variable plan accounting, amounting to 4.3 million and 59,542,
respectively. Depending on movements in the market value of the Company's common
stock, the accounting treatment may result in significant additional
compensation charges in future periods.
In May 1999, the Board of Directors authorized the Company to repurchase up
to $100 million of its common stock in the open market over a two-year period.
In July 2000, the Board of Directors authorized the Company to repurchase
additional common stock of up to $50 million in the open market over a two-year
period. Through March 31, 2001, the Company repurchased approximately 7.0
million shares of its common stock, including the repurchase of 2 million shares
on February 2, 2001 relating to the settlement of the outstanding put options.
Cash outlay, net of proceeds from put options described below, to date is
approximately $147.5 million. The timing and size of any future stock
repurchases are subject to market conditions, stock prices, the Company's cash
position and other cash requirements.
On August 3, 1999, February 16, 2000 and May 31, 2000, Network Associates
sold "European style" put options for 3 million shares of the Company's common
stock as part of its stock repurchase plan. The strike price for these put
options was $20.00, $30.00 and $24.07, respectively. The Company received total
proceeds of approximately $19.1 million from the sale. In August 2000, put
options sold on August 2, 1999 for 1 million shares were exercised in the
Company's stock. The strike price for these put options was $20.00. In February
2001, the Company settled the remaining put options which resulted in the
purchase of 2 million shares of the Company's common stock for approximately
$53.8 million.
On January 3, 2001, the Company's board of directors appointed George
Samenuk as the company's chief executive officer and president. As part of this
appointment, William Larson, former chief executive officer, and Prabhat Goyal,
former chief financial officer, and Peter Watkins, former president and chief
operating offer, became special advisors to the Company. Options held by Mr.
Larson, Mr. Goyal, and Mr. Watkins continue to vest while they each serve
one-year terms as special advisors to the Company. As a result, the Company
recorded stock compensation charges of approximately $603,000 in the three
months ended March 31, 2001.
On January 3, 2001, the Company entered into an employment agreement with
George Samenuk. In accordance with the terms of the agreement, the Company
issued 400,000 shares of restricted stock to Mr. Samenuk. The price of the
underlying shares is $0.01 per share. The Company's right to repurchase such
shares will lapse as follows: 12.5% on the first four quarterly anniversaries of
Mr. Samenuk's employment with the Company with the remaining 50% on the second
year anniversary of Mr. Samenuk's employment with the Company. The fair value of
the restricted stock was determined to be approximately $1.7 million and was
estimated based on the difference between the exercise price of the restricted
stock and the fair market value
6
9
NETWORKS ASSOCIATES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
of the Company's common stock on Mr. Samenuk's employment commencement date. In
the three months ended March 31, 2001, the Company recognized $209,000 related
to stock compensation associated with Mr. Samenuk's restricted stock.
4. STOCKHOLDERS' EQUITY
Stock Option Plans
On January 24, 2001, the Company's board of directors authorized the
reservation of an additional 3 million options for the 2000 Nonstatutory Stock
Option Plan.
Warrants
On January 3, 2001, the Company's board of directors appointed George
Samenuk as the company's chief executive officer. In January 2001, upon
completion of the search for the Company's CEO, the Company issued warrants to a
retained executive search firm for services performed. The warrants, if
exercised, can be exchanged for 166,667 shares of the Company's common stock.
The weighted-average exercise price of the underlying shares is $2.97 per share.
The warrants are immediately exercisable and expire in January 2004. The
combined fair value of the warrants was determined to be approximately $530,000
and was estimated using the Black-Scholes model with the following assumptions:
risk free interest rate of 4.82%; expected life of 3 years; dividend yield of 0;
and expected volatility of 91%. This amount was charged against earnings in the
current period and included in general and administrative expenses in the
accompanying financial statements.
5. RECENT ACCOUNTING PRONOUNCEMENTS
In June of 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for
Derivative Instruments and Hedging Activities, which establishes accounting and
reporting standards for derivative instruments and hedging activities. It
requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. In June, 1999, the FASB issued SFAS No. 137, Accounting for
Derivative Instruments -- Deferral of the Effective date of SFAS Statement No.
133. SFAS No. 137 deferred the effective date of SFAS No. 133 until June 15,
2000. The Company has adopted SFAS No. 133 as required for its first quarterly
filing of fiscal year 2001. SFAS 133 shall be effective for all subsequent
quarters and annual filings. The adoption of SFAS No. 133 did not have a
material effect on the financial position or results of operations of the
Company.
7
10
NETWORKS ASSOCIATES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
6. NET INCOME (LOSS) PER SHARE
In accordance with the disclosure requirements of SFAS 128, a
reconciliation of the numerator and denominator of basic and diluted net income
(loss) per share is provided as follows (in thousands, except per share
amounts):
THREE MONTHS ENDED
MARCH 31,
--------------------
2001 2000
-------- --------
Numerator -- Basic
Net income (loss)........................................... $(47,361) $ 29,025
======== ========
Numerator -- Diluted Net income (loss)...................... $(47,361) $ 29,025
Interest on convertible debentures(1)....................... -- --
-------- --------
$(47,361) $ 29,025
======== ========
Denominator -- Basic
Basic weighted average common shares outstanding............ 137,140 138,877
======== ========
Denominator -- Diluted
Basic weighted average common shares outstanding............ 137,140 138,877
======== ========
Effect of dilutive securities:
Common stock options(2)................................... -- 5,495
-------- --------
Diluted weighted average shares............................. 137,140 144,372
======== ========
Net income (loss) per share -- Basic........................ $ (0.35) $ 0.21
======== ========
Net income (loss) per share -- Diluted...................... $ (0.35) $ 0.20
======== ========
---------------
(1) Convertible debt interest and related as-if converted shares were excluded
from the calculation since the effect was anti-dilutive. The total number of
shares excluded from the calculation related to as-if converted shares was
7.6 million for the three months ended March 31, 2001 and 2000,
respectively.
(2) Common stock options were excluded from the March 31, 2001 calculation since
the effect was anti-dilutive. The total number of options excluded from the
calculation was 31.1 million and 9.7 million for the three months ended
March 31, 2001 and 2000, respectively.
7. ACQUISITIONS BY SUBSIDIARIES
On February 15, 2000, Network Associates' subsidiary, McAfee.com, acquired
all of the outstanding capital stock of Signal 9 Solutions Canada, Inc., a
privately held provider of personal firewall software, for approximately $2.0
million in cash and 385,001 shares of McAfee.com Class A common stock. The total
purchase price was approximately $18.0 million, including transaction costs.
McAfee.com recorded the total purchase price as purchased technology and
goodwill, and will be amortized on a straight-line basis over three years. The
activities of the acquired company were insignificant.
8. IMPAIRMENT OF STRATEGIC INVESTMENTS
The Company assesses the recoverability of the carrying value of strategic
investments on a regular basis. Factors we consider important which could
trigger an impairment include, but are not limited to, the likelihood that the
related company would have insufficient cash flows to operate for the next
twelve months. During the first quarter of 2001, the Company recorded a $5.0
million charge related to other than temporary declines in the value of certain
of our strategic investments. This amount is classified in interest and other
income and expense in the accompanying financial statements.
8
11
NETWORKS ASSOCIATES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
9. LITIGATION
General
From time to time, the Company has been subject to litigation including the
pending litigation described below. The Company's current estimated range of
liability related to some of the pending litigation below is based on claims for
which management can estimate the amount and range of loss. The Company has
recorded a liability related to these claims in accordance with generally
accepted accounting principles.
Because of the uncertainties related to the amount and range of loss on the
remaining pending litigation, management is unable to make a reasonable estimate
of the liability that could result from an unfavorable outcome. As additional
information becomes available, the Company will reassess its potential liability
and revise its estimates as appropriate. Pending and future litigation could be
costly and could cause the diversion of management attention and could have a
material adverse effect on the Company's business, results of operations, and
financial condition. At this time, management believes that the resolution of
these matters will not have a material adverse effect on these condensed
consolidated financial statements.
Securities Cases
In Re Network Associates, Inc. Securities Litigation. On April 7, 1999, a
putative securities class action, captioned Knisley v. Network Associates, Inc.,
et al., Civil Action No. C-99-1729-SBA, was filed against Network Associates and
several of its officers in the United States District Court for the Northern
District of California. The complaint alleged violations of Sections 10(b) and
20(a) of the Securities Exchange Act of 1934, and sought unspecified damages on
behalf of a purported class of purchasers of common stock between January 20,
1998 and April 19, 1999. Twenty-five similar actions asserting virtually
identical allegations were filed by other plaintiffs. The Court consolidated
these cases and an amended complaint was filed. Defendants filed a motion to
dismiss on June 6, 2000. The Court granted in part and dismissed in part the
motion to dismiss. The Court allowed only plaintiffs' claims related to
In-Process Research and Development to go forward and shortened the class period
to April 6, 1999. Plaintiffs filed a First Amended Consolidated Complaint, and
defendants filed an answer. In February 2001, the Company settled the class
action. The amount of the settlement is $30 million and is being funded
principally by the Company's Directors and Officers insurance carriers. The
settlement is subject to court approval.
On October 26, 2000, a new action, captioned The State Board of
Administration of Florida v. Network Associates, Inc. et. al., Civil Action No.
C-00-3981-WHA, naming the same defendants as the class-action, was filed in the
Northern District of California by an opt-out plaintiff. The action had been
coordinated with the class action for pretrial and trial proceedings. The
parties have stipulated to dismissal of the action without prejudice and have
entered into a tolling agreement with respect to the claims asserted by the
State Board of Administration of Florida.
In Re Network Associates, Inc. Derivative Litigation. On May 12, 1999, a
purported derivative action, captioned Dow Jones Investment Club v. Network
Associates, Inc. et al., Civil Action No. CV-781854, was filed against nominal
defendant Network Associates and certain of its officers and directors in the
Superior Court of California, County of Santa Clara. The complaint alleges
violations of Sections 25402 and 1507 of the California Corporations Code,
breach of fiduciary duty, insider trading, gross negligence, and unjust
enrichment. The complaint seeks unspecified damages. Two similar derivative
actions have been filed by other plaintiffs in the Superior Court of California,
County of Santa Clara, including Leighton v. Network Associates, Inc. et al.,
Civil Action No. CV-781947, and Katz v. Network Associates, Inc., et al., Civil
Action No. CV-782194. The court ordered these three actions consolidated for
pretrial and trial proceedings and deemed the complaint filed in the Leighton
action the operative complaint. Defendants' demurrer to the operative complaint
was sustained with leave to amend. A First Amended Complaint was filed by the
9
12
NETWORKS ASSOCIATES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
plaintiffs. Network Associates and the individual defendants demurred to the
First Amended Complaint. The demurrer was overruled, except with respect to the
Sixth Cause of Action, which was sustained without leave to amend. Discovery is
ongoing.
Gage v. Network Associates. A similar case, captioned Gage v. Network
Associates, Inc., et al., Civil Action No. B C211552, has been filed in the
Superior Court of California, County of Los Angeles. Plaintiffs allege
violations of Sections 25400 et seq. of the California Corporations Code,
Section 17200 of the California Business and Professions Code, and breach of
fiduciary duty. The parties stipulated to transfer the action to Santa Clara
County Superior Court where it is now pending under Civil Action No. CV-785715.
The complaint was dismissed without prejudice. Gage filed a First Amended
Complaint asserting claims in his individual capacity, which was dismissed
without prejudice. Gage then filed a Second Amended Complaint. The individual
defendants' and Network Associates' demurrer to the Second Amended Complaint was
overruled in part, sustained in part with prejudice, and sustained in part
without prejudice. Gage has filed a Third Amended Complaint. A Motion to Strike
certain allegations of the Third Amended Complaint is pending. Discovery is
ongoing.
Securities Lawsuits. Between December 29, 2000 and February 7, 2001,
Network Associates and certain of its current and former officers and directors
were named in securities class action lawsuits filed in the United States
District Court for the Northern District of California. The cases are
encaptioned as follows: Lukoff v. Network Associates, Inc., et al., Case No.
CV-01-0008-MEJ; Armour v. Network Associates, Inc., et al., Case No.
C00-4849-EDL; Ann & Wendall Prevat. v. Network Associates, Inc., et al., Case
No. C01-0007-WDB; Rizzuti v. Network Associates, et al., Case No.
C-01-20008-EAI; McDougald v. Network Associates, et al., Case No.
CV01-20103-ADR; 539, Inc. v. Network Associates, et al., Case No. C 01 0599-MMC.
The Armour, Wendel, Rizzuti, McDougald, and 539, Inc. complaints assert claims
against Network Associates, William Larson and Prabhat Goyal on behalf of a
putative class of persons who purchased Network Associates stock between July 19
and December 26, 2000; the Lukoff complaint asserts claims against Network
Associates, William Larson, Prabhat Goyal, Leslie Denend, Virginia Gemmell,
Edwin Harper and Enzo Torressi on behalf of a putative class of persons who
purchased and/or acquired Network Associates stock between October 16 and
December 26, 2000. All of the complaints assert causes of action (and seek
unspecified damages) for alleged violations of Exchange Act Section 10(b)/SEC
Rule 10b-5 and Exchange Act Section 20(a). In particular, the complaints allege
that defendants made false and misleading statements about the Company's
anticipated financial results for the fourth fiscal quarter of 2000, and that
the Company's class period financial statements failed to comply with GAAP.
Motions for appointment of lead plaintiff and for appointment of lead
plaintiffs' lead counsel were filed on February 27, 2001. A motion for
consolidation was also filed on that date. A hearing was held May 8, 2001 the
result of which is unknown at this time.
Derivative Lawsuit. On February 5, 2001, the Company was nominally sued in
a derivative lawsuit filed in the Superior Court in Santa Clara County. The
lawsuit, encaptioned Mean Ann Krim v. William L. Larson, et al., Case No.
CV795734, asserts claims against certain of its current and former officers,
directors, and other parties for breach of fiduciary duty, unjust enrichment and
professional negligence against the accountants. In particular, the complaints
allege that the defendants engaged in a course of conduct by which they
improperly accounted for revenue from software license sales, and that, as a
result of their actions, certain of the Company's financial statements were
false and misleading and not in compliance with GAAP. The complaint seeks an
unspecified amount of damages.
Other Litigation
Hilgraeve v. Network Associates. On September 15, 1997, Network Associates
was named as a defendant in a patent infringement action filed by Hilgraeve
Corporation ("Hilgraeve") in the United States
10
13
NETWORKS ASSOCIATES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
District Court, Eastern District of Michigan. Hilgraeve alleges that Network
Associates' VirusScan product infringes a Hilgraeve patent which was issued on
June 7, 1994. Hilgraeve's action seeks injunctive relief and unspecified money
damages. The District Court granted Network Associates' motion for summary
judgment of non-infringement on May 20, 1999 and entered judgment in favor of
Network Associates on July 7, 1999. On August 2, 2000 the United States Court of
Appeal for the Federal Circuit vacated in part, affirmed in part, and remanded
the case to the District Court for further proceedings. The Court has set a
hearing on the Company's further summary judgment motion for May 25, 2001.
Hilgraeve, Inc. and Hilgraeve Associates v. Network Associates. On October
10, 2000, Hilgraeve filed another complaint against Network Associates, also in
the United States District Court, Eastern District of Michigan. Hilgraeve
alleges that Network Associates' Webshield Proxy product infringes the same
Hilgraeve patent in the first suit. Hilgraeve's action seeks injunctive relief
and unspecified money damages. The Court has stayed this action until at least
May 25, 2001, pending the hearing on the Company's summary judgment in the
related matter (see above) that day.
Foremost Systems v. Network Associates, No. CV 777301 (Santa Clara
County). A former agent of Network Associates in India, Foremost Systems Pvt.
Ltd., filed this action on October 14, 1998, in California State court and filed
a Second Amended Complaint on February 18, 2000. Network Associates removed the
action to the United States District Court, Northern District of California, San
Jose Division. The Second Amended Complaint alleges that Network Associates
wrongly terminated Foremost Systems in breach of their agency agreement and, in
addition, contains counts for breach of oral contract, promissory estoppel,
intentional and negligent misrepresentation, breach of fiduciary duty, tortious
interference with contractual relations, unfair competition, and racketeering in
violation of 18 U.S.C 1962 et seq. The parties held a preliminary mediation
session in this matter on April 5, 2000 and attended a full session for March
12, 2001. A Case Management Conference in this matter is set to take place on
May 14, 2001.
Homenexus Inc. f/k/a HomeRun Network, Inc. v. DirectWeb, Inc., et al, No.
99-CV-2316 (CRW) (E.D. Pa.). In this action, filed in federal court in the
Eastern District of Pennsylvania on May 5, 1999, plaintiff Homenexus alleges
that DirectWeb successfully conspired with all defendants, including Network
Associates and William Larson, to wrongly misappropriate plaintiff's purported
proprietary business plan and to deliberately infringe plaintiff's purported
trade dress in its alleged web-site. The complaint further alleges that all
defendants conspired to commit, and did commit, the torts of conversion and
unfair competition. Plaintiff filed an amended complaint on June 21, 2000,
adding a new defendant, Riaz Karamali.
Simple.com v. McAfee.com, Civil Action No. CV-00-20816 RMW, United States
District Court, Northern District of California, San Jose Division. On August 1,
2000, Simple.com ("Simple") filed a complaint against McAfee.com ("McAfee"),
alleging that McAfee misappropriated Simple's trade secrets and infringed
Simple's copyrights in certain software code. The complaint includes seven
claims for relief: copyright infringement; breach of contract; misappropriation
of trade secrets; statutory unfair competition under Cal. Bus. & Prof. Code
Section 17200; common-law unfair competition; conversion; and breach of the
covenant of good faith and fair dealing. The complaint seeks preliminary and
permanent injunctive relief preventing McAfee from; inter alia, using the
information McAfee allegedly acquired from Simple. The complaint also seeks
compensatory damages in an amount alleged to be not less than $18 million, plus
interest. The complaint also seeks statutory, exemplary and punitive damages as
well as recovery for unjust enrichment. McAfee answered the complaint on August
30, 2000, denying all the material allegations in the complaint and asserting
affirmative defenses. The parties have served discovery requests on one another.
By the Court's December 1, 2000 case management order, fact discovery is
scheduled to close March 31, 2001, expert discovery is scheduled to close July
13, 2001, and the trial is scheduled for October 9, 2001.
11
14
NETWORKS ASSOCIATES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
10. SUBSEQUENT EVENTS
The Company's board of directors authorized the reservation of an
additional 5 million options for the 1997 Stock Incentive Plan. These additional
options are subject to shareholder approval at the Company's 2001 annual meeting
to be held May 24, 2001.
On April 3, 2001 the Company entered into an employment agreement with
Stephen C. Richards to become Executive Vice President and Chief Financial
Officer ("CFO"). In accordance with the terms of the agreement, the Company will
issue 50,000 shares of common stock to Stephen C. Richards. The price of the
underlying shares is $0.01 per share. The fair value of the common stock was
determined to be approximately $300,000.
12
15
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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.
This Report on Form 10-Q contains forward-looking statements, including but
not limited to those specifically identified as such, that involve risks and
uncertainties. The statements contained in this Report on Form 10-Q that are not
purely historical are forward-looking statements within the meaning of Section
27A of the Securities Act and Section 21E of the Exchange Act, including without
limitation statements regarding our expectations, beliefs, intentions or
strategies regarding the future. All forward-looking statements included in this
Report on Form 10-Q are based on information available to us on the date hereof,
and we assume no obligation to update any such forward-looking statements. Our
actual results could differ materially from those anticipated in these
forward-looking statements as a result of a number of factors, including, but
not limited to, those set forth in "Risk Factors" and elsewhere in this Report
on Form 10-Q.
OVERVIEW
We are a leading supplier of security and availability solutions for
e-business. Our products focus on two important areas of e-business: network
security and network management. In the network security and network management
arenas, the majority of our revenue has historically been derived from our
McAfee anti-virus product group and our Sniffer network availability and
performance management product group, respectively. These two flagship product
groups form the customer base and product base from which the balance of our
product line has developed.
In recent years, we have focused our efforts on building a full line of
complementary network security and network management solutions. On the network
security side, we strengthened our anti-virus lineup by adding complementary
products in the firewall, intrusion protection, encryption, and virtual private
networking categories. On the network management side, we built upon our Sniffer
line by adding products in the help desk, asset management, network monitoring,
and network reporting categories. We continuously seek to expand our product
lines. In order to more effectively market our products, we have combined
complementary products into separate product groups, as follows:
- McAfee, which primarily markets the McAfee Active Virus Defense (AVD)
product group;
- Sniffer Technologies, which primarily markets the Sniffer Total Network
Visibility (TNV) product group;
- PGP Security, which primarily markets the PGP Total Network Security
(TNS) product group; and
- Magic Solutions, which primarily markets the Magic Total Support Desk
(TSD) product group.
The four product groups represent our infrastructure segment. The
reorganization around our product groups is designed to allow us to, among other
things, react faster to customers' changing needs and better specialize our
sales force so they know our products and their markets in greater depth. In
addition, although specialization between security (anti-virus and security
product lines) and manageability (availability and service desk product lines)
previously existed, with the reorganization we seek to better differentiate
anti-virus from security and availability from service desk.
For the three months ended March 31, 2001, our infrastructure segment
accounted for approximately $157.5 million in net revenue and a net operating
loss of $57.1 million.
In addition to our product groups, we also have one subsidiary that is an
applications service provider, or ASP. McAfee.com, our publicly traded
subsidiary, is a consumer applications service provider. For the three months
ended March 31, 2001, McAfee.com accounted for approximately $12.8 million in
net revenue and a net operating loss of $2.7 million.
13
16
MCAFEE
McAfee's products and services provide solutions designed to enforce
anti-virus policies and measure the performance of anti-virus activities. The
McAfee product group consists of products and services that provide multi-layer
anti-virus protection, management and reporting for desktops, servers,
GroupWare, internet technologies, and wireless technologies. McAfee's anti-virus
protection products include VirusScan for desktop protection, NetShield for file
server protection, GroupShield for GroupWare protection, WebShield for internet
gateway protection, and VirusScan Wireless for wireless technology protection.
McAfee's anti-virus management and reporting products include Anti-Virus
Informant and ePolicy Orchestrator, an anti-virus management and reporting tool
designed specifically for the internet. McAfee's services are provided by
McAfee's Anti-Virus Emergency Response Team (AVERT.) AVERT augments McAfee's
product offerings by identifying new viruses and deploying anti-virus solutions
to our customers. McAfee customers are primarily corporate customers, including
customers in the managed service market (includes application service providers,
ASPs, and managed service providers, MSPs.)
SNIFFER TECHNOLOGIES
Sniffer Technologies' products and services provide customers with network
and application management solutions designed to maximize network availability
and performance. Sniffer Technologies' products capture data, monitor network
traffic and collect key network statistics for small networks as well as
optimizing network and application performance and increasing network
reliability by uncovering and analyzing network problems and recommending
solutions to such problems, automatically and in real-time for mid-level and
high-speed networks. In addition, Sniffer Technologies' products proactively
monitor and diagnose network and application-level problems on complex,
multi-segment networks from centralized locations as well as troubleshooting
high-speed telecommunications and Internet service provider networks. The
Sniffer Technologies product group consists of the Sniffer Portable Analysis
Line, the Sniffer Distributed Analysis Line, the Sniffer Reporter Line and
Sniffer Pro for Packet over SONET. Sniffer Technologies' service offerings
consist primarily of network and application management education and consulting
services. Sniffer Technologies' customers are primarily corporate customers,
including customers in the managed service market (MSPs and ASPs.)
PGP SECURITY
PGP Security's products help organizations worldwide secure their networks
using firewall, encryption, intrusion detection, risk assessment and Virtual
Private Network (VPN) technologies. PGP Security's products include E-Business
Server, Gauntlet Firewall, CyberCop Scanner and e-ppliance. E-Business Server
provides an encryption and data authentication solution designed to protect the
integrity and security of the customers' data using self-decrypting archives for
a wide range of server platforms and integrates with our customers' existing
network architectures. Gauntlet Firewall delivers integrated anti-virus
protection, a built-in standards-based VPN server, and spam and content
filtering to assure broad protection. CyberCop Scanning tools deliver risk
assessment solutions that continually scan networks for weak spots, enabling
network administrators to prevent security breaches before they occur. PGP's
e-ppliance, a web-based configuration tool, deploys the latest firewall
technologies and continually administers anti-virus protection. PGP Security's
vulnerability research team is known as COVERT, whose mission is to identify and
resolve serious customer vulnerabilities before attackers are able to exploit
them. PGP Security's customers include individuals, government agencies,
financial institutions, and corporations, including e-businesses.
MAGIC SOLUTIONS
Magic Solutions' products provide customers with a set of tools to manage
their customer support and problem management needs. Magic Solutions' product
group consists of products that promote information sharing, facilitate
workflow, and improve service delivery. Magic Solutions' products include the
Magic Total Service Desk Suite, a 100% browser based service desk and problem
management solution. The Magic Total Service Desk Suite includes customization
features (Database, User Interface and Business Rules). In
14
17
addition, Magic Solutions' stand-alone products include Magic HelpDesk,
SelfServiceDesk, Remote Desktop and Event Management. Magic Solutions' customers
are primarily corporations.
MCAFEE.COM
Effective January 1, 1999, we contributed our consumer e-commerce business
to our then wholly owned subsidiary, McAfee.com. In December 1999, McAfee.com
completed its initial public offering in which it sold to the public
approximately 7.2 million shares of its Class A common stock, entitled to one
vote per share. As of March 31, 2001, we owned 36,000,000 shares of McAfee.com
Class B common stock, entitled to three votes per share and representing
approximately 81% of McAfee.com's outstanding common stock and 93% of its total
voting power.
McAfee.com's products and services provide customers with an on-line
systems security solution. McAfee.com is a security Application Service Provider
(ASP) that delivers security applications software and related services through
an Internet browser. The McAfee.com applications allow consumers to detect and
eliminate viruses on their PCs, repair their PCs from damage caused by viruses,
optimize their hard drives and update their PCs' virus protection system with
current software patches and upgrades. The McAfee.com web site provides the
online products and services personalized for consumers based on their PC
configurations, software and attached peripherals. McAfee.com's offerings
include McAfee Clinic to scan their PC's for viruses, protect their data, clean
and optimize their hard drives and update applications and operating systems.
Additionally, McAfee.com offers customers access to McAfee.com Personal
Firewall, McAfee.com Wireless Security Center and McAfee.com Internet Privacy
Service.
In November 2000, McAfee.com expanded its home page and offerings to
include, on a preview basis, its .NET initiative, a managed application service
for small to medium sized businesses. Services available to these businesses on
a preview basis,, include:
- Security.NET -- up-to-date anti-virus and firewall security at work,
home, and on the road -- all via the Internet;
- HelpDesk.NET -- self-help tutorials, file management, and PC maintenance
services on a 24x7 basis;
- Productivity.NET -- anytime, anyplace computing with Microsoft Office
compatible applications.
In addition, McAfee.com has developed strategic relationships with original
equipment manufacturers and suppliers and other software companies, to
incorporate McAfee.com technology into hardware and other software applications.
McAfee.com's customers include individuals and corporations.
Our existing license agreement with McAfee.com currently restricts
McAfee.com's business to offering products and services incorporating our
technology to consumers over the Internet. However, in March 2001, we entered
into a reseller agreement permitting McAfee.com's resale of our products and
service offerings to businesses over the Internet.
15
18
RESULTS OF OPERATIONS
The following table sets forth, for the period's indicated, the percentage
of net revenues represented by certain items in our statements of operations for
the three months ended March 31, 2001 and 2000.
THREE MONTHS
ENDED
MARCH 31,
------------
2001 2000
---- ----
Net revenue:
Product................................................... 63% 77%
Services and support...................................... 37 23
--- ---
Total net revenue................................. 100 100
Cost of net revenue:
Product................................................... 14 11
Services and support...................................... 6 4
--- ---
Total cost of net revenue......................... 20 15
Operating costs and expenses:
Research and development.................................. 23 19
Marketing and sales....................................... 65 45
General and administrative................................ 18 10
Amortization of intangibles............................... 9 7
--- ---
Total operating costs and expenses................ 115 81
Income (loss) from operations..................... (35) 4
Interest and other income and expense, net................ 1 2
Gain (loss) on investments, net........................... -- 19
--- ---
Income (loss) before provision for income taxes
and minority interest........................... (34) 25
Provision for income taxes (income tax benefit)............. (6) 12
--- ---
Net Income (loss) before minority interest........ (28) 13
Minority interest in consolidated subsidiaries.............. -- 1
--- ---
Net income (loss)................................. (28)% 14%
=== ===
Net Revenue. Net revenue decreased 21% to $170.3 million from $214.5
million for the three months ended March 31, 2001 and 2000, respectively. The
decrease in net revenue is primarily due to growth in MSP and ASP services and
support offerings for which revenue is recognized ratably over the service
period, the reorganization of our European sales force around our product
groups, in addition to our transition to a sell-through model during the first
quarter of 2001. In December 2000, in light of the business decision by some of
our distributors, including our largest distributor, to reduce inventory levels,
and due to the unpredictability of demand in the distribution channel, we began
a transition from a sell-in to a sell-through business model.
Under our new business model, we have and continue to enter into amended
distribution arrangements under which we permit our distributors to purchase
software licenses at the time they fill customer orders and to pay for hardware
and retail products only when these products are sold to the distributors'
customers. In addition, we permit our distributors to make hardware and retail
product returns at any time prior to the time they sell the products to their
customers. This right of return is unconditional. After sale by the distributor
to its customer, there will be no right of return from the distributor to us
with respect to such product, unless we approve the return from the final
customer to the distributor. Accordingly, due to this change in business
practice, commencing on January 1, 2001, we recognize revenue on products when
products are sold through by the distributor.
Product revenue includes revenue from product licenses and hardware.
Product revenue decreased 35% to $107.2 from $165.1 million for the three months
ended March 31, 2001 and 2000, respectively. The decrease
16
19
in product revenue is primarily attributable to the reorganization of our
European sales force around our product groups, in addition to our transition to
the sell-through model, as described above.
Services and support revenues include revenues from software support and
maintenance contracts, education and consulting services, which are deferred and
recognized over the related service period. Service revenues increased 28% to
$63.1 million from $49.3 million for the three months ended March 31, 2001 and
2000, respectively. The increase in services and support revenues resulted from
growth in all categories of service revenues, principally due to the growth of
our installed customer base and the resulting renewal of support and maintenance
contracts. In addition, we experienced growth in our MSP and ASP service
offerings, including those offered by McAfee.com, during the fourth quarter of
2000 and the first quarter of 2001.
Our future profitability and rate of growth, if any, will be directly
affected by increased price competition, a maturing anti-virus market and an
increasingly higher revenue base from which to grow. Our growth rate and net
revenue depend significantly on renewals of existing orders as well as expanding
our customer base. If our renewal of existing orders or our pace of new customer
orders slows, our net revenues and operating results would be adversely
affected.
International revenue accounted for approximately 33% and 39%, of net
revenue for the three months ended March 31, 2001 and 2000, respectively. The
decrease in international net revenue as a percentage of net revenue for the
three months ended March 31, 2001 compared to the same period in 2000 was due to
the reorganization of our European sales force around our product groups, under
performance in sales operations, changes in sales management, a slow down due to
softening market conditions, and continued weakness of the Euro. To minimize the
impact of foreign currency fluctuations, we use non-leveraged forward currency
contracts. However, our future results of operations may be adversely affected
by currency fluctuations or by costs associated with currency risk management
strategies. Other risks inherent in international revenue include the impact of
longer payment cycles, greater difficulty in accounts receivable collection,
unexpected changes in regulatory requirements, seasonality due to the slowdown
in European business activity during the third quarter, tariffs and other trade
barriers, uncertainties relative to regional economic circumstance, political
instability in emerging markets and difficulties staffing and managing foreign
operations. These factors may have a material adverse effect on our future
international revenue. Further, in countries with a high incidence of software
piracy, we may experience a higher rate of piracy of our products.
Cost of Net Revenue. Cost of net revenue increased 5% to $33.9 million from
$32.2 million for the three months ended March 31, 2001 and 2000, respectively.
The increase in cost of net revenues was primarily due to a higher percentage of
our revenues attributable to our lower margin products and services, such as
hardware, consulting, and maintenance services in comparison to the same period
in prior year.
Our cost of product revenue consists primarily of the cost of media,
manuals and packaging for products distributed through traditional channels,
royalties, and with respect to hardware based Sniffer and E-ppliance products,
computer platforms and other hardware components. There was no significant
change in cost of product revenue which was $23.5 million from $23.7 million for
the three months ended March 31, 2001 and 2000, respectively. As a percentage of
net product revenue, cost of product revenue was 22% and 14% for the three
months ended March 31, 2001 and 2000, respectively. Cost of product revenue
increased as a percentage of product revenue for the three months ended March
31, 2001 compared to the same period in 2000 due to our lower margin products,
such as hardware, making up a higher percentage of our product revenues.
Cost of services and support revenue consists principally of salaries and
benefits related to employees providing customer support and consulting
services. The cost of services and support revenue increased 23% to $10.5
million from $8.5 million for the three months ended March 31, 2001 and 2000,
respectively. Costs of services and support revenue increased due to the
increase in services and support revenue. Cost of services and support revenue
as a percentage of net services and support revenue was 17% for the three months
ended March 31, 2001 and 2000.
Research and Development. Research and development expenses consist
primarily of salary and benefits for our development and technical support
staff. Excluding the effects of stock-based compensation of
17
20
approximately $91,000 and $454,000 for the three months ended March 31, 2001 and
2000, respectively, research and development expenses decreased 3% to $39.9
million from $41.2 million for the three months ended March 31, 2001 and 2000,
respectively. Research and development expenses decreased due to focused product
development, discontinuance of certain development efforts, more efficient
operations in our research and development groups, the relocation of personnel
to lower cost offices and the conversion of temporary personnel into full time
employees. As a percentage of net revenue, research and development expenses
were 23% and 19% for the three months ended March 31, 2001 and 2000,
respectively.
We believe that our ability to maintain our competitiveness will depend in
large part upon our ability to enhance existing products, develop and acquire
new products and develop and integrate acquired products. The market for
computer software is characterized by low barriers to entry and rapid
technological change, and is highly competitive with respect to timely product
introductions. The timing and amount of research and development expenses may
vary significantly based upon the number of new products and significant
upgrades under development and products acquired during a given period.*
Marketing and Sales. Marketing and sales expenses consist primarily of
salary, commissions and benefits for marketing, sales and customer support
personnel and costs associated with advertising and promotions. Excluding the
effects of stock-based compensation of approximately $144,000 and $720,000 for
the three months ended March 31, 2001 and 2000, respectively, marketing and
sales expenses increased 15% to $110.0 million from $96.0 million for the three
months ended March 31, 2001 and 2000, respectively. These increases were
primarily due to continued investment in the marketing of our products and
services, hiring and training of our enterprise level sales force, and
advertising and promotions for McAfee.com. As a percentage of net revenue,
marketing and sales expense was 65% and 45% for the three months ended March 31,
2001 and 2000, respectively. We anticipate that marketing and sales expenses
will continue to increase in absolute dollars, but will continue to fluctuate as
a percentage of net revenue.*
General and Administrative. General and administrative expenses consist
principally of salary and benefit costs for administrative personnel and general
operating costs. Excluding the effect of stock-based compensation of $1.4
million and $392,000 for the three months ended March 31, 2001 and 2000,
respectively, general and administrative expenses increased 41% to $28.9 million
from $20.5 million for the three months ended March 31, 2001 and 2000. The
increase is primarily attributable to recruiting and hiring additional
personnel, including senior management, legal fees and continued expansion of
the information technology infrastructure to support business information
systems. As a percentage of net revenues, general and administrative expenses
were 18% and 10% for the three months ended March 31, 2001 and 2000,
respectively.
STOCK-BASED COMPENSATION
We expensed $1.7 million and $1.6 million for the three months ended March
31, 2001 and 2000, respectively. Stock-based compensation charges relate to the
repricing of employee stock options and the issuance of McAfee.com stock options
to our executives and employees, as well as non-recurring stock compensation
charges related to primarily executive compensation. We do not expect to incur
charges related to these McAfee.com option grants in the future. However, we do
expect significant stock-based compensation charges related to repriced employee
stock options.
On April 22, 1999, we offered to substantially all of our employees,
excluding executive officers, the right to cancel certain outstanding stock
options and receive new options with exercise prices at the current fair market
value of the stock. Options to purchase a total of 10.3 million shares were
canceled and the same number of new options were granted at an exercise price of
$11.063, which was based on the closing price of our common stock on April 22,
1999. The new options vest at the same rate that they would have vested under
previous option plans. As a result, options to purchase approximately 3.2
million shares at $11.063 were vested and outstanding at March 31, 2001.
---------------
* This statement is a forward looking statement reflecting current expectations.
There can be no assurance that our actual performance will meet our current
expectations. See Risk Factors on page 23 for discussion of certain factors
that could affect future performance.
18
21
In accordance with Accounting Principles Board Opinion No. 25 "Accounting
for Stock Issued to Employees," we incurred an initial stock based compensation
charge in connection with this repricing. This charge was calculated based on
the difference between the exercise price of the new options and their market
value on the date of acceptance by employees. Approximately $314,000 and $1.6
million was expensed in the three months ended March 31, 2001 and March 31,
2000, respectively.
In March 2000, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock
Compensation, an interpretation of APB Opinion No. 25" ("Interpretation"). Among
other issues, this Interpretation clarifies (a) the definition of employee for
purposes of applying Opinion 25, (b) the criteria for determining whether a plan
qualifies as a non-compensatory plan, (c) the accounting consequence of various
modifications to the terms of a previously fixed stock option or award, and (d)
the accounting for an exchange of stock compensation awards in a business
combination. As of July 1, 2000 this guidance was effective.
As a result of the introduction of this Interpretation, stock options
repriced on April 22, 1999 are subject to variable plan accounting treatment
from July 1, 2000. Accordingly, we have and will continue to remeasure
compensation cost for the repriced options until these options are exercised,
cancelled, or forfeited without replacement. The first valuation period began
with the effective date of the Interpretation which was July 1, 2000. The
valuation has and will be based on any excess of the closing stock price at the
end of the reporting period or date of exercise, forfeiture or cancellation
without replacement, if earlier, over the fair value of our common stock on July
1, 2000, which was $20.375. The resulting compensation charge to earnings will
be recorded over the remaining vesting period, using the accelerated method of
amortization discussed in FASB Interpretation No. 28. When options are fully
vested, the charge will be recorded to earnings immediately. Depending upon
movements in the market value of our common stock, this accounting treatment may
result in significant additional compensation charges in future periods.
In addition, variable plan accounting as described above, applied to
options issued to employees of McAfee.com and myCIO.com as a replacement for
Network Associates options which were subject to the repricing described above.
As a result, we will record variable charges based on the movements in the fair
value of McAfee.com and myCIO.com common stock from July 1, 2000. Because
myCIO.com employees were reintegrated into our Infrastructure segment, we will
record charges for McAfee.com and the Infrastructure segment.
During the three months ended March 31, 2001, we did not incur charges to
earnings related to options subject to variable plan accounting as our stock
price was below the July 1, 2000 closing price of $20.375. As of March 31, 2001
Network Associates and McAfee.com had options, outstanding and subject to
variable plan accounting, amounting to 4.3 million and 59,542, respectively.
Depending on movements in the market value of our common stock, the accounting
treatment may result in significant additional compensation charges in future
periods.
On January 3, 2001, our board of directors appointed George Samenuk as our
chief executive officer and president. As part of this appointment, William
Larson, former chief executive officer, and Prabhat Goyal, former chief
financial officer, and Peter Watkins, former president and chief operating
officer, became special advisors to Network Associates. Options held by Mr.
Larson, Mr. Goyal, and Mr. Watkins continue to vest while they each serve
one-year terms as special advisors. As a result, we recorded stock compensation
charges of approximately $603,000 in the three months ended March 31, 2001.
On January 3, 2001, we entered into an employment agreement with George
Samenuk. In accordance with the terms of the agreement, we issued 400,000 shares
of restricted stock to Mr. Samenuk. The price of the underlying shares is $0.01
per share. Our right to repurchase such shares will lapse as follows: 12.5% on
the first four quarterly anniversaries of Mr. Samenuk's employment with the
remaining 50% on the second year anniversary of Mr. Samenuk's employment. The
fair value of the restricted stock was determined to be approximately $1.7
million and was estimated based on the difference between the exercise price of
the restricted stock and the fair market value of our common stock on Mr.
Samenuk's employment commencement date. In the three months ended March 31,
2001, we recognized $209,000 related to stock compensation associated with Mr.
Samenuk's restricted stock.
19
22
On January 3, 2001, our board of directors appointed George Samenuk as the
company's chief executive officer. In January 2001, upon completion of the
search for our CEO, we issued warrants to a retained executive search firm. The
warrants, if exercised, can be exchanged for 166,667 shares of our common stock.
The weighted-average exercise price of the underlying shares is $2.97 per share.
The warrants are immediately exercisable and expire in January 2004. The
combined fair value of the warrants was determined to be approximately $530,000
and was estimated using the Black-Scholes model with the following assumptions:
risk free interest rate of 4.82%; expected life of 3 years; a dividend yield of
0; and expected volatility of 91%.
Amortization of Intangibles. We expensed $15.8 million and $14.4 million of
amortization related to intangibles in the three months ended March 31, 2001 and
2000, respectively. Intangibles consist of purchased goodwill and certain
acquired technology. The increase in amortization was primarily a result of
additions to goodwill related to McAfee.com's acquisitions during 2000.
Interest and Other Income and Expense. Interest and other income and
expense decreased to $1.4 million from $4.6 million for the three months ended
March 31, 2001 and 2000, respectively. During the first quarter of 2001, we
assessed the recoverability of the carrying value of our strategic investments.
Factors we consider important which could trigger an impairment include, but are
not limited to, the likelihood that the related company would have insufficient
cash flows to operate for the next twelve months. During the first quarter of
2001, we recorded a $5.0 million charge related to other than temporary declines
in the value of certain of our strategic investments. Excluding the affects of
the impairment charge described above, we earned $6.4 million and $4.6 million
in interest and other income and expense, net for the three months ended March
31, 2001 and 2000, respectively. The increase in interest and other income and
expense, net, excluding the impairment charge, increased from the three months
ended March 31, 2000 compared to the same period in 2001, due to investing in
available-for-sale securities at slightly higher interest rates.
Gain (Loss) on Investments. In 2000, we recognized a total gain of $40.4
million on the sale of our venture and strategic investments, including a gain
on the sale of shares of Network Associates Japan, amounting to $11.9 million.
Provision for Income Taxes/Income Tax Benefit. Our income tax benefit was
$10.4 million for the three months ended March 31, 2001, which was primarily
attributable to current period net operating losses generated in various taxing
jurisdictions. The provision for income taxes was $25.5 million for three months
ended March 31, 2000 which was primarily attributable to federal income tax
gains from the sale of investments and to income taxes payable in foreign
jurisdictions.
If we cease to own at least 80% of McAfee.com's outstanding common stock,
we may be required to include in our consolidated federal taxable income an
amount equal to the excess of the cumulative McAfee.com net operating losses
deducted in our prior year consolidated tax returns over our tax basis in
McAfee.com. As of March 31, 2001, there were excess cumulative net operating
losses.
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 2001, we had $298.4 million in cash and cash equivalents and
$338.2 million in marketable securities, for a combined total of $636.6 million.
Net cash provided by operating activities was $6.9 million and $32.8
million for the three months ended March 31, 2001 and 2000, respectively. Net
cash provided by operating activities for the three months ended March 31, 2001
consisted primarily of collections of accounts receivable, non-cash expenses
incurred in the first quarter related to depreciation and amortization, an
increase in our deferred revenue, interest on our convertible notes and the
impairment of our strategic investments. Cash provided by these activities was
offset by payments made on our accounts payable and other accrued liabilities
during the first quarter of 2001, in addition to an increase in our deferred tax
balance. Net cash provided by operating activities for the three months ended
March 31, 2000 consisted primarily of increases in our accounts payable and
accrued liabilities balances and collections of accounts receivable, as well as
non-cash expenses incurred in the first quarter of 2000 related to depreciation
and amortization, interest on our convertible notes, and an increase in our
deferred revenue balance. Cash provided by these activities was offset by the
gain on the sale of our
20
23
investments in Goto.com and Network Associates, Japan, an increase in prepaid
expenses, taxes and other and an increase in our deferred tax balance.
Our accounts receivable balance as a percentage of sales may increase due
to our increased emphasis on server/enterprise based sales and expanding
international sales, both of which typically have longer payment terms.
Additionally, our receivable collection has become more dependent on the longer
payment cycle for VARs, distributors and system integrators. To address this
increase in accounts receivable and to improve cash flow, we may from time to
time take actions to encourage earlier payment of receivables and sell
receivables. To the extent that our accounts receivable balance increases, we
will be subject to greater general credit risks with respect thereto.
Net cash provided by investing activities was $67.4 million and $50.6
million for the three months ended March 31, 2001 and 2000, respectively,
primarily reflecting proceeds from the sale of marketable securities. In the
three months ended March 31, 2000, we obtained proceeds of $36.8 million and
$11.9 million from our sale of Goto.com shares and the sale of less than 5% of
the shares of our Japanese subsidiary, Network Associates Japan, respectively.
Net cash used in financing activities was $49.7 million and $8.8 million
for the three months ended March 31, 2001 and 2000. Cash used in financing
activities in the three months ended March 31, 2001 was primarily attributable
to settling the remaining put options which resulted in purchasing 2,000,000
shares of our stock for approximately $53.8 million. Cash used in financing
activities in the three months ended March 31, 2000 was primarily attributable
to repurchases of our common stock as authorized by our Board of Directors. (See
Note 3.)
As discussed below, in February 2003 we may be required to use a
significant portion of our cash balances to redeem our outstanding zero coupon
debentures.
We believe that our available cash and anticipated cash flow from
operations will be sufficient to fund our working capital and capital
expenditure requirements for at least the next twelve months.*
EURO
On January 1, 1999, the "Euro" was introduced. On that day, the exchange
ratios of the currencies of the eleven countries participating in the first
phase of the European Economic and Monetary Union were fixed. The Euro became a
currency in its own right and the currencies of the participating countries,
while continuing to exist for a three-year transition period, are now fixed
denominations of the Euro. The conversion to the Euro will have significant
effects on the foreign exchange markets and bond markets and is requiring
significant changes in the operations and systems within the European banking
industry. Our information system is designed to accommodate multi-currency
environments. As a result, we have the flexibility to transact business with
vendors and customers in either Euro or traditional national currency units.
FINANCIAL RISK MANAGEMENT
The following discussion about our risk management activities includes
"forward-looking statements" that involve risks and uncertainties. Actual
results could differ materially from those projected in the forward-looking
statements.
As a global concern, we face exposure to adverse movements in foreign
currency exchange rates. These exposures may change over time as business
practices evolve and could have a material adverse impact on our financial
results. Historically, our primary exposures related to nondollar-denominated
sales and operating expenses in Japan, Canada, Australia, Europe, Latin America,
and Asia. We have recently expanded our business activities in Europe. As a
result, we expect to see an increase in exposures related to nondollar-
denominated sales in several European currencies. At the present time, we hedge
only those currency
---------------
* This statement is a forward looking statement reflecting current expectations.
There can be no assurance that our actual performance will meet our current
expectations. See Risk Factors on page 23 for discussion of certain factors
that could affect future performance.
21
24
exposures associated with certain assets and liabilities denominated in
nonfunctional currencies and do not generally hedge anticipated foreign currency
cash flows. Our hedging activity is intended to offset the impact of currency
fluctuations on certain nonfunctional currency assets and liabilities. The
success of this activity depends upon estimates of transaction activity
denominated in various currencies, primarily the Euro, Japanese yen, Canadian
dollar, Australian dollar, and certain European currencies. To the extent that
these estimates are overstated or understated during periods of currency
volatility, we could experience unanticipated currency gains or losses.
We maintain investment portfolio holdings of various issuers, types and
maturities. These securities are classified as available-for-sale, and
consequently are recorded on the balance sheet at fair value with unrealized
gains and losses reported as a separate component of accumulated other
comprehensive income (loss). These securities are not leveraged and are held for
purposes other than trading.
We also maintain minority investments in non-publicly traded companies.
These investments amounting to $5.6 million are carried at cost less reductions
for other-than-temporary impairments. Reasons for reductions for
other-than-temporary impairments include but are not limited to, decline in
value as if the related company would have insufficient cash flow to operate for
the next twelve months.
CONVERTIBLE DEBT
On February 13, 1998, we completed a private placement of our Zero Coupon
Convertible Subordinated Debentures due in 2018. The debentures, with an
aggregate face amount at maturity of $885.5 million, generated net proceeds to
us of approximately $337.6 million (after deducting the fee paid to the initial
purchaser of our debentures, but no other expenses of the placement). The
initial price to the public for our debentures was $391.06 per $1,000 of face
amount at maturity, which equates to a yield to maturity over the term of the
bonds of 4.75% (on a semi-annual bond equivalent basis). The debentures are
convertible into common stock at the rate of 8.538 shares per $1,000 of face
amount at maturity, which equates to an initial conversion price of $45.80 per
share. The debentures are subordinated in right of payment to all existing and
future Senior Indebtedness (as defined in the related indenture) and effectively
subordinated in right of payment to all indebtedness and other liabilities of
our subsidiaries. The debentures may be redeemed for cash at our option
beginning on February 13, 2003. At the option of the holder, we will purchase
the debentures as of February 13, 2003, February 13, 2008 and February 13, 2013
at purchase prices (to be paid in cash or common stock or any combination
thereof and subject to certain conditions) equal to the initial issue price plus
the accretion of the discount on the debentures to such dates. The debentures
may also be redeemed at the option of the holder if there is a Fundamental
Change (as defined in the related indenture) at a price equal to the issue price
plus the accretion of the discount on the debentures to the date of redemption,
subject to adjustment.
Assuming that as of February 13, 2003 all debenture holders require that we
redeem their debentures, we would be required to pay an aggregate redemption
price in cash and/or shares of common stock equal to approximately $437.9
million. The number of shares, if any, issued in connection with any redemption
will be based on the fair value of our common stock at the time of redemption.
22
25
RISK FACTORS
Investing in our common stock involves a high degree of risk. The risks
described below are not the only ones facing our company. Additional risks not
presently known to us or that we deem immaterial may also impair our business
operations. Any of the following risks could materially adversely affect our
business, operating results and financial condition and could result in a
complete loss of your investment.
OUR QUARTERLY FINANCIAL RESULTS WILL LIKELY FLUCTUATE
Our quarterly operating results have varied greatly in the past and will
likely vary greatly in the future depending upon a number of factors. Many of
these factors are beyond our control. Our revenues, gross margins and operating
results may fluctuate significantly from quarter to quarter due to, among other
things:
- volume, size and timing of new licenses and renewals of existing
licenses;
- our ability to timely and accurately obtain end-user sales information
and information related to inventory levels from our distributors;
- introduction of new products, product upgrades or updates by us or our
competitors;
- the mix of products we sell;
- the size and timing of our non-cash stock-based charges;
- changes in product prices by us or our competitors;
- trends in the computer industry and general economic conditions;
- our ability to develop, market and sell our products;
- costs related to acquisitions of technology or businesses;
- fluctuations in McAfee.com's expenditure levels related to its efforts to
build brand awareness and establish strategic relationships with various
Internet companies;
- fluctuations in our expenditure levels related to our efforts to expand
our international sales organization;
- our investment experience related to our strategic minority equity
investments;
- the percentage of our revenue, particularly that portion attributable to
our ASP subscription model, that is deferred;
- the effectiveness of our channel strategy and our mix of direct and
indirect revenues;
- pressure on employee wages as competition for skilled employees
increases; and
- costs related to extraordinary events including litigation, acquisitions
or any reductions in forces.
Our business is impacted by seasonal trends and global or regional
macroeconomic trends. For example, our net revenue is typically higher in the
fourth quarter, as many customers complete annual budgetary cycles, and lower in
the summer months when many businesses experience lower sales, particularly in
the European market. Our European business has been adversely impacted in recent
periods primarily because of the continued weakness of the Euro against the
dollar. For some time, our business in Asia and Latin America has been adversely
impacted by the adverse economic conditions there. Most recently, our business
in the U.S. and elsewhere has been adversely impacted by customer concerns about
weakening economic conditions.
We have not been profitable for the last two years. In addition to risks we
face in operating our business, continued economic weakness in the U.S. and
other countries could slow or prevent our efforts to successfully expand
internationally and regain profitability.
23
26
THE TIMING AND AMOUNT OF OUR REVENUES ARE SUBJECT TO A NUMBER OF FACTORS THAT
MAKE IT DIFFICULT TO ESTIMATE OPERATING RESULTS PRIOR TO THE END OF A QUARTER
We do not maintain a significant level of backlog. As a result, product
revenues in any quarter are dependent on contracts entered into or orders booked
and shipped in that quarter. Historically, we have experienced a trend toward
higher order receipt, and therefore a higher percentage of revenue shipments,
toward the end of the last month of a quarter. This trend makes predicting
revenues more difficult. Under our recently adopted sell-through model for sales
to distributors, we do not invoice the distributor or recognize revenue until
products or services are sold through our distributors to their customers. Under
the sell-through model, it is essential that we gather sales information from
our distributors to accurately record our financial results for a particular
quarter in a timely manner. The timing of closing larger orders sold directly to
end-users of our products increases the risk of quarter-to-quarter fluctuation.
If orders forecasted for a specific customer for a particular quarter are not
realized or revenues are not otherwise recognized in that quarter, our operating
results for that quarter could be materially adversely affected.
WE SELL OUR PRODUCTS THROUGH INTERMEDIARIES, WHO MAY NOT VIGOROUSLY MARKET OUR
PRODUCTS, MAY NOT ACCEPT OUR SELL-THROUGH BUSINESS MODEL, MAY NOT PROVIDE US
REQUIRED INFORMATION TO ACCURATELY RECOGNIZE REVENUE OR MAY HAVE DIFFICULTY IN
TIMELY PAYING FOR PURCHASED PRODUCTS
We market a significant portion of our products to end-users through
intermediaries, including distributors, resellers and value-added resellers.
These distributors sell other products that are complementary to, or compete
with, our products. While we encourage our distributors to focus on our products
through market and support programs, these distributors may give greater
priority to products of other suppliers, including competitors.
In December 2000, in light of the decision by some of our distributors,
including our largest distributor, to reduce inventory levels and due to the
unpredictability of demand in the distribution channel, we began a transition
from a sell-in to a sell-through business model. Subject to certain limitations,
we agreed to accept requests from certain distributors to return inventory over
and above permitted contractual levels. Under our new business model, we entered
into amended distribution arrangements under which we permit our distributors to
purchase software licenses at the time they fill customer orders and to pay for
hardware and retail products only when these products are sold to the
distributors' customers. In addition, we permit our distributors to make
hardware and retail product returns at any time prior to the time they sell the
products to their customers. This right of return is unconditional. After sale
by the distributor to its customer, there will be no right of return from the
distributor to us with respect to such product, unless we approve the return
from the final customer to the distributor. Accordingly, due to this change in
business practice, commencing on January 1, 2001, we recognized revenue on
products when products are sold through by the distributor.
Among other risks in connection with this transition are the following:
- our intermediaries may resist or be slow to adopt our new business
practice;
- to determine our business performance at any point in time or for any
given period, we must timely and accurately gather sales information from
our intermediaries' information systems, at an increased cost to us; and
- our intermediaries' information systems may be less accurate or reliable
than our internal systems.
Some of our distributors are experiencing financial difficulties worldwide,
which may adversely impact our collection of accounts receivable. We regularly
review the collectibility and credit worthiness of our distributors to determine
an appropriate allowance for doubtful accounts. Our uncollectable accounts could
exceed our current or future allowance for doubtful accounts, which would
adversely impact our operating results.
24
27
WE FACE RISK ASSOCIATED WITH EMPLOYEE RETENTION AND NEW EMPLOYEE ASSIMILATION
Many of our employees are located in areas and have skills in fields where
there is high worker mobility and work force turnover. The departure of a large
number of our employees or a meaningful number of key non-executive employees
could have a material adverse impact on many facets of our business, including
our ability to develop new products, upgrade existing products, sell our
products and provide adequate internal infrastructure. After April 22, 2000, the
end of the 12-month lock-up period for options repriced in April 1999, we
experienced a larger than normal level of employee departures as many of these
employees elected to terminate their employment with us. We anticipate that we
will continue to have difficulties in retaining employees because many of our
employees hold options to purchase our stock at prices significantly above the
current market price for our stock.
We hired a significant number of new employees in 2000 and we may continue
to add new employees to fill positions vacated by departing employees and to
expand our business. We will face challenges in attracting and assimilating
qualified new employees, in particular, in key international markets, such as
Japan, the United Kingdom, Germany and other regions. We expect that there may
be reduced levels of productivity as these individuals are trained and otherwise
adapt to our organization. We also may experience employee retention and
assimilation issues in connection with the integration of our myCIO.com service
offerings into our key offerings and in connection with our recent decision to
postpone indefinitely any public offering in Japan of our Network Associates
Japan subsidiary.
WE FACE RISKS RELATED TO ORGANIZING OUR SALES EFFORT INTO PRODUCT GROUPS
In order to more effectively market our products, we have combined
complementary products into separate product groups, as follows: McAfee, which
markets the McAfee Active Virus Defense (AVD) product group; Sniffer
Technologies, which markets the Sniffer Total Network Visibility (TNV) product
line; PGP Security, which markets the PGP Total Network Security (TNS) product
group; and Magic Solutions, which markets the Magic Total Support Desk (TSD)
product group. This structure is intended to allow us to react faster to
customers' needs and to focus each product group's sales force on selling their
respective product line and the individual point products contained in those
product groups. Our U.S. professional services organization is also organized
around our product groups. Our customers and potential customers may not respond
to this structure and our business and future financial performance could
suffer. This structure may be unsuccessful due to, among other things:
- uncertainty and customer dissatisfaction surrounding our shift in focus
to our product group strategy, including uncertainty as to our level of
support for our combined product groups, previously marketed as one line
and integration of our various product groups;
- customer confusion or irritation related to multiple sales calls from
different members of our reorganized sales force;
- a loss of potential cross selling opportunities and a lack of lead
sharing between the separate product groups' sales representatives who
are primarily compensated for sales made by them of products within their
respective product groups;
- the possibility that our centralized general and administrative group may
be unable to meet on a timely basis or at all each product group's
individualized infrastructure and support requirements; and
- one or more of our product groups may lack sufficient qualified
professional services personnel to support its products.
WE COULD EXPERIENCE CUSTOMER AND MARKET CONFUSION DUE TO OUR MARKETING AND
ADVERTISING EFFORTS TARGETED AT THE PRODUCT GROUP OR SUBSIDIARY LEVEL, RATHER
THAN AT THE CORPORATE LEVEL, AND DUE TO SIMILARITIES IN THE NAMES USED BY OUR
PRODUCT GROUPS AND SUBSIDIARIES
We have spent a significant portion of our total marketing efforts and
advertising spending building awareness of the Network Associates name. Our
marketing efforts and advertising spending have been focused
25
28
on building brand awareness at the product group and subsidiary level, rather
than at the Network Associates corporate level. This has created and could
continue to create confusion in the marketplace and in the investor community if
people are unclear about the relationships between Network Associates and our
product groups and our McAfee.com subsidiary. These groups and subsidiaries also
have potentially confusing names and products. For example, our online consumer
anti-virus products, our retail and corporate anti-virus products and our hosted
anti-virus products to date have been marketed and sold, respectively, by our
publicly traded McAfee.com subsidiary, our retail division which is called
McAfee Retail and our McAfee product group.
OUR REVENUES MAY BE ADVERSELY IMPACTED BY OUR SHIFT TO A TWO-YEAR SUBSCRIPTION
LICENSE THAT INCLUDES ONLY ONE-YEAR OF MAINTENANCE
Historically, our two-year subscription license included two years of
maintenance. However, in 2001, we introduced two-year subscription licenses that
include the first year of maintenance. During the first year of the subscription
license, the customer has the option to purchase the second year of maintenance.
We believe this new offering allows the customer greater flexibility in
selecting the appropriate level of maintenance support. However, if customers
delay the purchase of their second year of maintenance support, this could
adversely affect our near term revenue and cash flows.
OUR STOCK PRICE HAS BEEN VOLATILE AND IS LIKELY TO REMAIN VOLATILE
During 2000, our stock price was extremely volatile and ranged from a
per-share high of $36.69 to low of $4.13. On May 10, 2001, the per share closing
price for our common stock was $12.36. Announcements, litigation developments,
and our ability to meet the expectations of investors with respect to our
operating and financial results may contribute to current and future stock price
volatility. We may not discover, or be able to confirm, revenue or earnings
shortfalls until the end of a quarter, which could result in an immediate drop
in our stock price. In addition, similar events with respect to McAfee.com, our
publicly traded subsidiary, and fluctuations in its stock price may also
contribute to the volatility of our stock price. In the past, following periods
of volatility in the market price of a company's stock, securities class action
litigation has often been instituted. A number of putative class actions were
brought against our officers, directors and us. See Note 9, Notes to the
Condensed Consolidated Financial Statements. This litigation, and any other
litigation if instituted, could result in substantial costs and a diversion of
management's attention and resources.
COMPETITORS MAY INCLUDE PRODUCTS SIMILAR TO OURS IN THEIR HARDWARE OR SOFTWARE
AND RENDER OUR PRODUCTS OBSOLETE
Vendors of hardware and of operating system software or other software
(such as firewall or e-mail software) may enhance their products or bundle
separate products to include network security and management software similar to
our products. The widespread inclusion of products that perform the same or
similar functions as our products within computer hardware or other software
could render our products obsolete and unmarketable. Furthermore, even if these
incorporated products are inferior or more limited than our products, customers
may elect to accept the incorporated products rather than purchase our products.
If we are unable to develop new network security and management products to
further enhance operating systems or other software and to successfully replace
any obsolete products, our business could suffer.
WE EXPECT SIGNIFICANT STOCK-BASED COMPENSATION CHARGES RELATED TO REPRICED
OPTIONS
In light of the decline in our stock price at the time and in an effort to
retain our employee base, on April 22, 1999, we offered to substantially all of
our employees, excluding executive officers, the right to cancel certain
outstanding stock options and receive new options with exercise prices at the
current fair market value of the stock. Options to purchase a total of 10.3
million shares were canceled and the same number of new options were granted at
an exercise price of $11.063, which was based on the closing price of our common
stock on April 22, 1999. The new options vest at the same rate that they would
have vested under previous option plans. As a result, options to purchase
approximately 3.2 million shares at $11.063 were vested and outstanding at March
31, 2001.
26
29
In accordance with Accounting Principles Board Opinion No. 25 "Accounting
for Stock Issued to Employees," we incurred an initial stock based compensation
charge in connection with this repricing. This charge was calculated based on
the difference between the exercise price of the new options and their market
value on the date of acceptance by employees. Approximately $314,000 and $1.6
million was expensed in the three months ended March 31, 2001 and 2000,
respectively.
In March 2000, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock
Compensation, an interpretation of APB Opinion No. 25" ("Interpretation"). Among
other issues, this Interpretation clarifies (a) the definition of employee for
purposes of applying Opinion 25, (b) the criteria for determining whether a plan
qualifies as a non-compensatory plan, (c) the accounting consequence of various
modifications to the terms of a previously fixed stock option or award, and (d)
the accounting for an exchange of stock compensation awards in a business
combination. As of July 1, 2000 this guidance was effective.
As a result of the introduction of this Interpretation, stock options
repriced by us on April 22, 1999 are subject to variable plan accounting
treatment from July 1, 2000. Accordingly, we have and will continue to remeasure
compensation cost for the repriced options until these options are exercised,
cancelled, or forfeited without replacement. The first valuation period began
with the effective date of the Interpretation which was July 1, 2000. The
valuation has and will be based on any excess of the closing stock price at the
end of the reporting period or date of exercise, forfeiture or cancellation
without replacement, if earlier, over the fair value of our common stock on July
1, 2000, which was $20.375. The resulting compensation charge to earnings will
be recorded over the remaining vesting period, using the accelerated method of
amortization discussed in FASB Interpretation No. 28. When options are fully
vested, the charge will be recorded to earnings immediately. Depending upon
movements in the market value of the our common stock, this accounting treatment
may result in significant additional compensation charges in future periods.
In addition, variable plan accounting as described above, applied to
options issued to employees of McAfee.com and myCIO.com as a replacement for
Network Associates options which were subject to the repricing described above.
As a result, we will record variable charges based on the movements in the fair
value of McAfee.com and myCIO.com common stock from July 1, 2000. Because
myCIO.com employees were reintegrated into our Infrastructure segment, we will
record charges for McAfee.com and the Infrastructure segment.
As a result, during the three months ended March 31, 2001, we did not incur
charges to earnings related to options subject to variable plan accounting as
our stock price was below the July 1, 2000 closing price of $20.375. As of March
31, 2001 our Infrastructure segment and McAfee.com had options, outstanding and
subject to variable plan accounting, amounting to 4.3 million and 59,542,
respectively. Depending on movements in the market value of our common stock,
the accounting treatment may result in significant additional compensation
charges in future periods.
WE HAVE RECENTLY EXPERIENCED SIGNIFICANT CHANGES IN SENIOR MANAGEMENT
On January 3, 2001, our board of directors appointed George Samenuk as our
chief executive officer and president. Mr. Samenuk was also named chairman of
our Board of Directors. As part of this appointment, William Larson, our former
chairman of the board of directors and chief executive officer, and Prabhat
Goyal, our former chief financial officer, left their former positions. In
addition, Peter Watkins, our former president and chief operating officer, left
his former position on December 31, 2000. On April 4, 2001, Stephen C. Richards
was hired as our new executive vice president and chief financial officer. On
April 9, 2001, Zachary Nelson, the former CEO of myCIO.com, became our chief
strategy officer and Ang Miah Boon, was named vice president and managing
director for our Asia-Pacific operations.
These changes in executive management may be disruptive to our business and
may result in the departure of existing employees and/or customers. It may take
significant time to locate, retain and integrate qualified management personnel.
It may take significant time to integrate recently hired senior management
personnel, who may ultimately be unable to effectively work together.
27
30
OUR MANAGEMENT AND TECHNICAL PERSONNEL ARE CRITICAL TO OUR BUSINESS, THESE
INDIVIDUALS MAY NOT REMAIN WITH US IN THE FUTURE
We rely, and will continue to rely, on a number of key technical and
management employees. While employees are required to sign standard agreements
concerning confidentiality and ownership of inventions, our employees are
generally not otherwise subject to employment agreements or to non-competition
covenants. If any of our key employees leave, our business, results of
operations and financial condition could suffer. Furthermore, we do not maintain
life insurance policies on our key employees.
Our ability to achieve our revenue and operating performance objectives
will depend in large part on our ability to attract and retain technically
qualified and highly skilled sales, consulting, technical, marketing and
management personnel. Competition for these employees is intense and is expected
to remain so for the foreseeable future. We have seen upward pressure on wages
as a result of this intense competition for employees, which could cause an
increase in our operating expenses. We may not be successful in retaining our
existing key personnel and in attracting and retaining the personnel we require,
and our failure to retain and hire key employees could adversely affect our
business and operating results. Additions of new, and departures of existing,
employees, particularly in key positions, can be disruptive and can result in
departures of existing employees, which could adversely affect our business.
COMPUTER "HACKERS" MAY DAMAGE OUR PRODUCTS AND SERVICES
Given our high profile in the security software market, we have been a
target of computer hackers who have, among other things, created viruses to
sabotage or otherwise attack our products. While to date, these efforts have
been discovered quickly and their adverse impact has been limited, similar
viruses or efforts may be created or replicated in the future. In this event,
users' computer systems could be damaged and demand for our software products
may suffer as a result. In addition, since we do not control diskette
duplication by distributors or our independent agents, diskettes containing our
software may be infected with viruses. Given our increased use of the Internet
to deliver products and services, any successful sabotage or other attack on our
websites, including the McAfee.com and myCIO.com web sites, could disrupt our
ability to provide products and services to customers. Recently a number of
websites have been subject to denial of service attacks, where a web site is
bombarded with information requests eventually causing the website to overload,
which causes a delay or disruption of service. A successful sabotage of one of
our affiliates' web based businesses could result in reduced demand for our or
our affiliates' web based products and services and could have a material
adverse effect on our business and our results of operation.
WE DEPEND ON REVENUE FROM OUR FLAGSHIP ANTI-VIRUS AND SNIFFER PRODUCTS
We have historically derived a majority of our net revenues from our
flagship McAfee anti-virus software products and Sniffer network fault and
performance management products. These products are expected to continue to
account for a significant portion of our net revenues for the foreseeable
future. Because of this concentration of revenue, a decline in demand for, or in
the prices of, these products as a result of competition, technological change,
a change in our pricing model, inclusion of anti-virus or network management and
analysis software as a standard part of hardware or operating system software or
other software, or a maturation in the markets for these products, could harm
our business.
WE FACE RISKS ASSOCIATED WITH PAST AND FUTURE TRANSACTIONS
Our industry has experienced, and is expected to continue to experience, a
significant amount of consolidation. As part of our growth strategy, we may buy
or make investments in complementary companies, products and technologies. Since
1995 we have completed a large number of significant acquisitions involving both
public and private companies, including:
- CyberMedia in September 1998;
- Dr. Solomon in August 1998;
- Secure Networks in May 1998;
28
31
- Magic Solutions and TIS in April 1998;
- Network General, PGP and Helix Software in December 1997;
- Cinco Networks in August 1997;
- Vycor Corporation in February 1996; and
- Saber Software in August 1995.
We have also completed a number of smaller acquisitions and acquired a
number of our international distributors. In 2000, we continued making strategic
minority investments in pre-public companies with complementary products,
services and technologies. As of March 31, 2001, the minority venture
investments we continue to hold totaled $5.6 million valued at cost less
reductions for other than temporary impairments. In the first quarter of 2001,
we recorded a $5.0 million impairment charge in connection with these
investments.
Our acquisitions and strategic investments involve a number of risks and we
may not realize the expected benefits of these transactions. We may lose all or
a portion of our investment, particularly in the case of our strategic minority
investments. We plan to continue investing and may make acquisitions of other
strategic investments in the future.
In 1997 and 1998, we incurred significant nonrecurring charges associated
with our previous acquisitions. Our available cash and securities may be used to
buy or invest in companies or products, which could result in significant
acquisition-related charges to earnings and dilution to our stockholders.
Moreover, if we buy a company, we may have to incur or assume that company's
liabilities, including liabilities that are unknown at the time of acquisition,
which may result in a material adverse effect on us.
WE WILL EXPERIENCE SIGNIFICANT AMORTIZATION CHARGES AND FACE THE RISK OF FUTURE
NON-RECURRING CHARGES IN THE EVENT OF IMPAIRMENT
In connection with our previous acquisitions accounted for under the
purchase method of accounting, in future periods we will experience significant
charges related to the amortization of purchased technology and goodwill. In
addition, if we later determine that this purchased technology and goodwill is
impaired, we will be required to take a related non-recurring charge to
earnings. For the three months ended March 31, 2001, our amortization expense
related to purchased technology and goodwill was $15.8 million.
WE MAY BE REQUIRED TO USE A LARGE PORTION OF OUR CASH BALANCES, OR ISSUE A
SIGNIFICANT AMOUNT OF OUR COMMON STOCK, IF OUR DEBENTUREHOLDERS REQUIRE THAT WE
REDEEM THEIR DEBENTURES IN FEBRUARY 2003
On February 13, 1998, we issued zero coupon debentures, which have an
aggregate face amount at maturity of $885.5 million and generated net proceeds
to us of approximately $337.6 million (after deducting fees and expenses). The
initial price for the debentures was $391.06 per $1,000 of face amount at
maturity. At the option of the holder, we are required to redeem the debentures
as of February 13, 2003, February 13, 2008 and February 13, 2013 at purchase
prices equal to the initial issue price plus the accretion of the discount on
the debentures to such dates (or $494.52, $625.35 and $790.79 per $1,000 of face
amount at maturity, respectively). At our option, we may pay the aggregate
redemption price in cash, shares of our common stock or a combination thereof.
The number of shares of common stock required to be issued by us will be based
on the fair value of our common stock at the time of any redemption. As of March
31, 2001, our aggregate cash and cash equivalents and long-term securities were
approximately $637 million, including $76 million held by McAfee.com. Assuming
that as of February 13, 2003 all debenture holders require that we redeem their
debentures, we would be required to pay an aggregate redemption price in cash
and/or shares of common stock equal to approximately $437.9 million.
OUR HARDWARE BASED PRODUCTS FACE MANUFACTURING, SUPPLY, INVENTORY, LICENSING AND
OBSOLESCENCE RISKS
Some of our Sniffer products and E-ppliance products include, in addition
to our software, a hardware platform as well as software licensed from other
companies. We expect the number of our hardware-based
29
32
products to increase as, among other things, the data rate in computer networks
increases, making a software-only solution a less viable solution. Third party
manufacturers do the manufacturing of these products under contract for us.
Reliance on third party manufacturers involves a number of risks, including the
lack of control over the manufacturing process and the potential absence or
unavailability of adequate capacity. In the event that any third party
manufacturers cannot or will not continue to manufacture our products in
required volumes, on a cost effective basis, in a timely manner or at all, we
will have to secure additional manufacturing capacity. Even if such additional
capacity is available at commercially acceptable terms, the qualification
process could be lengthy and could create delays in product shipments.
Our hardware-based products contain critical components supplied by a
single or a limited number of third parties. We have been required to purchase
certain computer platforms around which we design our network fault and
performance management products to ensure an available supply of these products
for our customers. Any significant shortage of these platforms or other
components or the failure of the third party supplier to maintain or enhance
these products could lead to cancellations of customer orders or delays in
placement of orders.
Some of our hardware based products incorporate licensed software, such as
operating system software. Our ability to successfully market these products
depends on our ability to obtain reasonably priced licenses from third party
software providers, as well as on our ability to integrate our hardware and
software with the software provided from third parties. If we are unable to
obtain software licenses from third parties or to integrate third party software
with our hardware products, our ability to market hardware based products would
suffer.
Hardware based products may face greater obsolescence risks than software
products. If our hardware products are not easily upgradable to meet future
market needs, they may become obsolete. In addition to lost future sales, we
could incur losses or other charges in disposing of obsolete inventory, both of
which could also materially adversely affect our results of operations.
WE FACE RISKS RELATED TO OUR APPLICATION SERVICE PROVIDER STRATEGY
With our ASP or hosted products and services, customers "rent versus buy"
the software. For example, McAfee.com is dedicated to updating, upgrading and
managing PCs over the Internet for single use retail, non-corporate, consumers.
This web-based model is a relatively new concept and there is a risk that our
ASP products and services may fail to gain market acceptance. The growth, market
acceptance and ultimate profitability of our ASP services is highly uncertain
and subject to a number of factors, including:
- our ability to successfully adapt existing products or develop new or
enhanced products that operate in a fast, secure and reliable manner over
the Internet;
- increased expenditures associated with the creation of a new business or
delivery platform, such as product development, marketing and technical
and administrative support;
- the introduction of new products by third party competitors;
- potential unwillingness of customers to pay for ASP subscription based
products and services and our ability to properly price our products and
services to generate the greatest revenue opportunities;
- our ability to cost effectively offer our ASP products and services;
- reluctance by businesses and consumers to change their software
purchasing behavior in favor of services hosted on our, or third party,
servers; and
- concerns of businesses and consumers about whether the Internet is fast,
reliable and secure enough to deliver critical network security and
availability services effectively.
30
33
Our corporate ASP services were historically offered through our myCIO.com
subsidiary. In February 2001, we announced our plan to reintegrate myCIO.com's
operations with our own, while continuing to offer myCIO.com's products and
services as key offerings. The success of this decision is dependent on our
ability to successfully:
- retain myCIO.com's existing customers and employees;
- migrate myCIO.com's experience and knowledge in the development and
marketing of hosted products and services to our other product groups;
and
- coordinate future product group and McAfee.com ASP offerings so as to
avoid or minimize, among other things, customer confusion, redundant
development efforts and expenses.
OUR MANAGED SERVICE PROVIDER STRATEGY EXPOSES US TO RISKS IN ADDITION TO THOSE
GENERALLY EXPERIENCED AS AN ASP
We also make our hosted products and services available over the Internet
in what we refer to as a managed environment. These MSP solutions differ from
our ASP solutions, among other ways, in that our solutions are customized to
service a specific customer's needs and are monitored and updated by networking
professionals for that customer. To successfully offer MSP services we must:
- effectively monitor and customize each customer's managed services;
- attract and retain qualified networking professionals to manage customer
accounts; and
- effectively price our products and services to account for the higher
costs associated with selling managed services.
We also allow intermediaries, such as Internet Service Providers, to sell
and host our products and services in a managed environment. This MSP reseller
strategy exposes us to additional risks:
- we must select, train and maintain qualified and financially stable MSP
resellers;
- it is more difficult for us to ensure customer satisfaction as we do not
have direct customer contact and we rely on our resellers to timely and
properly customize and administer our products and services;
- we must develop and maintain mutually satisfactory revenue sharing
arrangements with our MSP resellers; and
- our MSP resellers may compete with our own MSP efforts.
WE MAY EXPERIENCE HIGHER OVERALL REVENUE IN THE NEAR-TERM BUT LOWER FUTURE
RECURRING REVENUE DUE TO EXPECTED INCREASED LEVELS OF PERPETUAL SALES
We may experience an increase in the number of, and amount of, our net
revenue attributable to our sale of perpetual software licenses and hardware.
Under a perpetual license, a customer purchases the base-line software and
subsequently acquires software upgrades and updates. In contrast, under a
time-based license model, customers license the software, including upgrades and
updates, for a specified period of time. At the end of the initial license
period, the customer must renew their software time-based license to use our
software. Sales of perpetual licenses typically result in significantly higher
up-front revenue and lower recurring and future revenues as the sales price for
upgrades and updates tends to be significantly lower than that of a perpetual
license. Factors which may contribute to this increase in perpetual sales
include greater sales of hardware-based Sniffer and E-ppliance products where
software is bundled on to the hardware platform and a general customer
preference for perpetual licenses. To offset potential reductions in future
revenue, among other things, it will be incumbent upon us to introduce new
software products for sale and we may elect to unbundle some of the products
previously offered by us on a bundled subscription basis.
31
34
WE FACE RISKS RELATED TO RELATIONSHIP WITH MCAFEE.COM
We have entered into various inter-company arrangements including
technology, licenses, shared facilities, functions, services and tax sharing
agreements with McAfee.com. At March 31, 2001, we owned 36.0 million shares of
McAfee.com's Class B common stock, which is generally entitled to three votes
per share and converts to shares of McAfee.com Class A common stock if sold by
us to a third party. McAfee.com Class A common stock is entitled to one vote per
share. At December 31, 2000, our McAfee.com holdings represented approximately
81% of McAfee.com's outstanding capital stock and approximately 93% of its total
voting power.
Pursuant to our cross license agreement with McAfee.com, we have licensed
all our technology to McAfee.com for use in the markets specified below and
McAfee.com has licensed its technology to us for our use outside of McAfee.com's
markets. Under our license and other agreements with McAfee.com, among other
things:
- McAfee.com has the exclusive right to use the licensed technology for
providing single-user consumer licenses for our products and services
sold over the Internet or for Internet-based products and licensing the
technology to original equipment manufacturers for sale to individual
consumers;
- we are permitted to continue to sell our consumer products through
non-online channels, such as traditional retail stores, however
McAfee.com's sales of online products and services could significantly
reduce sales of these products;
- we may not offer a product incorporating third party technology if those
products are competitive with products offered by McAfee.com;
- McAfee.com is required to pay us a license fee of 7% of net revenue
derived from product sales that include the licensed technology;
- the license agreement is perpetual and may only be terminated by us if
McAfee.com fails to cure a material breach of the license within 30 days
after we notify it of the breach, subject to mandatory dispute resolution
prior to the effectiveness of any proposed termination;
- we are required to indemnify McAfee.com with respect to existing
litigation related to the licensed technology to which we are a party,
including the litigation described in Note 9 of the Notes to the
Condensed Consolidated Financial Statements;
- generally, we are required to cause to be elected to the McAfee.com board
of directors at least two independent directors, which term would exclude
any serving Network Associates officer or director; and
- if, without the prior approval of our continuing directors (being our
current directors and directors approved or not objected to by our
current directors), someone acquires 15% or more of our outstanding
capital stock or our continuing directors cease to constitute a majority
of our board (1) we are required to vote our shares of McAfee.com common
stock and otherwise seek to cause to the McAfee.com board of directors to
consist of at least a majority of independent directors and (2) our
shares of McAfee.com Class B common stock will be entitled to only one
vote per share instead of three.
WE FACE RISKS RELATED TO THE ALLOCATION OF OPPORTUNITIES WITH RESPECT TO
PRODUCTS, CUSTOMERS AND TERRITORIES AMONG OUR PRODUCT GROUPS AND SUBSIDIARIES
We are continuing to focus our business on our products, our customers and
geographic territories. Our product groups are primarily product focused. Our
McAfee.com subsidiary sells its products and services over the Internet to
consumers and businesses. Network Associates Company, Ltd.("Network Associates
Japan") is both geographically and customer focused, selling Network Associates'
products on a generally exclusive basis in Japan and to large Japanese business
customers outside of Japan and acting as McAfee.com's reseller in Japan. Except
as provided under our technology licensing agreements and arrangements, we do
not
32
35
currently have in place a policy to govern the pursuit or allocation of business
opportunities between our subsidiaries and product groups. These and any future
internal allocation of products, customers and territories could result in,
among other things:
- sales force conflict;
- customer confusion surrounding the entity or party with whom they are
expected to deal;
- disputes over product and research and development priorities;
- disputes over allocation of corporate resources and focus; and
- loss of management focus due to efforts spent to resolve internal
conflicts.
WE MUST ADAPT TO THE RAPIDLY CHANGING BUSINESS ENVIRONMENT BROUGHT ON BY THE
WIDESPREAD USE OF THE INTERNET
We utilize the Internet and depend on its functionality and reliability in
many parts of our business, including sales, distribution and support of our
products. There are still many uncertainties regarding many facets of the
Internet, including reliability, security, access, tax, government regulation
and cost. We also run the risk of not adapting to the latest changes in the
Internet, which could affect our business operations. If growth of the Internet
does not develop at the rapid pace we expect, our operating results could be
adversely affected.
OUR MARKET IS CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE; WE FACE RISK
ASSOCIATED WITH PRODUCT DEVELOPMENT
The network security and management market is highly fragmented and
characterized by ongoing technological developments, evolving industry standards
and rapid changes in customer requirements. Our success will depend on our
ability to:
- offer a broad range of network security and management software products;
- continue to enhance existing products and expand product offerings;
- develop and introduce in a timely manner new products with technological
advances;
- respond promptly to new customer requirements;
- comply with evolving industry standards without delays in compliance;
- provide upgrades and updates to users frequently and at low cost; and
- remain compatible with popular operating systems such as Windows 98,
Windows 2000, Windows XP, Windows NT and NetWare, and develop products
that are compatible with new or otherwise emerging operating systems.
We may not be able to successfully develop and market, on a timely basis,
enhancements to our existing products or new products. Our product enhancements
or new products may not adequately address the changing needs of the
marketplace. New products with new technological capabilities could replace or
shorten the life cycle of our products or cause our customers to defer or cancel
purchases of our existing products.
We may continue to experience delays in software development as we have at
times in the past. Complex software products like ours may contain undetected
errors or version compatibility problems, particularly when first released,
which could delay or cost us market acceptance. For example, our anti-virus
software products have in the past falsely detected viruses that did not
actually exist. Difficulties and delays associated with new product
introductions, performance or enhancements could have a material adverse effect
on our business, financial condition and results of operation.
Our product development efforts are impacted by the adoption or evolution
of industry standards. For example, no uniform industry standard has developed
in the market for encryption security products. As
33
36
industry standards are adopted or evolve, we may have to modify existing
products or develop and support new versions of existing products. In addition,
if no industry standard develops, our products and our competitors' products
could be incompatible, which could prevent or delay overall development of the
market for a particular product. If our products fail to comply with existing or
evolving industry standards in a timely fashion, our business, results of
operation and financial condition could be materially and adversely affected.
Our long-term success depends on our ability to upgrade and update existing
product offerings, modify and enhance acquired products and introduce new
products which meet our customers' needs. Future upgrades and updates may
include additional functionality, respond to user problems or address
compatibility problems with changing operating systems and environments. We
believe that our ability to provide these upgrades and updates frequently and at
low costs is key to our success. For example, the proliferation of new and
changing viruses makes it imperative to update anti-virus products frequently to
avoid obsolescence. Failure to release upgrades and updates could have a
material adverse effect on our business, results of operations and financial
condition. We may not be successful in these efforts. In addition, future
changes in Windows 98, Windows 2000, Windows NT, NetWare or other popular
operating systems could cause compatibility problems with our products. Further,
delays in the introduction of future versions of operating systems or lack of
market acceptance of these future versions would delay or reduce demand for our
future products which were designed to operate with these future operating
systems. Our failure to introduce in a timely manner new products that are
compatible with operating systems and environments preferred by desktop computer
users would have a material adverse effect on our business, results of operation
and financial condition.
IF THE NETWORK MANAGEMENT AND NETWORK SECURITY MARKETS DO NOT EVOLVE AS WE
ANTICIPATE, OUR BUSINESS COULD SUFFER
The markets for our network management and network security products are
evolving, and their growth depends upon broader market acceptance of this
software, including help desk software. Although the number of PCs attached to
large-area networks has increased dramatically, the network management and
network security markets continue to be emerging markets. These markets may not
continue to develop or may not develop rapidly enough to benefit our business
significantly. In addition, there are a number of potential approaches to
network management and network security, including the incorporation of
management and security tools into network operating systems. Therefore, even if
network management and network security tools gain broader market acceptance,
potential purchasers may not select our products. To the extent that either the
network management or network security market does continue to develop, we
expect that competition will increase.
WE ARE SUBJECT TO INTENSE COMPETITION IN THE NETWORK MANAGEMENT AND SECURITY
MARKETS AND WE EXPECT TO FACE INCREASED COMPETITION IN THE FUTURE
The markets for our products are intensely competitive and we expect
competition to increase in the near-term. We believe that the principal
competitive factors affecting the markets for our products include:
- performance;
- functionality;
- quality;
- customer support;
- breadth of product group;
- frequency of upgrades and updates;
- integration of products;
- manageability of products;
- brand name recognition;
34
37
- reputation; and
- price.
We may be unable to compete effectively against existing and potential
competitors. Some of our competitors have longer operating histories, greater
name recognition, larger technical staffs, established relationships with
hardware vendors and/or greater financial, technical and marketing resources.
These factors may provide our competitors with an advantage in penetrating the
market with their network security and management products. As is the case in
many segments of the software industry, we have been encountering, and we expect
to further encounter, increasing competition. This increased competition could
reduce average selling prices and, therefore, profit margins. Competitive
pressures could result not only in price reductions but also in a decline in
sales volume, which could cause our business to suffer.
Performance and quality of our anti-virus software products are measured by
number and type of viruses detected, the speed at which the products run and
ease of use. Our principal competitor in the anti-virus market serviced by our
McAfee product groups and McAfee.com is the Peter Norton Group of Symantec.
Trend Micro remains the strongest competitor in the Asian anti-virus market.
Other competitors include numerous smaller companies and shareware authors that
may in the future develop into stronger competitors or be consolidated into
larger competitors.
Our principal competitors in the security market vary by product type. For
firewalls, our principal competitors include CheckPoint, Symantec, and larger
companies such as Cisco Systems and Microsoft. For intrusion detection products,
we compete with ISS, Symantec and Cisco. The markets for encryption and virtual
private network, or VPN, products are highly fragmented with numerous small and
large vendors. Public key infrastructure, or PKI, encryption vendors such as
Entrust Technologies offer some products that compete with our PGP products. VPN
competitors include hardware and software vendors, including telecommunications
companies and traditional networking suppliers.
Our principal competitor in the network management market is Agilent. Other
competitors include Cisco, Computer Associates, Compuware, Concord
Communications, DeskTalk Systems, GN Nettest, Network Instruments, Radcom
Technologies, Shomiti Systems and Acterna Corporation.
Our principal competitors in the help desk market are Computer Associates,
FrontRange Solutions , Peregrine and Remedy.
We also face competition from large software companies such as Microsoft,
Intel, Novell and HP, which may offer network security and management products
as enhancements to their operating system.
Finally, as the network management market develops, we may face increased
competition from a number of large companies, as well as other companies seeking
to enter the market. The trend toward enterprise-wide network management and
security solutions may result in a consolidation of the network management and
security market around a smaller number of companies who are able to provide the
necessary software and support capabilities.
OUR CUSTOMERS MAY CANCEL OR DELAY THEIR PURCHASES OF OUR PRODUCTS, WHICH COULD
ADVERSELY AFFECT OUR BUSINESS
Our products may be considered to be capital purchases by certain customers
or prospective customers. Capital purchases are often discretionary and,
therefore, are canceled or delayed if the customer experiences a downturn in its
business prospects or as a result of economic conditions in general. Any
cancellation or delay could adversely affect our results of operations.
WE NEED TO EXPAND AND DEVELOP AN EFFECTIVE PROFESSIONAL SERVICES ORGANIZATION;
WE RELY ON THIRD-PARTY PROFESSIONAL SERVICES
As our products and computer networks in general increase in complexity,
customers require greater professional assistance to design, install, configure
and implement our products. To date, we have relied on our limited professional
services capabilities and increasingly on outside professional service
providers, including
35
38
our distributors, resellers and system integrators. These third party service
providers may provide inadequate levels of professional services. Moreover,
reliance on these third parties places a greater burden on them and reduces our
ability to control and establish standards for providing these support services.
Our reliance on these third parties could delay our recognition of product
revenue, harm our relationships or reputation with these third parties or the
end users of our products or result in decreased future sales of, or prices for,
our products.
The failure to develop and maintain an effective professional services
organization could have a material adverse effect on our business. To more
effectively service our customers' evolving needs, we intend to significantly
expand and develop our worldwide professional services organization. We may not
succeed in these efforts. Effectively expanding and developing our professional
services organization will require that we hire and train more service
professionals who must be continually trained and educated to ensure that they
possess sufficient technical skills and product knowledge. The market for
qualified professionals is intensely competitive, making hiring and retention
difficult. We expect significant competition in this market from existing
providers of professional services and future entrants. We must also properly
price our services to attract customers, while maintaining sufficient margins
for these services. We therefore expect that we will have lower profit margins
on our service revenues. In addition, we reorganized our U.S. professional
services organization, in part, to enable the professional services organization
to become more specialized on individual products and product groups. As a
result, a particular product group may have insufficient qualified personnel to
perform its professional services needs as there will no longer be a "pool" of
professional services personnel from which to draw. A product group's lack of
sufficient professional services personnel could lead to customer
dissatisfaction, missed revenue opportunities and a loss of future business.
WE RELY ON THE CONTINUED PROMINENCE OF MICROSOFT TECHNOLOGY
Although we intend to support other operating systems, our mission is to be
the leading supplier of network security and management products for Windows
NT/Intel based networks. Sales of our products would be materially and adversely
affected by market developments that are adverse to the Windows operating
environments, including the failure of users and application developers to
accept Windows NT. In addition, our ability to develop products using the
Windows operating environments is dependent on our ability to gain timely access
to, and to develop expertise in, current and future developments by Microsoft.
We may not be able to gain the necessary access from Microsoft.
WE MAY FAIL TO SUPPORT OPERATING SYSTEMS WHICH SUCCESSFULLY COMPETE WITH
MICROSOFT'S TECHNOLOGY, INCLUDING COMPETING VERSIONS OF THE UNIX OPERATING
SYSTEM
We are expanding our product support to include the Unix operating system
and the Linux operating system. Sales of our products could be materially and
adversely impacted by our failure to support those versions of the Unix
operating system or competing operating systems that receive broad market
acceptance. The Unix system encompasses many separate operating systems of which
we only support a few, including for example, Sun Microsystems' Solaris Unix
operating system.
WE MUST EFFECTIVELY MANAGE OUR GROWTH
Our business has grown both internally and through acquisitions. This
growth has placed, and any future growth would continue to place, a significant
strain on our limited personnel, management and other resources. Our ability to
manage any future growth, particularly with the anticipated expansion of our
international business and our ASP businesses, and growth in distribution
business, will require us to:
- attract, train, retain, motivate and manage new employees successfully;
- effectively integrate new employees into our operations; and
- continue to improve our operational, financial, management and
information systems and controls.
36
39
If we continue to grow, our management systems currently in place may be
inadequate or we may not be able to effectively manage this growth. We are
currently investing in our Internet infrastructure in anticipation of expected
growth from the Internet, which may fail to materialize.
WE RELY HEAVILY ON OUR INTELLECTUAL PROPERTY RIGHTS WHICH OFFER ONLY LIMITED
PROTECTION AGAINST POTENTIAL INFRINGERS; WE MAY FACE LITIGATION RELATED TO OUR
PROPRIETARY TECHNOLOGY AND RIGHTS
Our success depends significantly upon our proprietary software technology.
We rely on a combination of contractual rights, trademarks, trade secrets,
patents and copyrights to establish and protect proprietary rights in our
software. However, these protections may be inadequate or competitors may
independently develop technologies or products that are substantially equivalent
or superior to our products. We do not typically obtain signed license
agreements from our corporate, government and institutional customers who
license products directly from us. Rather, we include an electronic version of a
"shrink-wrap" license in all of our electronically distributed software and a
printed license in the box for our products distributed through traditional
distributors in order to protect our copyrights and trade secrets in those
products. Since the licensee has not signed any of these licenses, many legal
authorities believe that such licenses may not be enforceable under the laws of
many states and foreign jurisdictions. In addition, the laws of some foreign
countries either do not protect these rights at all or offer only limited
protection for these rights. The steps taken by us to protect our proprietary
software technology may be inadequate to deter misuse or theft of this
technology. For example, we are aware that a substantial number of users of our
anti-virus products have not paid any registration or license fees to us.
Changing legal interpretations of liability for unauthorized use of our
software, or lessened sensitivity by corporate, government or institutional
users to avoiding infringement of intellectual property, could have a material
adverse effect on our business, results of operations and financial condition.
There has been substantial litigation regarding the intellectual property
rights of technology companies. The increased issuance of software patents in
recent years has led to and is likely to continue to lead to increased patent
and intellectual property litigation in the software industry. In the past we
have been, and we currently are, subject to litigation related to our
intellectual property, including patent infringement cases involving Hilgraeve.
See Note 9, Notes to the Condensed Consolidated Financial Statements. We may
also be subject to litigation in connection with our advertising and marketing
programs. Although we intend to defend ourselves vigorously against claims
asserted against us in the foregoing actions or matters, developments arising
out of this pending litigation or any other litigation to which we are or may
become a party could have a material adverse effect on our business, results of
operation and financial condition. Adverse determinations in litigation could:
- result in the loss of our proprietary rights;
- subject us to significant liabilities, including monetary liabilities;
- require us to seek licenses from third parties; or
- prevent us from manufacturing or selling our products.
The litigation process is subject to inherent uncertainties and we may not
prevail in these matters, or we may be unable to obtain licenses with respect to
any patents or other intellectual property rights that may be held valid or
infringed upon by our products or us. Uncertainties inherent in the litigation
process include, among other things, the complexity of the technologies
involved, potentially adverse changes in the law and discovery of facts
unfavorable to us.
In addition, as we may acquire a portion of software included in our
products from third parties, our exposure to infringement actions may increase
because we must rely upon such third parties as to the origin and ownership of
any software being acquired. Similarly, exposure to infringement claims will
increase to the extent that we employ or hire additional software engineers
previously employed by competitors, notwithstanding measures taken by these
competitors to protect their intellectual property. In the future, litigation
may be necessary to enforce and protect trade secrets and other intellectual
property rights that we own. We may also be subject to litigation to defend
against claimed infringement of the rights of others or determine the
37
40
scope and validity of the proprietary rights of others. This litigation could be
costly and cause diversion of management's attention, either of which could have
a material adverse effect on our business, results of operations and financial
condition.
OUR INTERNATIONAL OPERATIONS SUBJECT US TO FOREIGN CURRENCY FLUCTUATIONS AND
OTHER INHERENT RISKS RELATED TO DOING BUSINESS IN FOREIGN COUNTRIES
For the three months ended March 31, 2001 and 2000, net revenue from
international sales represented approximately 33%, and 39%, respectively, of our
net revenue. Historically, we have relied upon independent agents and
distributors to market our products internationally. We expect that
international revenue will continue to account for a significant percentage of
net revenue. We also expect that a significant portion of this international
revenue will be denominated in local currencies. To reduce the impact of foreign
currency fluctuations, we use non-leveraged forward currency contracts. However,
our future results of operations may be adversely affected by currency
fluctuations or by costs associated with currency risk management strategies.
Other risks inherent in international revenue generally include:
- the impact of longer payment cycles;
- greater difficulty in accounts receivable collection;
- unexpected changes in regulatory requirements;
- seasonality due to the slowdown in European business activities during
the third quarter;
- tariffs and other trade barriers;
- export restrictions on our encryption and other security products;
- uncertainties relative to regional economic circumstances including the
continued economic weakness in Asia;
- political instability in emerging markets and difficulties in staffing;
- hiring and retaining key international employees; and
- managing foreign operations.
These factors may have a material adverse effect on our future
international license revenue. Further, in countries with a high incidence of
software piracy, we may experience a higher rate of piracy of our products.
In addition, a portion of our international revenue is expected to continue
to be generated through independent agents. Since these agents are not our
employees and are not required to offer our products exclusively, they may
discontinue marketing our products entirely. Also, we may have limited control
over these agents, limited access to the names of the customers to whom these
agents sell products and limited knowledge of the information provided by, or
representations made by, these agents to customers.
FALSE DETECTION OF VIRUSES AND ACTUAL OR PERCEIVED SECURITY BREACHES COULD
ADVERSELY AFFECT OUR BUSINESS
Our anti-virus software products have in the past and may at times in the
future falsely detect viruses that do not actually exist. These false alarms,
while typical in the industry, may impair the perceived reliability of our
products and may therefore adversely impact market acceptance of our products.
In addition, we have in the past been subject to litigation claiming damages
related to a false alarm, and similar claims may be made in the future. In
addition, an actual or perceived breach of network or computer security at one
of our customers, regardless of whether the breach is attributable to our
products, could adversely affect the market's perception of our security
products. This could adversely affect our business, results of operations and
financial condition.
38
41
OUR CRYPTOGRAPHY TECHNOLOGY IS SUBJECT TO EXPORT RESTRICTIONS AND MAY BECOME
OBSOLETE
All of our products are subject to the U.S. Export Administration
Regulations, governed by the U.S. Department of Commerce. Certain of our network
security products, technology and associated technical assistance, particularly
products and technology incorporating encryption, may be subject to export
restrictions. Recent changes to U.S. laws enable Network Associates to export
more products without restrictions; however, certain products still may not be
exported to foreign customers without prior approval from the U.S. government.
The list of products and end users for which export approval is required, and
the regulatory policies with respect thereto, are subject to revision by the
U.S. government at any time. The cost of compliance with U.S. and international
export laws and changes in existing laws could affect our ability to sell
certain products in certain markets, and could have a material adverse effect on
our international revenues.
In addition, some of our network security products are dependent on the use
of public key cryptography technology. This technology depends in part upon the
application of certain mathematical principles known as factoring and discrete
logarithms. The security afforded by public key cryptography technology is based
on our belief that the factoring of large prime numbers and solving the discrete
log problem is not computationally practical. Should an easy factoring method be
developed or the discrete log problem is solved, the security afforded by
encryption products using public key cryptography technology would be reduced or
eliminated. Furthermore, any significant advance in techniques for attacking
cryptographic systems could also render some or all of our existing products and
services obsolete or unmarketable. Moreover, the cryptographic algorithms used
in our products can theoretically be solved by computer systems significantly
faster and more powerful than those presently available. If these improved
techniques for attacking cryptographic systems were ever developed, our business
would be adversely affected.
PRODUCT LIABILITY CLAIMS ASSERTED AGAINST US IN THE FUTURE COULD ADVERSELY
AFFECT OUR BUSINESS
Our network security and management software products are used to protect
and manage computer systems and networks that may be critical to organizations.
As a result, our sale and support of these products involves the risk of
potential product liability and related claims. Our license agreements with our
customers typically contain provisions designed to limit our exposure to
potential product liability claims. It is possible, however, that the limitation
of liability provisions contained in these license agreements may not be
effective under the laws of certain jurisdictions, particularly in circumstances
involving unsigned licenses. A product liability claim brought against us could
have a material adverse effect on our business, results of operations and
financial condition.
WE FACE RISKS ASSOCIATED WITH U.S. GOVERNMENT CONTRACTING
We are currently engaged in several research and development contracts with
agencies of the U.S. government. We believe that the willingness of these
government agencies to enter into future contracts with us will in part be
dependent upon our continued ability to meet their expectations.
Minimum fee awards for companies entering into government contracts are
generally between 3% and 7% of the costs incurred by them in performing their
duties under the related contract. However, these fee awards may be as low as 1%
of the contract costs. Furthermore, these contracts are subject to cancellation
at the convenience of the governmental agencies. Although we have been awarded
contract fees of more than 1% of the contract costs in the past, minimum fee
awards or cancellations may occur in the future. Reductions or delays in federal
funds available for projects we are performing could also have an adverse impact
on our government business. Contracts involving the U.S. government are also
subject to the risks of disallowance of costs upon audit, changes in government
procurement policies, required competitive bidding and, with respect to
contracts involving prime contractors or government-designated subcontractors,
the inability of those parties to perform under their contracts. In addition,
our government customers and potential customers may not respond favorably to
the division of our business into product groups and our business and future
financial performance could suffer. Any of the foregoing events could adversely
affect our results of operations or financial conditions.
39
42
BUSINESS INTERRUPTION RISKS
We face a number of potential business interruption risks that are beyond
our control. The State of California has recently experienced intermittent power
shortages, sharp increases in the cost of energy and even interruptions of
service to some business customers. If power shortages continue to be a problem
our business may be materially adversely effected. Additionally, we may
experience natural disasters that could interrupt our business.
Our corporate headquarters is located near a major earthquake fault. The
impact of a major earthquake on our facilities, infrastructure and overall
operations is not known. Safety precautions have been implemented, however there
is no guarantee that an earthquake would not seriously disturb our entire
business process. We are largely uninsured for losses and business disruptions
caused by an earthquake and other natural disasters.
We are in the process of installing an updated enterprise resource planning
(ERP) program. We may face delays or difficulties in installing and implementing
the software.
DELAWARE LAW, OUR CERTIFICATE OF INCORPORATION AND BYLAWS, OUR ADOPTION OF A
RIGHTS PLAN AND OUR STOCKHOLDERS AGREEMENT WITH MCAFEE.COM MAY INHIBIT POTENTIAL
ACQUISITION BIDS; THIS MAY ADVERSELY AFFECT THE MARKET PRICE FOR OUR COMMON
STOCK AND PREVENT CHANGES IN OUR MANAGEMENT
Our board of directors has the authority to issue up to 5,000,000 shares of
preferred stock and to determine the price, rights, preferences, privileges and
restrictions, including voting rights, of those shares without any further vote
of action by its stockholders. The issuance of preferred stock, while providing
desirable flexibility in connection with possible acquisitions and other
corporate purposes, could have the effect of making it more difficult for a
third party to acquire a majority of the outstanding voting stock.
In October 1998, our board of directors adopted a shareholders rights plan.
Each right under this plan entitles the record holder to buy 1/1000 of a share
of our series B participating preferred stock at an exercise price of $200.00.
The rights will become exercisable following the tenth day after a person or
group announces acquisition of 15% or more of our common stock or announces
commencement of a tender or exchange offer the consummation of which would
result in ownership by the person or group of 15% or more of our common stock.
If the rights become exercisable, the holders of the rights (other than the
person acquiring 15% or more of our common stock) will be entitled to acquire in
exchange for the $200 exercise price shares of our common stock or shares of any
company in which we are merged having a value of $400. We are entitled to redeem
the rights at $0.01 per right at any time on or before the tenth day following
acquisition by a person or group of 15% or more of our common stock.
In October 1999, we entered into a stockholders agreement with McAfee.com.
Under this agreement we agreed that if (1) without the prior approval of our
continuing directors, as defined below, any person acquires or agrees to acquire
15% or more of our outstanding common stock or (2) our continuing directors
cease to constitute a majority of our serving directors, then for so long but
only for so long as that condition exists:
- our shares of McAfee.com Class B common stock will be entitled to only
one vote per share instead of three votes per share; and
- we will be obligated to vote our McAfee.com shares to cause, and to take
such actions reasonably within our control to cause, and shall seek to
cause the McAfee.com directors appointed by us to cause, the McAfee.com
board of directors to consist of at least a majority of independent
directors.
Our continuing directors consist of our current directors and any
subsequent directors approved or not objected to by a majority of our
then-continuing directors.
Certain provisions of Delaware law and our certificate of incorporation and
bylaws, such as a classified board, could delay or make a merger, tender offer
or proxy contest involving Network Associates more difficult. While these
provisions and our rights plan are intended to enable our board of directors to
maximize stockholder value, and the provisions of the McAfee.com stockholders
agreement are, among other things, intended to preserve McAfee.com's
independence, they may have the effect of discouraging takeovers, which may not
be in the best interest of certain stockholders. Our rights plan and these
provisions could have an adverse effect on the market value of our common stock.
40
43
PART II: OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS:
Information with respect to this item is incorporated by reference to Note
9 of the Notes to the Condensed Consolidated Financial Statements included
herein on page 9 of this Report on Form 10-Q.
ITEM 2. CHANGES IN SECURITIES:
Nothing to report.
ITEM 3. DEFAULTS IN SECURITIES:
Nothing to report.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS:
The information required hereunder is incorporated by reference from our
Proxy Statement filed on April 2, 2001, in connection with our annual meeting of
stockholders to be held on May 24, 2001.
ITEM 5. OTHER INFORMATION:
Nothing to report.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K:
(a) Exhibits. The exhibits listed in the accompanying Exhibit Index are
filed or incorporated by reference as part of this Report.
(b) On February 15, 2001, the Company filed an 8-K to publicly disclose
statements made by Mr. George Samenuk at an investment conference on that date.
41
44
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, and
the results and regulations promulgated thereunder, the registrant has duly
caused this amended report to be signed on its behalf by the undersigned
thereunto duly authorized.
NETWORKS ASSOCIATES, INC.
/s/ STEPHEN C. RICHARDS
--------------------------------------
Name: Stephen C. Richards
Title:Executive Vice President and
Chief Financial Officer
Date: May 15, 2001
42
45
EXHIBIT INDEX
EXHIBIT PAGE
NO. EXHIBIT TITLE NO.
------- ------------- ----
2.1 Agreement and Plan of Reorganization, dated October 13,
1997, among McAfee Associates, Inc., Mystery Acquisition
Corp. and Network General Corporation, as amended by the
First Amendment dated as of October 22, 1997.(1)............
2.2 Combination Agreement dated August 16, 1996 among the
Registrant, FSA Combination Corp., FSA Corporation and
Daniel Freedman.(2).........................................
2.3 Stock Exchange Agreement dated January 13, 1996 among the
Registrant, FSA Combination Corp., Kabushiki Kaisha Jade and
the shareholders of Jade.(3)................................
2.4 Agreement and Plan of Reorganization dated December 1, 1997
between the Registrant, Helix Software Company an DNA
Acquisition Corp.(4)........................................
2.5 Agreement and Plan of Reorganization dated December 1, 1997
between the Registrant, PGP and PG Acquisition Corp.(5).....
2.6 Agreement and Plan of Reorganization dated February 22,
1998, between the Registrant, TIS and Thor Acquisition
Corp.(6)....................................................
2.7 Agreement and Plan of Reorganization by and among the
Registrant, Magic Solutions International, Inc., Merlin
Acquisition Corp. and Igal Lichtman, Amendment Agreement by
and among the Registrant, Magic Solutions International,
Inc., Merlin Acquisition Corp., and Igal Lichtman dated
March 24, 1998. Second Amendment Agreement by and among the
Registrant, Magic Solutions International, Inc., Merlin
Acquisition Corp., and Igal Lichtman dated April 1,
1998.(7)....................................................
2.8 Stock Purchase Agreement, dated as of February 26, 1998, by
and between FSA Combination Corp., and Brenda Joyce
Cook.(8)....................................................
2.9 Share Purchase Agreement, dated as of March 30, 1998, among
FSA Combination Corp., and Irina Karlsson and Jarmo
Rouvinen.(8)................................................
2.10 Stock Purchase Agreement, dated as of May 8, 1998, among FSA
Combination Corp., and Secure Networks, Inc.(8).............
2.11 Transaction Agreement, dated June 9, 1998, by and between
the Registrant and Dr. Solomon's Group Plc.(21).............
2.12 Agreement and Plan of Merger, dated July 28, 1998, by and
between the Registrant and CyberMedia, Inc.(22).............
3.1 Second Restated Certificate of Incorporation of Networks
Associates, Inc., as amended on December 1, 1997.(6)........
3.2 Restated Bylaws of Networks Associates, Inc.(6).............
3.3 Certificate of Designation of Series A Preferred Stock of
Networks Associates, Inc.(9)................................
3.4 Certificate of Designation of Series B Participating
Preferred Stock of the Registrant.(23)......................
4.2 Registration Rights Agreement dated August 30, 1996 between
the Registrant and Daniel Freedman.(1)......................
4.5 Registration Rights Agreement dated December 9, 1997 between
the Registrant and certain shareholders of PGP.(4)..........
4.6 Registration Rights Agreement, dated as of February 13,
1998, by and between the Registrant and Morgan Stanley & Co.
Incorporated.(10)...........................................
43
46
EXHIBIT PAGE
NO. EXHIBIT TITLE NO.
------- ------------- ----
4.7 Indenture dated as of February 13, 1998 between the
Registrant and State Street Bank and Trust Company of
California, N.A., as Trustee.(10)...........................
4.10 Registration Rights Agreement dated May 8, 1998, by and
between the Registrant and the stockholders of Secure
Networks, Inc.(8)...........................................
4.11 Registration Rights Agreement, dated June 29, 1998, by and
between the Registrant and certain stockholders of CSB
Consulenza Software di Base S.r.l. ("CSB").(11).............
4.12 Registration Rights Agreement, dated July 30, 1998, by and
between the Registrant and certain stockholders of Anyware
Seguridad Informatica S.A.(11)..............................
4.13 Registration Rights Agreement, dated August 31, 1998, by and
between the Registrant and certain stockholders of QA
Information Security Holding AB.(24)........................
10.1 Standard Business Lease (Net) for Network General's
principal facility dated June 19, 1991, between Network
General and Menlo Oaks Partners, L.P.(12)...................
10.2 First Amendment to Lease dated June 10, 1992, between
Network General and Menlo Parks Partners, L.P.(12)..........
10.3 Standard Business Lease (Net) for Network General's
principal facility dated March 11, 1992, between Network
General and Menlo Oaks Partners L.P.(13)....................
10.4 First Amendment to Lease dated June 18, 1992, between
Network General and Menlo Oaks Partners, L.P.(12)...........
10.5 Lease dated March 31, 1992, between Network General and
Equitable Life Assurance Society of the United
States.(12).................................................
10.6 Second Amendment to Lease dated February 1, 1995, between
Network General and Menlo Oaks Partners, L.P.(13)...........
10.7 Third amendment to Lease dated February 1, 1995 between
Network General and Menlo Oaks Partners L.P.(13)............
10.8 Fourth Amendment to Lease dated May 31, 1995, between
Network General and Menlo Oaks Partners, L.P.(14)...........
10.9 Fifth Amendment to Lease dated June 13, 1995, between
Network General and Menlo Oaks Partners, L.P.(14)...........
10.10 Lease dated July 3, 1996 between Network General and
Campbell Avenue Associates.(15).............................
10.11 Sixth Amendment to Lease dated November 29, 1996, between
Network General and Menlo Oaks Partners, L.P.(15)...........
10.12 Sublease Agreement for facility at 2805 Bowers Avenue, Santa
Clara, California, dated as of February 20, 1997, by and
between McAfee Associates, Inc. and National Semiconductor
Corporation.(16)............................................
10.13 Lease Agreement dated November 17, 1997 for facility at 3965
Freedom Circle, Santa Clara, California by and between
Informix Corporation and McAfee Associates, Inc.(4).........
10.14 Consent to Assignment Agreement dated December 19, 1997 by
and among Birk S. McCandless, LLC, Guaranty Federal Bank,
F.S.B., Informix Corporation and Networks Associates,
Inc.(4).....................................................
10.15 Subordination, Nondisturbance and Attornment Agreement dated
December 18, 1997, between Guaranty Federal Bank, F.S.B.,
Networks Associates, Inc. and Birk S. McCandless, LLC.(4)...
10.16 Lease dated November 22, 1996 by and between Birk S.
McCandless, LLC and Informix Corporation for facility at
3965 Freedom Circle, Santa Clara, California.(4)............
44
47
EXHIBIT PAGE
NO. EXHIBIT TITLE NO.
------- ------------- ----
10.17 Quota Purchase Agreement, dated as of April 14, 1997 by and
among McAfee Associates, Inc. and McAfee Do Brasil Ltda.,
Compusul-Consultoria E Comercio De Informatica Ltda., and
the stockholders of Compusul-Consultoria E Comercio De
Informatica Ltda.(17).......................................
10.18* 1997 Stock Incentive Plan, as Amended.(17)..................
10.19* Stock Option Plan for Outside Directors.(18)................
10.20* 2000 Nonstatutory Stock Option Plan.(27)....................
10.21* Change in control agreement between the Company and Peter
Watkins dated May 11, 1999.(25).............................
10.22* Change in control agreement between the Company and William
L. Larson dated May 11, 1999.(25)...........................
10.23* Change in control agreement between the Company and Prabhat
K. Goyal dated May 11, 1999.(25)............................
10.24* Change in control agreement between the Company and Zachary
Nelson, dated May 11, 1999.(25).............................
10.25 Corporate Management Services Agreement between the
Registrant and McAfee.com Corporation, dated as of January
1, 1999.(26)................................................
10.26 Technology Cross License Agreement between the Registrant
and McAfee.com Corporation dated as of January 1,
1999.(26)...................................................
10.27 Registration Rights Agreement between the Registrant and
McAfee.com Corporation, dated as of January 1, 1999.(26)....
10.28 Asset Contribution and Receivables Settlement Agreement
between the Registrant and McAfee.com Corporation, dated as
of January 1, 1999.(26).....................................
10.29 Intercompany Revolving Loan Agreement between the Registrant
and McAfee.com Corporation, dated as of January 1,
1999.(26)...................................................
10.30 Tax Sharing Agreement between the Registrant and McAfee.com
dated as of January 1, 1999.(26)............................
10.31 Indemnification and Voting Agreement between the Registrant
and McAfee.com Corporation, dated as of January 1,
1999.(26)...................................................
10.32 Joint Cooperation and Master Services Agreement between the
Registrant and McAfee.com Corporation, dated as of January
1, 1999.(26)................................................
10.33* Employment Agreement between George Samenuk and Registrant,
dated January 2, 2001.(27)..................................
10.34* Agreement between the Registrant and William Larson, dated
January 2, 2001.(27)........................................
10.35* Agreement between the Registrant and Prabhat Goyal, dated
January 2, 2001.(27)........................................
10.36* Agreement between the Registrant and Peter Watkins, dated
December 26, 2000.(27)......................................
10.37* Agreement between Registrant and Zachary Nelson, dated
January 1, 2001.............................................
10.38 Reseller agreements between Registrant and McAfee.com, dated
March 30, 2001..............................................
10.39* Employment Agreement between Stephen C. Richards and
Registrant, dated April 3, 2001.............................
---------------
(1) Incorporated by reference from the Registrant's Registration Statement on
Form S-4 filed with the Commission on October 31, 1997.
(2) Incorporated by reference from the Registrant's Current Report on Form 8-K
filed with the Commission on September 24, 1996.
45
48
(3) Incorporated by reference from the Registrants Current Report on Form 8-K
filed with the Commission on March 14, 1997.
(4) Incorporated by reference from the Registrant's Registration Statement on
Form S-3, filed with the Commission on February 12, 1998.
(5) Incorporated by reference from the Registrant's Report on Form 8-K filed
with the Commission on December 11, 1997.
(6) Incorporated by reference from the Registrant's Registration Statement on
Form S-4 filed with the Commission on March 25, 1998.
(7) Incorporated by reference from the Registrant's Report on Form 8-K filed
with the Commission on April 2, 1998.
(8) Incorporated by reference from the Registrant's Registration Statement on
Form S-3 filed with the Commission on May 26, 1998.
(9) Incorporated by reference from the Registrant's Report on Form 10-Q for the
quarter ended September 30,, 1996, filed with the Commission on November 4,
1997.
(10) Incorporated by reference from the Registrant's Registration Statement on
Form S-3 filed with the Commission on May 6, 1998.
(11) Incorporated by reference from the Registrant's Registration Statement on
Form S-3 filed with the Commission on August 5, 1998.
(12) Incorporated by reference from the Network General Corporation's Report on
Form 10-K for the year ended March 31, 1992. Network General's filings with
the Commission were made under File Number 0-17431.
(13) Incorporated by reference from the Network General Corporation's Report on
Form 10-Q for the quarter ended December 31, 1994. Network General's
filings with the Commission were made under File Number 0-17431.
(14) Incorporated by reference from the Network General Corporation's Report on
Form 10-Q for the quarter ended September 30, 1995. Network General's
filings with the Commission were made under File Number 0-17431.
(15) Incorporated by reference from the Network General Corporation's Report on
Form 10-Q for the quarter ended September 30, 1996. Network General's
filings with the Commission were made under File Number 0-17431.
(16) Incorporated by reference from the Registrant's Report on Form 10-Q for the
quarter ended September 30, 1997, filed with the Commission on August 14,
1997.
(17) Incorporated by reference from the Registrant's Registration Statement on
Form S-8 filed with the Commission on July 21, 2000.
(18) Incorporated by reference from the Registrant's Registration Statement on
Form S-8 filed with the Commission on July 31, 1995.
(19) Incorporated by reference from the Registrant's Report on Form 10-Q for the
quarter ended September 30, 1996, filed with the Commission on August 13,
1996.
(20) Incorporated by reference from the Registrant's Report on Form 10-Q for the
quarter ended March 31, 1998, filed with the Commission on May 15, 1998.
(21) Incorporated by reference from the Registrant's Report on Form 8-K filed
with the Commission on June 16, 1998.
(22) Incorporated by reference from CyberMedia Inc.'s Schedule 13D filed by the
Registrant with the Commission on August 7, 1998. CyberMedia Inc.'s filings
with the Commission were made under File Number 0-21289.
(23) Incorporated by reference from the Registrant's Report on Form 8-A filed
with the Commission on October 22, 1998.
46
49
(24) Incorporated by reference from the registrant's report on form 10-Q for the
quarter ended September 30, 1998, filed with the Commission on November 13,
1998.
(25) Incorporated by reference from the Registrant's report on Form 10-Q for the
quarter ended March 31, 1999, filed with the Commission on May 13, 1999.
(26) Incorporated by reference from the Form S-1 filed by McAfee.com Corporation
with the Commission on September 23, 1999, under File Number 333-87609.
(27) Incorporated by reference from the registrant's report on form 10-K for the
year ended December 31, 2000, filed with the Commission on April 2, 2001
* Management contracts or compensatory plans or arrangements covering
executive officers or directors of Networks Associates, Inc.
47