Item 1. Business
Overview
Riverbed® develops and markets innovative and comprehensive solutions to the fundamental problems associated with IT performance across the global enterprise. Our flagship product is focused on addressing performance across wide area networks (WANs). Historically, computing across WANs has been plagued by poor performance, IT complexity and high cost. Our IT performance products allow organizations ranging from globally connected enterprises, government agencies and regional companies to understand the total performance picture; to optimize the yield from their WAN, storage infrastructure and applications; and to consolidate their IT infrastructure in the private cloud, public cloud and at the branch office. Riverbed’s complete family of performance products includes solutions for branch offices, mobile workers, private data centers, private clouds and cloud computing.
Our market leading Steelhead® products enable our customers to improve the performance of their applications and access to their data across WANs, typically increasing transmission speeds by 5 to 50 times and in some cases by up to 100 times. Our Cascade® product line, allows organizations to better assess, accelerate and adapt network performance. In 2010, we added packet capture and analysis to our Cascade network and application visibility solution and introduced our Whitewater cloud storage gateway product. In 2011, we added application delivery control to our product line with the Stingray product family. Our portfolio of IT performance products allows organizations to optimize their IT infrastructure to get the maximum return from network, storage and application investments.
The IT performance delivered by Riverbed solutions allows organizations to implement key initiatives, including:

Performance management across the WAN

Application performance across the WAN

Consolidation of remote office and data center IT

Collaboration between distributed offices and employees

Back-up and disaster recovery over the WAN

Virtualization

Cloud computing
Our goal is to establish our solutions as the preeminent performance and efficiency standard for organizations worldwide. We believe our products and services can provide significant benefits in millions of locations across the globe.
The Need for WAN Optimization
A common misconception is that increasing or optimizing bandwidth alone can adequately reduce the inefficiencies and performance problems inherent in wide-area distributed computing. Increasing or optimizing bandwidth may allow an organization to increase the amount of data that can traverse a WAN at a given point in time. However, application performance problems resulting from the distance between locations across a WAN and resulting from network and application protocol inefficiencies are not addressed by increasing or optimizing bandwidth alone. Inadequate bandwidth is only one of three inter-related causes of these performance problems. We believe that these problems can best be solved by simultaneously addressing all three inter-related root causes: software application protocol inefficiencies, transport network protocol inefficiencies and insufficient or unavailable bandwidth.
Unlike alternative approaches, our Steelhead products simultaneously address these root causes across a broad range of applications. Our products utilize our proprietary software to improve the performance of applications and access to data over distance by reducing:

application protocol inefficiencies through our proprietary application streamlining techniques;

network protocol inefficiencies through our proprietary transport streamlining techniques; and

bandwidth requirements through our proprietary data streamlining techniques and data compression.
Our Steelhead products are used at both ends of a WAN connection and are designed to be more easily and transparently integrated into existing networks than alternative products. Our products address a broad range of widely used software applications, are scalable across networks of all sizes and address the wide-area distributed computing needs of every major industry.
Extending Performance Beyond WAN Optimization
In 2010, we introduced solutions for the public cloud, including a cloud-intelligent WAN optimization solution and a cloud storage gateway targeting back-up and improved disaster recovery (DR) readiness. By extending our award-winning acceleration and de-duplication capabilities to cloud storage, we provide organizations with a fast, secure and cost-efficient method to eliminate antiquated tape based data protection systems, reduce backup costs by 30% to 50% and improve DR readiness, without changes in the existing infrastructure.
In February 2009, we acquired Mazu Networks, Inc. (Mazu). Mazu helps organizations manage, secure and optimize the availability and performance of global applications and was the foundation for our Cascade product line. In October 2010, we acquired CACE Technologies, Inc. (CACE), which complemented the capabilities of our existing Cascade offerings. Our Cascade products allow us to meet enterprise and service provider customer demands by extending our suite of WAN optimization products to include global application performance, reporting and analytics.
In November 2010 we acquired Global Protocols LLC (Global Protocols), which added SkipWare technology to our WAN optimization and will bolster our leadership position in delivering optimization solutions for satellite networks.
In July 2011, we acquired Zeus Technology Ltd. and Aptimize Ltd., which became the Stingray product line. The Stingray application delivery controller (ADC) family is used by enterprises and large-scale web organizations to improve application performance and to manage the delivery of complex, business-critical web services. Its virtual ADC (vADC) and web content optimization (WCO) capabilities give Riverbed customers an asymmetric performance solution.
WAN Optimization Industry Background
The WAN optimization market provides global access to data and applications across WANs with local area network (LAN) like performance. The WAN optimization market is large and growing. The key drivers of demand in this market are the increasingly geographically distributed nature of organizations and employees, the transition towards cloud storage and computing, the growing business dependence on application performance and real-time access to data, the increasing desirability of IT infrastructure consolidation in order to achieve compelling cost reductions or organizational efficiencies, and management and data protection benefits.
Increasingly Distributed Organizations and Workforces
Organizations are becoming more geographically distributed, with businesses becoming more global by expanding into new markets, migrating manufacturing facilities to lower-cost locations and outsourcing certain business processes. In addition, existing enterprises continue to expand their geographic scope through mergers, acquisitions, partnerships and joint ventures.
Transition Towards Cloud Architecture
Organizations have begun transitioning towards either a public or private cloud architecture in order to achieve greater financial efficiency, elastic resource provisioning and automation of IT management. This transition, however, typically reduces application performance by moving data and applications further away from end users, and also taxes network resources by more frequently migrating large amounts of data across the network.
Organizations are Increasingly Dependent on Timely Access to Critical Data and Applications
Application performance and effective access to data are critical to executing, maintaining and expanding business operations. Employees are increasingly dependent on a wide array of software applications to perform their jobs effectively, such as e-mail, document management, enterprise resource planning and customer relationship management.
Benefits of IT Infrastructure Consolidation
As organizations have become more geographically distributed, installing and managing IT infrastructure has become increasingly costly and complex. Accordingly, IT managers often seek to consolidate IT infrastructure resources into headquarters or centralized data center locations, which can provide a number of benefits, including:

reduction in capital costs as IT infrastructure resources (file servers, e-mail servers, web servers, application servers, back-up systems and databases) are consolidated and shared within an organization;

reduction in IT support costs as fewer personnel are required to manage more centralized data and applications;

more efficient and reliable data back-up and recovery and application and database administration by managing these processes from a central point of control;

improved data protection as consolidated IT infrastructure resources are less vulnerable to theft, loss and misuse; and

enhanced ability to implement internal controls and comply with other regulatory requirements as centralized data and applications are easier to monitor, store and access.
Despite these benefits, many organizations have foregone or delayed consolidation projects because of network performance and manageability problems.
Wide-Area Distributed Computing Challenges
Technological advances in computing, networking, semiconductor and storage technologies have improved users’ ability to access data and use applications rapidly across their LANs and store enormous amounts of information economically. However, these same applications and storage technologies, which were often designed to operate optimally on LANs, perform slowly across WANs and frequently exhibit the following performance challenges:

delays in accessing, saving and transferring files;

slow execution of critical software application functions;

incomplete or inconsistent back-up and recovery of sensitive data;

loss of worker productivity and increased end-user frustration; and

limited visibility into performance and security metrics at remote locations.
Although many companies have attempted to solve these problems solely by adding bandwidth, we believe these performance problems can best be solved by addressing the technical root causes of these challenges:

Latency and protocol chattiness - “Latency” is the amount of time it takes data to travel distances across a WAN. “Chattiness” refers to the numerous interactions between clients and servers that are often required by applications or network transport protocols to complete an operation or transfer data. When combined in geographically distributed computing environments, latency and chattiness can result in dramatically slower performance. For example, a simple request to open a file may require hundreds if not thousands of sequential round-trip interactions that, when aggregated, can result in substantial delays. This problem arises from two distinct sources:
- Application protocol chattiness - Many business applications were designed for optimal use within LAN environments and employ unique communications procedures that cause high chattiness, resulting in slow performance for the end-user when transmitted over a WAN; and
- Network protocol chattiness - Transmission Control Protocol (TCP), the underlying transport protocol for most WAN traffic, divides data into relatively small packets that are sent sequentially across the WAN, and require return acknowledgement from the recipient. These numerous round trips across the WAN can result in slow performance for the end-user.

Bandwidth limitations - Bandwidth is defined as the amount of data that can traverse a network in a given amount of time and is typically measured in megabits per second (Mbps). While most organizations’ LANs typically operate at 100 or 1,000 Mbps, their remote office WAN connections typically operate at 2 Mbps or less. This often results in WAN congestion and poor application and data services performance. In addition, WAN outages limit the effectiveness of workers who are dependent on remote access to data and applications.

Visibility limitations - Enterprises typically are forced to buy expensive technology to capture detailed performance data, but at the same time lack tools that can quickly and comprehensively assemble that data into meaningful information or actionable analysis around performance problems.
Limitations of Alternative Approaches
Historically, organizations have implemented partial solutions in attempting to improve the performance of wide-area distributed computing, including:

Bandwidth - Organizations often attempt to improve application performance by making costly investments in more bandwidth. While additional bandwidth may reduce network congestion, no amount of bandwidth can address performance issues caused by high latency and application and network protocol chattiness; and

IT infrastructure resources - Deploying additional IT infrastructure resources at remote locations can increase selected application and data services performance. However, this approach is expensive, complex to manage and increases the risks of data inconsistency and compromised security.
The Riverbed WAN Optimization Solution
We have developed an innovative and comprehensive solution that broadly addresses the inter-related root causes of poor performance of wide-area distributed computing: latency and protocol chattiness, bandwidth limitations, data growth, and limited visibility. By simultaneously addressing these causes, we are able to significantly improve the performance of applications and access to data across WANs and enable the consolidation of costly IT infrastructures. Our solution, the Riverbed Optimization System (RiOS®) consists of hardware and software products that simultaneously address the fundamental performance limitations of distributed computing environments.
Through the application of our proprietary technology, our WAN optimization solution simultaneously addresses each of these root causes of poor WAN performance:

Application protocol chattiness - Our application streaming technology significantly reduces unnecessary protocol chattiness for a broad range of applications and protocols such as CIFS (Windows file sharing), NFS (UNIX file sharing), MAPI (Microsoft Exchange), Oracle Forms, Lotus Notes, MS-SQL HTTP, SSL and others;

Network protocol chattiness - Our transport streaming technology employs a variety of techniques to significantly improve TCP performance. Our technology allows more data to be transmitted in each trip, which reduces the number of trips required; and

Bandwidth and Storage limitations - Our data streaming technology employs sophisticated data mapping and pattern recognition techniques to minimize the amount of redundant data traversing WAN connections or minimize the amount of data that needs to be stored. Our products detect requests for redundant information and send very little more than the data that has actually been modified over the WAN.

Visibility limitations - Our Cascade products utilize a unique combination of flow-based and packet-based data capture techniques that can quickly assemble a near real-time view of application performance and deliver it within a system that allows for easy analysis of complex data.
When combined, these key technologies allow us to deliver significant benefits to our customers, including the ability to:

Accelerate performance of applications and access to data over the WAN - Our solution enables our customers to recognize dramatic increases in performance of applications and access to data across a WAN, typically increasing transmission speeds by five to 50 times and in some cases by up to 100 times. Benefits include increased employee productivity, more efficient collaboration of globally distributed workgroups and more consistent rollout and adoption of enterprise applications;

Accelerate performance and access to software as a services (SAAS) applications - Akamai and Riverbed announced in 2011 our intention to develop a joint application acceleration solution for hybrid cloud networks that leverages a combination of Internet optimization and WAN optimization. The planned solution is designed to accelerate cloud-based applications, including SAAS applications.

Consolidate geographically distributed IT resources - Our solution enables the consolidation of remote office infrastructure, including servers, storage back-up systems, databases and IT support personnel, while achieving more LAN-like performance. Also, consolidation enhances data security by centralizing IT resources in more secure data centers;

Reduce the need for WAN bandwidth - Our solution nearly eliminates redundant traffic traversing the WAN and enables more efficient use of existing bandwidth, reducing the pressure to add bandwidth, which is often expensive or unavailable, as network traffic increases;

Shorten storage back-up and replication time over the WAN - Our solution enables back-up and replication of data over the WAN to private cloud or public cloud data centers in a fraction of the time previously allocated to the task. Additional benefits to our solution include reduced IT support needed to execute daily back-up procedures, as well as reduced security concerns related to storing and transporting backed-up data on physical tape media at every remote computing location;

Improve productivity and reduce frustration for IT managers and end-users - Our solution allows users in sites linked by a WAN to collaborate and share files and other data without the delays normally caused by WANs. Additional benefits include faster development cycles, better data synchronization, lower error rates and more flexibility with respect to staffing and personnel coordination; and

Continuously assess network and application performance - Our solution collects performance information from devices across the WAN, at both optimized and non-optimized sites, and gives operators early warning about any application performance problems.
Our products are designed to be easily and transparently deployed into our customers’ networks. Our products are also designed to be easily managed with scalability across networks of all sizes, and to address the wide-area distributed computing needs of every major industry.
The Broader Performance Need
As business has become more complex, so have the needs of enterprise IT. Recognizing this, we have expanded our product line beyond pure WAN optimization to application aware network performance management (NPM), virtual application delivery controllers (vADCs), web content optimization (WCO), and cloud storage delivery.
While our Cascade product line integrates closely with the Steelhead WAN optimization solution, it also offers compelling benefits for customers who have not yet deployed WAN optimization. Cascade offers superior application-aware NPM, so managers can resolve network and application performance problems before they impact the business. Users can discover, monitor and troubleshoot critical services, get accurate data for strategic IT projects, and communicate performance results clearly to the business, all while lowering IT management costs. Cascade combines flow-based and packet-based monitoring for a complete view of the environment, and integrates seamlessly with Wireshark, our most widely used open source network analysis tool.
Using Cascade means an enterprise can effectively gain an end-to-end view of performance throughout their distributed infrastructure. These views allow enterprises to find problems faster, and reduce the mean time to respond by 80% or more in some cases.
With the addition of our cloud backup and DR solution, the Whitewater gateway, we have extended our industry-proven de-duplication to cloud storage. Our de-duplication solutions, incorporated into our WAN optimization products, significantly reduce the volume of data traversing networks. Our Whitewater appliance cuts the cost of data back-up and DR by reducing both the cost of storage consumed and the bandwidth requirements for moving back-up data into and out of the cloud.
Our Stingray product line is software-based. The ADC family is used by enterprises and large-scale web organizations to improve application performance and to manage the delivery of complex, business-critical web services. Stingray provides data-center based performance optimization, server offload, application reliability, WCO, and application firewall capabilities. Stingray also provides robust scripting capabilities that allow enterprises to customize functionality based on their own business requirements.
Thousands of customers use Stingray today, both in private cloud environments and in public cloud environments such as Amazon, RackSpace, ACS and more.
The Riverbed Strategy
Our goal is to establish our solutions as the preeminent performance and efficiency standard for organizations relying on wide-area distributed computing. Key elements of our strategy include:

Build a unified performance platform - Riverbed is the performance company. Our vision is to give customers the tools to create the highest performing IT environment possible, enabling users everywhere to be more productive while giving IT teams greater control over their enterprises’ technology resources. Our vision focuses on the intersection of applications, networks, and storage, and brings customers a single, unified view of performance in their distributed environment;

Maintain and extend our technological advantages - We believe that we offer the broadest ability to enable rapid, reliable access to applications and data for our customers. We intend to enhance our position as a leader and innovator in the WAN optimization market. We also intend to continue to sell new capabilities, such as our new cloud solutions, into our installed base and to new customers. Continuing investments in research and development are critical to maintaining our technological advantage;

Enhance and extend our product lines - We plan to introduce enhancements to our product capabilities in order to address our customers’ size and application requirements. We also plan to introduce new products to extend our market and utilize our technology platform to extend our capabilities;

Extend our technology partner ecosystem - We plan to enhance our product capabilities via integration of partner technologies, in particular by increasing the selection of third-party applications on the Riverbed Services Platform;

Increase market awareness - To generate increased demand for our products, we will continue promoting our brand and the effectiveness of our comprehensive IT performance solutions;

Scale our distribution channels - Growth in revenue and increase in market share are key goals for us. We sell our products directly through our sales force and indirectly through channel partners. We derived 96% of our revenue through indirect channels in 2011. We intend to expand our direct sales force and leverage our indirect channels to extend our geographic reach and market penetration; and

Enhance and extend our support and services capabilities - On an ongoing basis, we plan to enhance and extend our support and services capabilities to continue to support our growing global customer base.
Products
Steelhead Product Family
Our Steelhead appliances consist of our proprietary software that is delivered as appliances on a purpose-built hardware computing platform, and as software for end users for public and private cloud environments. We sell different Steelhead appliances to address the needs of customers ranging from small office deployments to large headquarters and data center locations. The U.S. list prices for our Steelhead appliances currently range from $3,495 to $234,995. During 2010, we introduced the Steelhead 7050 WAN optimization appliance, Virtual Steelhead, and Cloud Steelhead. The Steelhead 7050 appliance combines new levels of bandwidth and TCP session scalability with solid-state drives
and 10 Gigabit Ethernet targeted to large data centers and private cloud environments. Virtual Steelhead provides all the functionality of our appliances, in a software-based virtual appliance designed for private cloud environments. Cloud Steelhead delivers our WAN optimization functionality specifically for public cloud environments.
Riverbed Services Platform (RSP)
In addition to WAN optimization functionality, Steelhead appliances support the RSP, a virtualized environment within Steelhead appliances upon which third-party applications can be installed. RSP benefits customers by further enabling branch office IT consolidation. Applications or services that require local deployment can be deployed (for example, print services that must remain functional in the event of a WAN outage can be deployed on the already installed Steelhead appliance, which enables the decommissioning of a dedicated print server in the branch. RSP runs within the Steelhead appliances, and now supports up to five third-party applications or services, including Microsoft Windows Server, print server, DNS/DHCP, security, video and numerous other packages. Over time we expect additional products and services to become available for installation on RSP. The U.S. list prices of our RSP kits currently range from $1,590 to $3,985.
Steelhead Mobile
Steelhead Mobile enables faster application performance and better support for mobile workers. With Steelhead Mobile client software, companies of any size can give mobile workers LAN-like access to corporate files and applications no matter where they are in the world. Steelhead Mobile overcomes the challenges that plague remote users, including variable locations, inconsistent links, and high-latency environments, and it does so seamlessly and transparently. This results in higher productivity and more efficient operations, access, and performance anywhere. The base list price of our SMC is currently $14,995. The Steelhead Mobile Controller-Virtual Edition (SMC-VE), is a software only version of the SMC and currently has a base list price of $5,995.
Virtual Steelhead
The Riverbed Virtual Steelhead appliance extend the reach of WAN optimization. With Riverbed Virtual Steelhead appliances, WAN optimization now extends to deployments where physical hardware may not be conveniently suited. Military deployments, for example, typically use ruggedized, custom hardware on which running a virtual machine is more convenient. Space-limited scenarios, such as mobile news vans or construction trailers, may also require a form factor that is free from the physical limitations of hardware appliances.
Cloud Steelhead
Cloud Steelhead extends the Riverbed WAN optimization to a solution that is purpose-built for public cloud computing environments. Public, private, and hybrid cloud environments all face the performance limitations inherent in today’s applications and networks. In order for enterprises to maximize the flexibility and cost savings of the public cloud they must overcome the same latency and bandwidth constraints that challenge distributed IT infrastructure environments. Cloud Steelhead offers a number of features to help ensure a smooth transition and user experience. Cloud Steelhead is available on a subscription basis, with monthly fees starting as low as $250 per month.
Central Management Console (CMC)
The Riverbed CMC provides centralized configuration, monitoring and control, which simplifies the process of deploying and managing Steelhead products that are distributed across a WAN. With this turnkey solution, businesses can easily configure, monitor, report on, and upgrade groups of Steelhead appliances and Virtual Steelhead - all through one web-based interface. The U.S. list prices of our CMC appliances and CMC-VE currently range from $4,995 to $49,995.
Interceptor
The Interceptor appliance provides high scalability and availability for sites with multiple Steelhead appliances and extends the scaling and high-availability capabilities of Steelhead appliances to meet the requirements of the largest and most complex enterprise networks and data center environments. The Interceptor appliance allows these organizations to scale their WAN optimization solutions to support hundreds of thousands of end users, and scale up to optimize very-high-bandwidth network connections in the data center. The U.S. list price of our Interceptor appliance is currently $34,995.
Cascade Product Family
Cascade appliances help organizations manage, secure and optimize the availability and performance of global applications.
Customers achieve the greatest value and return on investment when deploying the entire Cascade family, which combines sophisticated end-to-end, service-level monitoring with high-speed, high-fidelity packet capture and analysis for both broad and deep network performance monitoring and analysis. However, Cascade Shark with Cascade Pilot can be deployed as standalone network troubleshooting solutions, while Cascade Profile and Cascade Gateway provide robust, end-to-end network monitoring.
Cascade Profiler is the centralized analysis and reporting console for the Cascade family, correlating information collected by Cascade Shark, Cascade Gateway, Cascade Sensor and even Steelhead products to provide centralized monitoring, analysis and reporting of network and application performance problems. Cascade Profiler enables enterprises to proactively monitor and troubleshoot application and network, automate discovery and dependency mapping, plan for capacity planning and WAN optimization, and assure a consistent and reliable end user experience.
The Cascade Gateway appliance collects flow data (NetFlow, sFlow, J-Flow, IPFIX and other popular flow statistics) from network infrastructure devices and sends it to Cascade Profiler for analysis, providing cost-effective, enterprise-wide, behavior-based network monitoring.
The U.S. list prices of our Cascade appliances currently range from $36,995 to $185,000.
Cascade Shark appliances deliver scalable, high-performance continuous packet capture and long-term storage, enabling real-time and back-in-time forensic analysis and reporting of network and security events. Cascade Shark appliances are typically deployed wherever detailed and historical back-in-time analysis is needed, such as within the datacenter, headquarters or key branch offices, and can be used as an integral part of the Cascade visibility solution or as a standalone troubleshooting solution.
A software version of Cascade Shark that has been virtualized to run on VMware ESX environments, Virtual Cascade Shark taps into the virtual switch in the ESX hypervisor to monitor the performance of all inter-VM traffic and send data to Cascade Profiler for analysis and reporting and/or to continuously capture packets and store them on the local server or on a storage area network (SAN) for back-in-time analysis with Cascade Pilot.
The Cascade Sensor appliance performs deep packet inspection to supplement flow-based data with Layer 7 application classification, end-user experience and performance metrics.
Virtualized software that runs on the RSP on Steelhead appliances, Cascade Sensor-VE is functionally similar to Cascade Sensor, except that it lacks Layer-7 application identification capabilities.
Cascade Pilot is a robust analysis console that enables users to quickly analyze multi-terabyte packet recordings on remote Cascade Shark appliances and Steelhead products without having to transfer large packet captures files across the network.
All Steelhead models (Steelhead, Virtual Steelhead, Cloud Steelhead and Steelhead Mobile) can provide remote site visibility to Cascade via flow export, packet inspection (Sensor-VE) and packet capture.
Stingray Product Family
Riverbed Stingray is a software-based ADC designed to deliver faster and more reliable access to public web sites and private applications. Stingray frees applications from the constraints of legacy, proprietary, hardware-based load balancers, which enables them to run in any physical, virtual or cloud environment.
Stingray Traffic Manager provides complete control over user traffic, allowing administrators to accelerate, optimize, and secure key business transactions. With Stingray Traffic Manager, applications can run in any environment - physical, virtual, or cloud - and migrate and scale on demand. One of the fastest software-based ADCs on the market, Stingray Traffic Manager, is used by seven of the top 10 global telecommunications providers, and also powers some of the most popular sites on the web.
Stingray Application Firewall is a sophisticated, application-aware, web application firewall for deep application security that protects against known and unknown attacks at the application layer, secures applications, and meets compliance requirements with confidence.
Stingray Aptimizer is a web accelerator that dynamically groups activities for fewer long distance round trips. Stingray Aptimizer compresses images to maximize available bandwidth, increases caching for faster repeat visits, and prioritizes actions to provide the best possible response time for loading web pages on any browser.
Whitewater Product Family
Whitewater is a cloud storage gateway appliance, designed to accelerate, de-duplicate, secure and store backup data sets in the public cloud. Whitewater gateways are available as physical and virtual appliances with list prices starting at $7,995.
Whitewater Cloud Storage Gateways
Whitewater gateways are deployed in customer data centers or remote offices and provide a gateway to the public cloud that greatly improves data transmission speeds, security and DR readiness while reducing cloud storage costs. Whitewater cloud storage gateways allow organizations to reap the benefits of the public cloud’s scalability, flexibility and pay-per-use pricing model without changes to their existing data protection infrastructure. Whitewater connects all popular backup applications to the leading public cloud storage vendors such as Amazon®, AT&T, Nirvanix®, Rackspace and Windows Azure. Leveraging Riverbed’s industry-leading WAN optimization, sub-file deduplication, intelligent local data cache and strong encryption of data in motion and at rest, Whitewater gateways make public cloud storage a cost-effective and easy to implement solution for any organization.
Virtual Whitewater Gateways
Virtual Whitewater gateways provide all the functionality of a physical Whitewater appliance in a software form factor. This product, targeted at customers with virtualized environments and remote offices, offers increased flexibility for deployment for organizations of all sizes.
Technology
RiOS is our proprietary software platform that provides the core intelligence and essential functionality for our Steelhead products. To achieve performance improvements across a broad range of applications, RiOS integrates four key sets of technologies: data streamlining, transport streamlining, application streamlining and management streamlining.
Data Streamlining
Our data streamlining technologies address bandwidth limitations in existing networks. Our patented approach can be applied to all data and applications that run over TCP to reduce bandwidth consumption by dramatically reducing the need to send the same data multiple times over the WAN. Data streamlining also supports the classification of individual data packets for quality-of-service and route control.
In a non-optimized WAN setting, each time data is requested by a remote user, all of the data must be sent across the WAN, regardless of whether identical data (or an insignificantly modified version of the data) has previously been sent. In wide-area distributed computing environments where Steelhead products have been deployed, all of the requested data must be sent across the WAN only the first time data is requested by a user, at which time that data is stored by the Steelhead products on both sides of the network. In subsequent requests, redundant data segments will not be sent regardless of what application is requesting the data or which user is making the request. The detection of repetitive data patterns is very granular, with a typical segment of data being approximately 100 bytes. This fine level of granularity enables Steelhead products to detect tiny changes in files, e-mails, web pages and other application data, sending only those changes across the WAN.
Each end-user request for data is sent directly to the intended authoritative application server as opposed to a cache that typically utilizes a copy of the data. Our Steelhead product intercepts the server response, identifies redundant data patterns and then sends only the new segments across the WAN to the end-user. All of the existing segments are represented by references which point to those already existing segments stored on the end-user side of the WAN connection. In this way, significantly less traffic needs to be sent to deliver large amounts of data to the end-user. In addition, this approach eliminates data consistency issues inherent in cache-based approaches.
Transport Streamlining
Transport streamlining enhances the performance of the TCP protocol by increasing the amount of data carried per TCP round trip, thereby reducing the number of round trips required to move a given amount of data over the WAN. We accomplish this by both increasing the default TCP payload and by filling the window with references to data rather than actual data.
We also enhance TCP performance by reducing the time associated with creating new TCP connections (especially for small, short-lived transfers), adapting transfer parameters based on real-time network characteristics and assigning priority for necessary packet resends due to packet loss. A component of transport streamlining, High Speed TCP, also addresses the TCP chattiness and latency that is particularly pronounced in high speed connections (for example, OC-12 (622 Mbps)). Another component of transport streamlining, MXTCP, is designed to address private networks with packet loss.
Application Streamlining
Application streamlining provides a further mechanism to enhance the performance of specific applications. Many applications were designed for use over a LAN and require hundreds to thousands
of interactions between client and server to execute even simple requests, such as opening a file. By understanding the semantics of particular application protocols, Steelhead products reduce chattiness, collapsing hundreds of client-server interactions into a few round trips over the WAN.
While most important business applications that run over TCP immediately benefit from data streamlining and transport streamlining, application streamlining enables us to add additional acceleration for specific applications. We have built specific Application Streamlining modules that support file, e-mail, web, ERP, database application, and thin client protocols (CIFS, MAPI, HTTP, Oracle Forms, SSL, Lotus Notes, NFS and MS-SQL, Citrix, and others). We have also built special modules to address protocol inefficiencies for common storage back-up and replication applications. We believe these applications are especially inefficient in wide-area distributed computing. We have designed our architecture to enable additional application streamlining modules to be incorporated easily over time.
Management Streamlining
Management streamlining allows for simplified implementation and administration of our Steelhead products. Unlike alternative approaches, which usually require changes to clients, servers, routers and switches or the addition of an overlay network of tunnels, Steelhead products are designed to be transparently installed in existing IT infrastructure with minimal administration. The auto-discovery capabilities of RiOS allow our Steelhead products to identify automatically all Steelhead products on the WAN, typically without the need to reconfigure any network infrastructure. Our products automatically intercept WAN traffic without any further configuration requirements to applications, clients or other network infrastructure, while allowing non-optimized traffic to simply pass through.
Our RiOS software provides IT administrators with simplified management of Steelhead products through Command Line Interface (CLI), Graphical User Interface (GUI) and an optional CMC.
Other key elements of management streamlining include touchless configuration options, over-the-wire software upgrades for Steelhead products, singular and grouped appliance management and customizable reporting analytics.
Collection of Performance Data
Our Cascade software collects performance data from sources across the network, including switches, routers and WAN optimization devices. This includes flow records, layer 7 application data, and data about optimized links. All information is collected without any server-side agents or modifications to corporate applications.
Performance Metrics and Behavioral Analytics
Cascade presents the information collected from the network as a collection of useful metrics on application and network performance. It feeds these metrics into a behavioral analytics model, which learns the typical performance of applications and alerts an operator whenever performance deviates in a meaningful way from its learned “normal”.
Discovery and Dependency Mapping
Discovery and dependency mapping allows operators involved with performance troubleshooting, as well as IT consolidation initiatives, to rapidly understand all the components and associated interdependencies that are necessary for the delivery of an application to an end user.
Customers
Our products have been sold to over 17,000 customers worldwide in every major industry, including manufacturing, finance, technology, government, architecture, engineering and construction, professional services, utilities, healthcare and pharmaceuticals, media and retail. Our products are deployed in a wide range of organizations, from large global organizations with hundreds or thousands of locations to smaller organizations with few locations. As of December 31, 2011, one value-added distributor, Arrow Enterprise Computing Solutions, Inc. (Arrow), accounted for 14% of our trade receivable balance. As of December 31, 2010, no single customer accounted for more than 10% of our trade receivable balance. During the years ended December 31, 2011 and 2010, one value-added distributor, Arrow, accounted for 15% and 10%, respectively, of our consolidated revenue. During the year ended December 31, 2009, no single customer accounted for 10% or more of our consolidated revenue. We believe it is unlikely that the loss of any of our channel partners would have a long term material adverse effect on our consolidated net revenues as we believe end-users would likely purchase our products from a different channel partner. However, a loss of any one of these channel partners could have a material adverse impact during the transition period.
Sales and Marketing
We sell our products and support through channel partners and our field sales force:

Channel partners - We have over 1,800 channel partners worldwide, primarily VARs, VADs, service providers and systems integrators. These partners help market and sell our products to a broad array of organizations and allow us to leverage our field sales force; and

Field sales force - We have a field sales force that is responsible for managing all direct and indirect sales within each of our geographic territories.
With the ability to foster a strong, collaborative sales engagement environment between us and our partners, the Riverbed Partner Network (RPN) delivers a coverage model that optimizes our customer’s ability to acquire and implement our solutions in the manner that best fits its needs - through either value added resellers, systems integrators or service providers. We derived 96% of our revenue through indirect channels in 2011.
Our marketing activities include an integrated strategy comprised of lead generation, advertising, website operations, direct marketing, public relations, technology conferences and trade shows.
Many companies in our industry experience adverse seasonal fluctuations in customer spending patterns, particularly in the first and third quarters. We have experienced these seasonal fluctuations in the past and expect that this trend will continue in the future.
See Item 1A, “Risk Factors,” for a discussion of risks related to our sales and marketing efforts.
Support and Services
We offer tiered customer support programs depending upon the service needs of our customers’ deployments. Support contracts provide customers the right to receive unspecified software product upgrades, maintenance releases issued when and if available during the support period and hardware repair. Product support includes internet access to technical content, as well as telephone, internet and email access to technical support personnel. Support contracts typically have a one-year term. We have support centers in New York, the San Francisco Bay Area, Amsterdam, London, Singapore, Sydney and Tokyo, which enable us to respond at all times. As we expand, we plan to continue to hire additional technical support personnel to service our growing international customer base.
Primary product support for customers of our channel partners is often provided by the partners themselves and we provide back-up support.
Our product sales include a warranty on hardware and software. Hardware is typically warranted against material defects for 12 months. Software is typically warranted to meet published specifications for a period of 90 days.
Research and Development
Continued investment in research and development is critical to our business. To this end, we have assembled a team of engineers with expertise in various fields, including networking, applications, storage and systems management. We have invested significant time and financial resources into the development of our products. We plan to expand our product offerings and solutions capabilities in the future and plan to dedicate significant resources to these continued research and development efforts. Further, as we expand internationally and into different sectors, we may incur additional costs to conform our products to comply with local laws or local product specifications.
Research and development expenses were $123.0 million, $87.1 million, and $69.2 million in 2011, 2010, and 2009, respectively.
Manufacturing
We outsource manufacturing of all hardware products. Our manufacturers provide us with limited warranties to cover general product failures, and all our larger manufacturing partners provide specific quality control processes and replacement cycle time commitments. In addition, the lead times associated with certain components are lengthy and consequently make rapid changes in quantity requirements and delivery schedules difficult. Although we outsource manufacturing operations for cost-effective scale and flexibility, we perform rigorous quality control testing intended to ensure the reliability of our products once deployed. We provide long-term forecasts to our manufacturing partners and we maintain oversight of their supply chain activities.
Shortages in components that we use in our products are possible and our ability to predict the availability of such components may be limited. Some of these components are available only from single or limited sources of supply. Our ability to deliver products to our customers in a timely manner would be adversely impacted if we needed to qualify replacements for any of a number of the components used in our products.
We outsource our logistics functions to third parties. These third parties ship our products on our behalf and perform certain other shipping and product integration capabilities.
Competition
The WAN optimization market is highly competitive and continually evolving. We believe we compete primarily on the basis of offering a comprehensive WAN optimization solution that broadly addresses the root causes of poor performance of wide-area distributed computing. We believe other principal competitive factors in our market include product performance, ability to deploy easily into existing networks and ability to remotely manage products. We believe that our solution performs better than competitive products as measured by a broad range of metrics encompassing application performance, compression ratios and data transfer times. Our ability to sustain such a competitive advantage depends on our ability to achieve continuous technological innovation and adapt to the evolving needs of our customers.
We believe we are currently the only provider of a comprehensive WAN optimization solution. However, a large number of vendors have made acquisitions to enter the WAN optimization market and continue to invest in this area.
Our primary competitors include Cisco Systems, Silver Peak Systems, Blue Coat Systems, and Citrix Systems. We also face competition from a large number of smaller private companies and new market entrants.
We believe that we compete favorably in each of the sub-segments of WAN optimization in addition to being the only provider of a comprehensive WAN optimization solution. As we have a purpose-built architecture, compared to many vendors’ attempts to combine separate technology elements, we believe we have a significant advantage in performance, ease-of-use, and ability to scale to large numbers of locations and employees.
We have received broad industry recognition for our innovative technology. For six consecutive years, InfoWorld has named the Riverbed Steelhead appliances as a Product of the Year. For the last four years (2007 - 2010) we were positioned by Gartner in the Leaders’ Quadrant of the “WAN Optimization Controller (WOC) Magic Quadrant, authored by Joe Skorupa and Severine Real, and most recently published in January 2012. This Gartner report positions vendors in one of four quadrants - Leaders, Challengers, Visionaries and Niche Players - based on the companies’ vision and ability to execute on that vision. Riverbed’s WAN optimization solutions have received industry recognition from Forrester Research, IDC, NetworkWorld, The Wall Street Journal, eWeek, Storage Magazine, Network Computing and Byte & Switch, among others.
We also compete in the NPM market with our Cascade product line. Our primary competitors in this market are Netscout Systems, OPNET Technologies, CA Technologies and Fluke Network.
Our Stingray product line competes in the vADC market. Our primary competitors in this market are Networks, Citrix Systems, Cisco Systems and Radware.
See Item 1A, “Risk Factors,” for further discussion of risks regarding competition.
Intellectual Property
Our success as a company depends upon our ability to protect our core technology and intellectual property. To accomplish this, we rely on a combination of intellectual property rights, including patents, trade secrets, copyrights and trademarks, as well as customary contractual protections.
Our worldwide patent portfolio includes forty-eight U.S. patents and twenty-seven issued foreign patents. Patents generally have a term of twenty years from their priority date, which is generally either the date they were initially filed or the filing date of the earliest patent from which priority is claimed. Our issued patents will expire in 2020 through 2029. U.S. patent filings are intended to provide the holder with a right to exclude others from making, using, selling or importing in the U.S. the inventions covered by the claims of granted patents. We also have U.S. provisional and non-provisional patent applications pending, as well as counterparts pending in other jurisdictions around the world. We do not know whether any of our pending patent applications will result in the issuance of patents or whether the examination process will require us to narrow our claims. Our granted patents, and to the extent any future patents are issued, any such future patents, may be contested, circumvented or invalidated over the course of our business, and we may not be able to prevent third parties from infringing these patents. In addition, the laws of certain countries do not protect our proprietary rights to the same extent as do the laws in the U.S. Therefore, the exact effect of having a patent cannot be predicted with certainty.
Our registered trademarks in the U.S. include Riverbed, Steelhead, Virtual Steelhead, the Riverbed logo, RiOS, Think Fast, Cascade, Interceptor, Mazu, CACE Technologies, CACE Pilot,
TurboCap, WinPcap, AirPcap and Wireshark. We additionally have registered trademarks in selected foreign jurisdictions. We also have a number of trademark applications pending, in the U.S. as well as in other jurisdictions.
In addition to the foregoing protections, we generally control access to and use of our proprietary software and other confidential information through the use of internal and external controls, including contractual protections with employees, contractors, customers and partners. Our software is also protected by U.S. and international copyright laws.
We also incorporate third-party software programs into our products pursuant to license agreements. For example, we embed technology from VMware into our Steelhead appliances to provide the virtualization in our RSP. Any disruption in our access to any of these software programs could result in significant delays in our product releases and could require substantial effort to locate or develop a replacement program.
See Item 1A, “Risk Factors,” for discussion of risks related to protecting our intellectual property.
Employees
As of December 31, 2011, we had 1,610 employees in offices in all major geographies. Of these, 736 were engaged in sales and marketing, 466 in research and development, 199 in support and services, 179 in general and administration and 30 in manufacturing. None of our U.S. employees are represented by labor unions; however, in certain international subsidiaries, workers councils represent our employees. We consider current employee relations to be good.
Corporate Information
Riverbed Technology, Inc. was incorporated in Delaware in May 2002. We operate internationally primarily through a number of wholly owned subsidiaries that are designed primarily to support our sales, marketing and support activities outside the United States. A summary of our financial information by geographic location is found in Note 14, “Segment Information,” in the Notes to Consolidated Financial Statements. We have a single operating segment and substantially all of our operating assets are located in the United States.
Our Internet address is www.riverbed.com. There we make available, free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission (SEC). Our SEC reports can be accessed through the investor relations section of our website. The information found on our website is not part of this or any other report we file with or furnish to the SEC.
Item 1A.
Item 1A. Risk Factors
Set forth below and elsewhere in this Annual Report on Form 10-K, and in other documents we file with the SEC, are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Annual Report on Form 10-K and in our other public statements. Because of the following factors, as well as other variables affecting our operating results, past financial performance should not be considered as a reliable indicator of future performance and investors should not use historical trends to anticipate results or trends in future periods.
Risks Related to Our Business and Industry
Our operating results may fluctuate significantly, which makes our future results difficult to predict and could cause our operating results to fall below expectations or our guidance.
Our quarterly and annual operating results have varied significantly in the past and could vary significantly in the future, which makes it difficult for us to predict our future operating results. Our operating results may fluctuate due to a variety of factors, many of which are outside of our control, including the changing and volatile U.S., European and global economic environment, and any of which may cause our stock price to fluctuate. As a result, comparing our operating results on a period-to-period basis may not be meaningful. You should not rely on our past results as an indication of our future performance. In addition, revenues in any quarter are largely dependent on customer contracts entered into during that quarter. Moreover, a significant portion of our quarterly sales typically occurs during the last month of the quarter, and sometimes within the last few weeks or days of the quarter. As a result, our quarterly operating results are difficult to predict even in the near term and a delay in an anticipated sale past the end of a particular quarter may negatively impact our results of operations for that quarter, or in some cases, that year. A delay in the recognition of revenue, even from just one account, may have a significant negative impact on our results of operations for a given period. If our revenue or operating results fall below the expectations of investors or securities analysts or below any guidance we may provide to the market, as has occurred recently and at other times in the past, or if the guidance we provide to the market falls below the expectations of investors or securities analysts, as has occurred recently and at other times in the past, the price of our common stock could decline substantially. Such a stock price decline could occur, and has occurred in the past, even when we have met our publicly stated revenue and/or earnings guidance.
In addition to other risks listed in this “Risk Factors” section, factors that may affect our operating results include, but are not limited to:

fluctuations in demand, including due to seasonality, for our products and services. For example, many companies in our industry experience adverse seasonal fluctuations in customer spending patterns, particularly in the first and third quarters; we have experienced these seasonal fluctuations in the past and expect that this trend will continue in the future;

fluctuations in sales cycles and prices for our products and services;

reductions in customers’ budgets for information technology purchases and delays in their purchasing cycles;

general economic or political conditions in our domestic and international markets, in particular the recent deficit spending and government debt issues surrounding the U.S. and Eurozone economies;

limited visibility into customer spending plans;

changing market conditions, including current and potential customer consolidation;

customer or partner concentration. For example, one value-added distributor represented more than 10% of our revenue for the year ended December 31, 2011;

variation in sales channels, product costs or mix of products sold;

the timing of recognizing revenue in any given quarter as a result of revenue recognition accounting rules, including the extent to which sales transactions in a given period are unrecognizable until a future period or, conversely, the satisfaction of revenue recognition rules in a given period resulting in the recognition of revenue from transactions initiated in prior periods;

the sale of our products in the timeframes we anticipate, including the number and size of orders, and the product mix within any such orders, in each quarter;

our ability to develop, introduce and ship in a timely manner new products and product enhancements that meet customer requirements;

the timing and execution of product transitions or new product introductions, including any related or resulting inventory costs;

delays in customer purchasing cycles in response to our introduction of new products or product transitions;

customer acceptance of new product introductions. For example, we recently introduced solutions for the public cloud, including a cloud-intelligent WAN optimization solution and a cloud storage accelerator targeting back-up and select archive workloads. These new products may not achieve any significant degree of market acceptance or be accepted into our sales channel by our channel partners. Furthermore, many of our target customers have not purchased products similar to these and might not have a specific budget for the purchase of these products;

our ability to successfully integrate any businesses that we acquire, especially where those acquisitions result in our entering new markets. For example, in July 2011 we acquired Zeus Technology Ltd., a company that delivers high-performance software- based load balancing and traffic management solutions for virtual and cloud environments, and Aptimize Ltd., a web content optimization company;

unpredictability in the development of core, new or adjacent markets, including the public cloud computing market and including any markets that we enter as a result of acquisitions;

the timing of product releases or upgrades by us or by our competitors;

any significant changes in the competitive dynamics of our markets, including new entrants or substantial discounting of products;

our ability to control costs, including our operating expenses and the costs of the components we purchase;

any component shortages or price fluctuations in our supply chain; for example, we have been impacted by the limited availability of disk drive components following the recent flooding in Thailand;

our ability to establish and maintain successful relationships with channel partners, and the effectiveness of any changes we make to our distribution model;

any decision to increase or decrease operating expenses in response to changes in the marketplace or perceived marketplace opportunities;

our ability to derive benefits from our investments in sales, marketing, engineering or other activities;

our ability to successfully work with partners on combined solutions. For example, where our product features the Riverbed Services Platform (RSP), we are required to work closely with our partners in product validation, marketing, selling and support;

volatility in our stock price, which may lead to higher stock compensation expenses;

unpredictable fluctuations in our effective tax rate due to the geographic distribution of our worldwide earnings or losses, disqualifying dispositions of stock from the employee stock purchase plan and stock options, changes in the valuation of our deferred tax assets or liabilities, changes in actual results versus our estimates, or changes in tax laws, regulations, accounting principles, or interpretations thereof; and

the effects of natural disasters, including any effects on our supply chain or on the willingness of our customers or prospective customers to make capital commitments.
Adverse economic conditions make it difficult to predict revenues for a particular period and may lead to reduced information technology spending, which would harm our business and operating results. In addition, turmoil in credit markets during economic downturns increases our exposure to our customers’ and partners’ credit risk, which could result in reduced revenue or increased write-offs of accounts receivable.
Our business depends on the overall demand for information technology, and in particular for WAN optimization, and on the economic health and general willingness of our current and prospective customers, both enterprises and government organizations, to make capital commitments. These government organizations include non-U.S. as well as U.S. federal, state and local organizations. In some quarters, sales to government organizations have represented, and may in the future represent, a significant portion of overall sales. If the conditions in the U.S. and global economic environment, including the economies of any international markets that we serve, remain uncertain or continue to be volatile, or if they deteriorate further, our business, operating results, and financial condition would likely be materially adversely affected. For example, U.S. government deficit spending and debt levels, as well as actions taken by the U.S. Congress relating to these matters, could negatively impact the U.S. and global economies and adversely affect our financial results. In addition, our financial results could be negatively impacted by the continuing uncertainty surrounding, or any deterioration relating to, the debt levels or growth prospects for Eurozone economies.
Economic weakness, customer financial difficulties and constrained spending on IT initiatives have resulted, and may in the future result, in challenging and delayed sales cycles and could negatively impact our ability to forecast future periods. In addition, the markets we serve are emerging and the purchase of our products involves material changes to established purchasing patterns and policies. The purchase of our products is often discretionary and may involve a significant commitment of capital and other resources. In addition, our operating expenses are largely based on anticipated revenue trends and a high percentage of our expenses are, and will continue to be, fixed in the short-term. Uncertainty about future economic conditions makes it difficult to forecast operating results and to make decisions about future investments. Weak or volatile economic conditions would likely harm our business and operating results in a number of ways, including information technology spending reductions among customers and prospects, longer sales cycles, lower prices for our products and services and reduced unit sales. A reduction in information technology spending could occur or persist even if economic conditions improve. In addition, any increase in worldwide commodity prices may result in higher component prices and increased shipping costs, both of which may negatively impact our financial results.
Many of our customers and channel partners use third parties to finance their purchases of our products. Any freeze, or reduced liquidity, in the credit markets may result in customers or channel partners either delaying or entirely foregoing planned purchases of our products if they are unable to obtain the required financing. This would result in reduced revenues, and our business, operating results and financial condition would be harmed. In addition, these customers’ and partners’ ability to pay for products already purchased may be adversely affected by any credit market turmoil or an associated downturn in their own business, which in turn could harm our business, operating results and financial condition.
We face intense competition that could reduce our revenue and adversely affect our financial results.
The market for our products is highly competitive and we expect competition to intensify in the future. Other companies may introduce new products in the same markets we serve or intend to enter.
This competition could result, and has resulted in the past, in increased pricing pressure, reduced profit margins, increased sales and marketing expenses and failure to increase, or the loss of, market share, any of which would likely seriously harm our business, operating results and financial condition.
Competitive products may in the future have better performance, more and/or better features, lower prices and broader acceptance than our products. Many of our current or potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, sales, marketing and other resources than we do. Potential customers may prefer to purchase from their existing suppliers rather than a new supplier regardless of product performance or features. Currently, in the WAN Optimization market we face competition from a number of established companies, including Cisco Systems, Blue Coat Systems, Citrix Systems, Juniper Networks and Networks. We also face competition from a large number of smaller private companies and new market entrants. In the Network Performance Management market, our Cascade product line primarily competes with Netscout, Computer Associates (NetQos) and OpNet. As a result of our July 2011 acquisitions of Zeus and Aptimize, we face additional competition from Networks and Citrix Systems.
We expect increased competition from our current competitors as well as other established and emerging companies if our market continues to develop and expand. For example, third parties currently selling our products could market products and services that compete with our products and services. In addition, some of our competitors have made acquisitions or entered into partnerships or other strategic relationships with one another to offer a more comprehensive solution than they individually had offered. We expect this trend to continue as companies attempt to strengthen or maintain their market positions in an evolving industry and as companies enter into partnerships or are acquired. Many of the companies driving this consolidation trend have significantly greater financial, technical and other resources than we do and are better positioned to acquire and offer complementary products and technologies. The companies resulting from these possible consolidations may create more compelling product offerings and be able to offer greater pricing flexibility, making it more difficult for us to compete effectively, including on the basis of price, sales and marketing programs, technology or product functionality. Continued industry consolidation may adversely impact customers’ perceptions of the viability of smaller and even medium-sized technology companies and consequently customers’ willingness to purchase from such companies. These pressures could materially adversely affect our business, operating results and financial condition.
We also face competitive pressures from other sources. For example, Microsoft has improved, and has announced its intention to further improve, the performance of its software for remote office users. Our products are designed to improve the performance of many applications, including applications that are based on Microsoft protocols. Accordingly, improvements to Microsoft application protocols may reduce the need for our products, adversely affecting our business, operating results and financial condition. Improvement in other application protocols or in the Transmission Control Protocol (TCP), the underlying transport protocol for most WAN traffic, could have a similar effect. In addition, we market our products, in significant part, on the anticipated cost savings to be realized by organizations if they are able to avoid the purchase of costly IT infrastructure at remote sites by purchasing our products. To the extent other companies are able to reduce the costs associated with purchasing and maintaining servers, storage or applications to be operated at remote sites, our business, operating results and financial condition could be adversely affected.
We rely heavily on channel partners to sell our products. Disruptions to, or our failure to effectively implement, develop and manage, our distribution channels and the processes and procedures that support them could harm our business.
Our future success is highly dependent upon establishing and maintaining successful relationships with a variety of channel partners, including value-added resellers, value-added distributors, service providers, and systems integrators. A substantial majority of our revenue is derived from indirect channel sales and we expect indirect channel sales to continue to account for a substantial majority of our total revenue. We employ a two-tier distribution strategy, as part of a larger
effort to scale our reach and better serve the needs of our channel. Our revenue depends in large part on the effective performance of these channel partners, and changes to our distribution model, the loss of a channel partner or the reduction in sales to our channel partners could materially reduce our revenues and gross margins. By relying on indirect channels, we may have little or no contact with the ultimate users of our products, thereby making it more difficult for us to establish brand awareness, ensure proper delivery and installation of our products, service ongoing customer requirements and respond to evolving customer needs. In addition, we recognize a large portion of our revenue based on a sell-through model using information regarding the end user customers that is provided by our channel partners. If those channel partners provide us with inaccurate or untimely information, the amount or timing of our revenues could be adversely impacted. For example, we have encountered delays with certain partners where internal processing issues have prevented that partner from providing a purchase order to us in a timely manner.
Recruiting and retaining qualified channel partners and training them in our technology and product offerings requires significant time and resources. In order to develop and expand our distribution channel, we must continue to scale and improve our processes and procedures that support our distribution channel, including investment in systems and training, and those processes and procedures may become increasingly complex and difficult to manage. We have no minimum purchase commitments with any of our value-added resellers or other indirect distributors, and our contracts with these channel partners do not prohibit them from offering products or services that compete with ours. Our competitors may be effective in providing incentives to existing and potential channel partners to favor their products, to choose not to partner with us, or to prevent or reduce sales of our products. Our channel partners may choose not to offer our products exclusively or at all. If we fail to maintain successful relationships with our channel partners, fail to develop new relationships with channel partners in new markets or expand the number of channel partners in existing markets, fail to manage, train or motivate existing channel partners effectively or if these channel partners are not successful in their sales efforts, sales of our products would decrease and our business, operating results and financial condition would be materially adversely affected.
We expect our gross margins to vary over time and our recent level of product gross margin may not be sustainable. In addition, our product gross margins may be adversely affected by our introductions of new products.
Our product gross margins vary from quarter to quarter and the recent level of gross margins may not be sustainable and may be adversely affected in the future by numerous factors, including but not limited to product or sales channel mix shifts, increased price competition, increases in material or labor costs, excess product component or obsolescence charges from our contract manufacturers, write-downs for obsolete or excess inventory, increased costs due to changes in component pricing or charges incurred due to component holding periods if our forecasts do not accurately anticipate product demand, warranty-related issues, product discounting, freight charges, or our introduction of new products or new product platforms or entry into new markets with different pricing and cost structures.
Any introduction of, and transition to, a new product line requires us to forecast customer demand for both legacy and new product lines for a period of time, and to maintain adequate inventory levels to support the sales forecasts for both product lines. If new product line sales, or product line sales in general, exceed our sales forecast, we could possibly experience stock shortages, which would negatively affect our revenues. If legacy product line sales, or product lines sales in general, fall short of our sales forecast, we could have excess inventory, as has occurred in prior quarters. Any inventory charges would negatively impact our product gross margins.
Our sales cycles can be long and unpredictable, and our sales efforts require considerable time and expense. As a result, our revenue is difficult to predict and may vary substantially from quarter to quarter.
The timing of our revenue is difficult to predict. Our sales efforts involve educating our customers about the use and benefit of our products, including their technical capabilities and potential cost savings to an organization. Customers typically undertake a significant evaluation process that has in the past resulted in a lengthy sales cycle, in some cases over twelve months. Also, as our channel model distribution strategy evolves, utilizing value-added resellers, value-added distributors, systems integrators and service providers, the level of variability in the length of sales cycle across transactions may increase and make it more difficult to predict the timing of many of our sales transactions. We spend substantial time and money in our sales efforts without any assurance that these endeavors will produce any sales. Even after making the decision to purchase, customers may deploy our products slowly and deliberately. In addition, product purchases are frequently and increasingly subject to budget constraints, multiple approvals, and unplanned administrative, processing and other delays.
Customers may also defer purchases as a result of anticipated or announced releases of new products or enhancements by our competitors or by us. For example, in the past we have experienced delays in customer purchasing cycles in response to our introduction of new products or product transitions; we expect that this trend will continue in the future. Product purchases may be, and in the recent past have been, delayed by the volatile U.S. and global economic environment, which introduced additional risk into our ability to accurately forecast sales in a particular quarter. If sales expected from a specific customer for a particular quarter are not realized in that quarter or at all, revenue will be harmed and we may miss our stated guidance for that period.
If we do not successfully anticipate market needs and develop products and product enhancements that meet those needs, or if those products do not gain market acceptance, our business and operating results will be harmed.
We may not be able to anticipate future market needs or be able to develop new products or product enhancements to meet such needs, either on a timely basis or at all. For example, our failure to address additional application-specific protocols, particularly if our competitors are able to provide such functionality, could harm our business. In addition, our inability to diversify beyond our current product offerings could adversely affect our business. Any new products or product enhancements that we introduce, including by way of acquisitions, may not achieve any significant degree of market acceptance or be accepted into our sales channel by our channel partners, which would adversely affect our business and operating results. In addition, the introduction of new products or product enhancements may shorten the life cycle of our existing products, or replace sales of some of our current products, thereby offsetting the benefit of even a successful product introduction, or may cause customers to defer purchasing our existing products in anticipation of the new or enhanced products, any of which could adversely affect our business and operating results.
Acquisitions could disrupt our business and cause dilution to our stockholders.
In February 2009, we acquired Mazu Networks, Inc. In October 2010 and November 2010, we acquired CACE Technologies, Inc. and Global Protocols LLC, respectively. In July 2011, we acquired Zeus Technology Ltd. and Aptimize Ltd. In the future we may acquire other businesses, products or technologies. Our ability as an organization to integrate acquisitions is unproven. Any acquisitions that we complete may not ultimately strengthen our competitive position or achieve our goals, or the acquisition may be viewed negatively by customers, financial markets or investors. In addition, we may encounter difficulties in integrating personnel, operations, technologies or products from the acquired businesses and in retaining and motivating key personnel from these businesses. We may also encounter difficulties in maintaining uniform standards, controls, procedures and policies across locations, or in managing geographically or culturally diverse locations. We may experience significant
problems or liabilities associated with acquired or integrated product quality or technology. Acquisitions may disrupt our ongoing operations, divert management from day-to-day responsibilities and increase our expenses. Acquisitions may reduce our cash available for operations and other uses and could result in an increase in amortization expense related to identifiable assets acquired, potentially dilutive issuances of equity securities or the incurrence of debt.
We rely on third parties to perform shipping and other logistics functions on our behalf. A failure or disruption at a logistics partner would harm our business.
Currently, we use third-party logistics partners to perform storage, packaging, shipment and handling for us. Although the logistics services required by us may be readily available from a number of providers, it is time-consuming and costly to qualify and implement these relationships. If one or more of our logistics partners suffers an interruption in its business, or experiences delays, disruptions or quality control problems in its operations, or we choose to change or add additional logistics partners, our ability to ship products to our customers would be delayed and our business, operating results and financial condition would be adversely affected.
We are susceptible to shortages or price fluctuations in our supply chain. Any shortages or price fluctuations in components used in our products could delay shipment of our products or increase our costs and harm our operating results.
Our use of Riverbed-designed content in our hardware platforms has increased our susceptibility to scarcity or delivery delays for custom components within our systems. Shortages in components that we use in our products have occurred recently and may occur in the future and our suppliers’ ability to predict the availability of such components may be limited. For example, the recent flooding in Thailand has affected the availability of disk drive components and, consequently, increased our costs in procuring those components. Some components that we use are available only from limited sources of supply. In addition, the lead times associated with certain components are lengthy and preclude rapid changes in quantity requirements and delivery schedules. The unavailability of any component that is necessary to the proper functioning of our appliances would prevent us from shipping products. Any inability to ship our products in a timely manner would delay sales and adversely impact our revenue, business, operating results and financial condition.
Any growth in our business or the economy is likely to create greater pressures on us and our suppliers to project overall component demand accurately and to establish optimal component inventory levels. In addition, increased demand by third parties for the components we use in our products may lead to decreased availability and higher prices for those components. We carry limited inventory of our product components, and we rely on suppliers to deliver components in a timely manner based on forecasts we provide. We rely on both purchase orders and long-term contracts with our suppliers, but we may not be able to secure sufficient components at reasonable prices or of acceptable quality, which would seriously impact our ability to deliver products to our customers and, as a result, adversely impact our revenue.
If we fail to accurately predict our manufacturing requirements, we could incur additional costs or experience manufacturing delays, which would harm our business. We are dependent on contract manufacturers, and changes to those relationships, expected or unexpected, may result in delays or disruptions that could harm our business.
We depend on independent contract manufacturers to manufacture and assemble our products. We rely on purchase orders or long-term contracts with our contract manufacturers. Some of our contract manufacturers are not obligated to supply products to us for any specific period, in any specific quantity or at any specific price. Our orders may represent a relatively small percentage of the
overall orders received by our contract manufacturers from their customers. As a result, fulfilling our orders may not be considered a priority by one or more of our contract manufacturers in the event the contract manufacturer is constrained in its ability to fulfill all of its customer obligations in a timely manner. We provide demand forecasts and purchase orders to our contract manufacturers. To the extent that any such demand forecast or purchase order is binding, if we overestimate our requirements, the contract manufacturers may assess charges or we may have liabilities for excess inventory, each of which could negatively affect our gross margins. Conversely, because lead times for required materials and components vary significantly and depend on factors such as the specific supplier, contract terms and the demand for each component at a given time, if we underestimate our requirements, the contract manufacturers may have inadequate materials and components required to produce our products, which could interrupt manufacturing of our products and result in delays in shipments and deferral or loss of revenue.
Although the contract manufacturing services required to manufacture and assemble our products may be readily available from a number of established manufacturers, it is time-consuming and costly to qualify and implement contract manufacturer relationships. Therefore, if one or more of our contract manufacturers suffers an interruption in its business, or experiences delays, disruptions or quality control problems in its manufacturing operations, or we choose to change or add additional contract manufacturers, our ability to ship products to our customers would be delayed and our business, operating results and financial condition would be adversely affected.
In addition, a portion of our manufacturing is performed overseas and is therefore subject to risks associated with doing business in other countries.
We are dependent on various information technology systems, and failures of or interruptions to those systems could harm our business.
Many of our business processes depend upon our information technology systems (“IT”), the systems and processes of third parties, and on interfaces with the systems of third parties. For example, our order entry system provides information to the systems of our contract manufacturers, which enables them to build and ship our products. If those systems fail or are interrupted, or if our ability to connect to or interact with one or more networks is interrupted, our processes may function at a diminished level or not at all. This would harm our ability to ship products, and our financial results would likely be harmed.
In addition, reconfiguring our IT systems or other business processes in response to changing business needs may be time-consuming and costly. To the extent this impacted our ability to react timely to specific market or business opportunities, our financial results would likely be harmed.
If we are unable to protect our intellectual property rights, our competitive position could be harmed or we could be required to incur significant expenses to enforce our rights.
We depend on our ability to protect our proprietary technology. We rely on trade secret, patent, copyright and trademark laws and confidentiality agreements with employees and third parties, all of which offer only limited protection. Despite our efforts, the steps we have taken to protect our proprietary rights may not be adequate to preclude misappropriation of our proprietary information or infringement of our intellectual property rights, and our ability to police such misappropriation or infringement is uncertain, particularly in countries outside of the U.S. Further, with respect to patent rights, we do not know whether any of our pending patent applications will result in the issuance of patents or whether the examination process will require us to narrow our claims, and even if patents are issued, they may be contested, circumvented or invalidated over the course of our business. The invalidation of any of our key patents could benefit our competitors by allowing them to more easily design products similar to ours. Moreover, the rights granted under any issued patents may not provide us with proprietary protection or competitive advantages, and competitors may in any event be able to
develop similar or superior technologies to our own now or in the future. Protecting against the unauthorized use of our products, trademarks and other proprietary rights is expensive, difficult and, in some cases, impossible. Litigation has been necessary in the past and may be necessary in the future to enforce or defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. For example, in the third quarter of 2008 we settled a patent infringement lawsuit with Quantum Corporation where both we and Quantum asserted that the other party infringed a patent or patents. In addition, we are currently engaged in patent infringement litigation against Silver Peak Systems, in which both we and Silver Peak Systems assert patent infringement by the other party. Intellectual property litigation has resulted, and may in the future result, in substantial costs and diversion of management resources, and may in the future harm our business, operating results and financial condition. Furthermore, many of our current and potential competitors have the ability to dedicate substantially greater resources to enforce their intellectual property rights than we do. Accordingly, despite our efforts, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property.
Claims by others that we infringe their proprietary technology could harm our business.
Our industry is, and any industry or market that we may enter in the future may be, characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and other intellectual property rights. In the ordinary course of our business, we are involved in disputes and licensing discussions with others regarding their claimed proprietary rights and we cannot assure you that we will always successfully defend ourselves against such claims. Third parties have claimed and may in the future claim that our products or technology infringe their proprietary rights. For example, in the third quarter of 2008 we settled a patent infringement lawsuit with Quantum Corporation. In addition, in the third quarter of 2011, Silver Peak Systems alleged that we infringe certain of its patents. We expect that infringement claims may increase as the number of products and competitors in any of our markets increases and overlaps occur. In addition, as we have gained greater visibility and market exposure as a public company, we face a higher risk of being the subject of intellectual property infringement claims. Any claim of infringement by a third party, even those without merit, could cause us to incur substantial legal costs defending against the claim, and could distract our management from our business. Furthermore, we could be subject to a judgment or voluntarily enter into a settlement, either of which could require us to pay substantial damages. A judgment or settlement could also include an injunction or other court order that could prevent us from offering our products. In addition, we might elect or be required to seek a license for the use of third-party intellectual property, which may not be available on commercially reasonable terms or at all, or if available, the payments under such license may harm our operating results and financial condition. Alternatively, we may be required to develop non-infringing technology, which could require significant effort and expense and may ultimately not be successful. Any of these events could seriously harm our business, operating results and financial condition. Third parties may also assert infringement claims against our customers and channel partners. Any of these claims would require us to initiate or defend potentially protracted and costly litigation on their behalf, regardless of the merits of these claims, because we generally indemnify our customers and channel partners from claims of infringement of proprietary rights of third parties. If any of these claims succeed, or if we voluntarily enter into a settlement, we may be forced to pay damages on behalf of our customers or channel partners, which could have a material adverse effect on our business, operating results and financial condition.
Our international sales and operations subject us to additional risks that may harm our operating results.
In the year ended December 31, 2011, we derived approximately 45% of our revenue from customers outside the U.S. We have personnel in numerous countries worldwide. We expect to continue to add personnel in additional countries. Our international sales and operations makes us subject to various U.S. and international laws and regulations, including those relating to antitrust, data
protection, and business dealings with both commercial and governmental officials and organizations. Our international sales and operations subject us to a variety of additional risks, including:

the difficulty and cost of managing and staffing international offices and the increased travel, infrastructure, legal and other compliance costs associated with multiple international locations;

difficulties in enforcing contracts and collecting accounts receivable, and longer payment cycles, especially in emerging markets;

tariffs and trade barriers and other regulatory or contractual limitations on our ability to sell or develop our products in certain foreign markets;

the effects of any political instability on the general willingness of our current and prospective customers to make capital commitments;

unfavorable changes in tax treaties or laws;

increased exposure to foreign currency exchange rate risk; and

reduced protection for intellectual property rights in some countries.
As we continue to expand our business globally, our success will depend, in large part, on our ability to anticipate and effectively manage these and other risks associated with our international sales and operations. Our failure to manage any of these risks successfully, or to comply with these laws and regulations, could harm our operations, reduce our sales and harm our business, operating results and financial condition. For example, in certain foreign countries, particularly those with developing economies, certain business practices that are prohibited by laws and regulations applicable to us, such as the Foreign Corrupt Practices Act, may be more commonplace. Although we implement policies and procedures with the intention of ensuring compliance with these laws and regulations, our employees, contractors and agents, as well as channel partners involved in our international sales, may take actions in violation of our policies. Any such violation could have an adverse effect on our business and reputation.
Some of our business partners also have international operations and are subject to the risks described above. Even if we are able to successfully manage the risks of international operations, our business may be adversely affected if our business partners are not able to successfully manage these risks.
Foreign currencies periodically experience rapid fluctuations in value against the U.S. dollar. Any foreign currency devaluation against the U.S. dollar increases the real cost of our products to our customers and partners in foreign markets where we sell in U.S. dollars, which has resulted in the past and may result in the future in delayed or cancelled purchases of our products and, as a result, lower revenues. In addition, this increase in cost increases the risk to us that we will be unable to collect amounts owed to us by such customers or partners, which in turn would impact our revenues and could materially adversely impact our business and financial results. Any devaluation may also lead us to more aggressively discount our prices in foreign markets in order to maintain competitive pricing, which would negatively impact our revenues and gross margins. Conversely, a weakened U.S. dollar could increase the cost of local operating expenses and procurement of raw materials to the extent we purchase components in foreign currencies.
Starting in the first quarter of fiscal 2012, we entered into forward contracts designated as cash flow hedges to protect against foreign currency exchange rate risks. The effectiveness of our hedges depends on our ability to accurately forecast expenses denominated in non-US dollar currencies. As a result, we could incur significant losses from our hedging activities if our forecasts are incorrect. In addition, our hedging activities may be ineffective or may not offset any or more than a portion of the adverse financial impact resulting from currency variations. Gains or losses associated with hedging activities also may impact our profitability.
International customers may also require that we localize our products. The product development costs for localizing the user interface of our products, both graphical and textual, could be a material expense to us if the software requires extensive modifications. To date, such changes have not been extensive, and the costs have not been material.
We are investing in engineering, sales, marketing, services and infrastructure, and these investments may achieve delayed or lower than expected benefits, which could harm our operating results.
We intend to continue to add personnel and other resources to our engineering, sales, marketing, services and infrastructure functions as we focus on developing new technologies, growing our market segment, capitalizing on existing or new market opportunities, increasing our market share, and enabling our business operations to meet anticipated demand. We are likely to recognize the costs associated with these investments earlier than some of the anticipated benefits, and the return on these investments may be lower, or may develop more slowly, than we expect. If we do not achieve the benefits anticipated from these investments, or if the achievement of these benefits is delayed, our operating results may be adversely affected.
If we lose key personnel or are unable to attract and retain personnel on a cost-effective basis, our business would be harmed.
Our success is substantially dependent upon the performance of our senior management and key technical and sales personnel. For example, we believe that our sales execution in the EMEA region in the second quarter of 2011 was negatively impacted by the absence of a dedicated senior sales executive for the region. Our management and employees can terminate their employment at any time, and the loss of the services of one or more of our executive officers or other key employees could harm our business. Our success also is substantially dependent upon our ability to attract additional personnel for all areas of our organization, particularly in our sales, research and development and customer service departments. Competition for qualified personnel is intense, and we may not be successful in attracting and retaining such personnel on a timely basis, on competitive terms, or at all. Additionally, fluctuations or a sustained decrease in the price of our stock could affect our ability to attract and retain key personnel. When our stock price declines, our equity incentive awards may lose retention value, which may negatively affect our ability to attract and retain such key personnel. If we are unable to attract and retain the necessary technical, sales and other personnel on a cost-effective basis, our business, operating results and financial condition would be adversely affected.
We may not generate positive returns on our research and development investments.
Developing our products is expensive, and the investment in product development may involve a long payback cycle or may not generate additional revenue at all. In fiscal 2011, our research and development expenses were $123.0 million, or approximately 17% of our total revenue. Our future plans include significant investments in research and development and related product opportunities. We believe that we must continue to dedicate a significant amount of resources to our research and development efforts to maintain our competitive position. These investments may take several years to generate positive returns, if ever.
Our ability to sell our products is highly dependent on the quality of our support and services offerings, and our failure to offer high quality support and services would harm our operating results and reputation.
Once our products are deployed within our customers’ networks, our customers depend on our support organization to resolve any issues relating to our products. A high level of support is critical for the successful marketing and sale of our products. If we or our channel partners do not effectively
assist our customers in deploying our products, succeed in helping our customers quickly resolve post-deployment issues, and provide effective ongoing support, it would adversely affect our ability to sell our products to existing customers and would harm our reputation with potential customers. In addition, as we expand our operations internationally, our support organization will face additional challenges, including those associated with delivering support, training and documentation in languages other than English. Any failure to maintain high quality support and services would harm our operating results and reputation.
If we fail to manage future growth effectively, our business would be harmed.
We have expanded our operations significantly since inception and anticipate that further significant expansion will be required. This future growth, if it occurs, will place significant demands on our management, infrastructure and other resources. To manage any future growth, we will need to hire, integrate and retain highly skilled and motivated employees. We will also need to continue to improve our financial and management controls, reporting systems and procedures. We have an enterprise resource planning software system that supports our finance, sales and inventory management processes. If we were to encounter delays or difficulties as a result of this system, including loss of data and decreases in productivity, our ability to properly run our business could be adversely impacted. If we do not effectively manage our growth, our business would be harmed. Organizations are increasingly concerned with the security of their data, and to the extent they elect to encrypt data being transmitted from the point of the end user in a format that we’re not able to decrypt, rather than only across the WAN, our products will become less effective.
Our products are designed to remove the redundancy associated with repeated data requests over a WAN, either through a private network or a virtual private network (VPN). The ability of our products to reduce such redundancy depends on our products’ ability to recognize the data being requested. Our products currently detect and decrypt some forms of encrypted data. Since most organizations currently encrypt most of their data transmissions only between sites and not on the LAN, the data is not encrypted when it passes through our products. For those organizations that elect to encrypt their data transmissions from the end-user to the server in a format that we are not able to decrypt, our products will offer limited performance improvement unless we are successful in incorporating additional functionality into our products that address those encrypted transmissions. Our failure to provide such additional functionality could limit the growth of our business and harm our operating results.
If our products do not interoperate with our customers’ infrastructure, installations could be delayed or cancelled, which would harm our business.
Our products must interoperate with our customers’ existing infrastructure, which often have different specifications, utilize multiple protocol standards, deploy products from multiple vendors, and contain multiple generations of products that have been added over time. If we find errors in the existing software or defects in the hardware used in our customers’ infrastructure or problematic network configurations or settings, as we have in the past, we may have to modify our software or hardware so that our products will interoperate with our customers’ infrastructure. In such cases, and others, our products may be unable to provide significant performance improvements for applications deployed in our customers’ infrastructure. These issues could cause longer installation times for our products and could cause order cancellations, either of which would adversely affect our business, operating results and financial condition. In addition, government and other customers may require our products to comply with certain security or other certifications and standards. If our products are late in achieving or fail to achieve compliance with these certifications and standards, or our competitors achieve compliance with these certifications and standards, we may be disqualified from selling our products to such customers, or at a competitive disadvantage, which would harm our business, operating results and financial condition.
If functionality similar to that offered by our products is incorporated into existing network infrastructure products, organizations may decide against adding our products to their network, which would harm our business.
Other providers of network infrastructure products, including our partners, are offering or announcing functionality aimed at addressing the problems addressed by our products. For example, Cisco Systems incorporates WAN optimization functionality into certain of its router blades. The inclusion of, or the announcement of intent to include, functionality perceived to be similar to that offered by our products in products that are already generally accepted as necessary components of network architecture or in products that are sold by more established vendors may have an adverse effect on our ability to market and sell our products. Furthermore, even if the functionality offered by other network infrastructure providers is more limited than our products, a significant number of customers may elect to accept such limited functionality in lieu of adding appliances from an additional vendor. Many organizations have invested substantial personnel and financial resources to design and operate their networks and have established deep relationships with other providers of network infrastructure products, which may make them reluctant to add new components to their networks, particularly from new vendors. In addition, an organization’s existing vendors or new vendors with a broad product offering may be able to offer concessions that we are not able to match because we currently offer a focused line of products and have fewer resources than many of our competitors. If organizations are reluctant to add network infrastructure products from new vendors or otherwise decide to work with their existing vendors, our business, operating results and financial condition will be adversely affected.
Our products are highly technical and may contain undetected software or hardware errors. These errors, and any related claims against our products, could cause harm to our reputation and our business.
Our products, including software product upgrades and releases, are highly technical and complex and, when deployed, are critical to the operation of many networks. Our products have contained and may contain undetected errors, defects or security vulnerabilities. In particular, new products and product platforms may be subject to increased risk of hardware issues. Some errors in our products may be discovered only after a product has been installed and used by customers. Some of these errors may be attributable to third-party technologies incorporated into our products, which makes us dependent upon the cooperation and expertise of such third parties for the diagnosis and correction of such errors. The diagnosis and correction of third-party technology errors is particularly difficult where our product features the RSP, because it is not always immediately clear whether a particular error is attributable to a technology incorporated into our product or to the third-party RSP software deployed on our product. In addition, our RSP solutions, because they involve a third-party, are more complex, and the solutions may lead to new technical errors that may prove difficult to diagnose and support. Any delay or mistake in the initial diagnosis of an error will result in a delay in the formulation of an effective action plan to correct such error. Any errors, defects or security vulnerabilities discovered in our products after commercial release could result in loss of revenue or delay in revenue recognition, loss of customers and increased service and warranty cost, any of which could harm our reputation, business, operating results and financial condition. Any such errors, defects or security vulnerabilities could also adversely affect the market’s perception of our products and business. In addition, we could face claims for product liability, tort or breach of warranty, including claims relating to changes to our products made by our channel partners. Our contracts with customers contain provisions relating to warranty disclaimers and liability limitations, which may not be upheld. Defending a lawsuit, regardless of its merit, is costly and may divert management’s attention and harm the market’s perception of us and our products. In addition, if our business liability insurance coverage proves inadequate or future coverage is unavailable on acceptable terms or at all, our business, operating results and financial condition could be adversely impacted.
Our use of open source and third-party software could impose limitations on our ability to commercialize our products.
We incorporate open source software into our products. Although we monitor our use of open source closely, the terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that such licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to commercialize our products. We could also be subject to similar conditions or restrictions should there be any changes in the licensing terms of the open source software incorporated into our products. In either event, we could be required to seek licenses from third parties in order to continue offering our products, to re-engineer our products or to discontinue the sale of our products in the event re-engineering cannot be accomplished on a timely or successful basis, any of which could adversely affect our business, operating results and financial condition.
We also incorporate certain third-party technologies, including software programs, into our products and may need to utilize additional third-party technologies in the future. However, licenses to relevant third-party technology may not continue to be available to us on commercially reasonable terms, or at all. Therefore, we could face delays in product releases until equivalent technology can be identified, licensed or developed, and integrated into our current products. These delays, if they occur, could materially adversely affect our business, operating results and financial condition. We currently use third-party software programs in our appliance and software products, some of which are currently available from only one vendor. Any disruption in our access to these or other software programs or third-party technologies could result in significant delays in our product releases and could require substantial effort to locate or develop a replacement program. If we decide in the future to incorporate into our products any other software program licensed from a third party, and the use of such software program is necessary for the proper operation of our appliances, then our loss of any such license would similarly adversely affect our ability to release our products in a timely fashion.
We are subject to various regulations that could subject us to liability or impair our ability to sell our products.
Our products are subject to a variety of government regulations, including export controls, import controls, environmental laws and required certifications. For example, our products are subject to export controls of the U.S. and other countries and may be exported outside the U.S. and other countries only with the required level of export license or through an export license exception, because we incorporate encryption technology into our products. In addition, various countries regulate the import of certain encryption technology and have enacted laws that could limit our ability to distribute our products or could limit our customers’ ability to implement our products in those countries. Changes in our products or changes in regulations may increase the cost of building and selling our products, create delays in the introduction of our products in international markets, prevent our customers with international operations from deploying our products throughout their global systems or, in some cases, prevent the export or import of our products to certain countries altogether. Any change in regulations, shift in approach to the enforcement or scope of existing regulations, or change in the countries, persons or technologies targeted by such regulations, could result in decreased use of our products by, or in our decreased ability to export or sell our products to, existing or potential customers with international operations. We must comply with various and increasing environmental regulations, both domestic and international, regarding the manufacturing and disposal of our products. For example, we must comply with Waste Electrical and Electronic Equipment Directive laws, which are being adopted by certain European Economic Area countries on a country-by-country basis. Failure to comply with these and similar laws on a timely basis, or at all, could have a material adverse effect on our business, operating results and financial condition. This would also be true if we fail to comply, either on a timely basis or at all, with any U.S. environmental laws regarding the manufacturing or disposal of our products. Any decreased use of our products or limitation on our ability to export or sell our products would harm our business, operating results and financial condition.
We compete in rapidly evolving markets and have a limited operating history, which makes it difficult to predict our future operating results.
We were incorporated in May 2002 and shipped our first Steelhead appliance in May 2004. We have a limited operating history and offer a focused line of products in an industry characterized by rapid technological change. It is very difficult to forecast our future operating results. You should consider and evaluate our prospects in light of the risks and uncertainty frequently encountered by companies in rapidly evolving markets characterized by rapid technological change, changing customer needs, increasing competition, evolving industry standards and frequent introductions of new products and services. As we encounter rapidly changing customer requirements and increasing competitive pressures, we likely will be required to reposition our product and service offerings and introduce new products and services. We may not be successful in doing so in a timely and appropriately responsive manner, or at all. Furthermore, many of our target customers have not purchased products similar to ours and might not have a specific budget for the purchase of our products and services. All of these factors make it difficult to predict our future operating results.
We incur significant costs as a result of operating as a public company, and our management devotes substantial time to new compliance initiatives.
We incur significant legal, accounting and other expenses as a public company, including costs resulting from regulations regarding corporate governance practices and costs relating to compliance with Section 404 of the Sarbanes-Oxley Act. For example, the listing requirements of the Nasdaq Stock Market’s Global Select Market require that we satisfy certain corporate governance requirements relating to independent directors, audit committees, distribution of annual and interim reports, stockholder meetings, stockholder approvals, solicitation of proxies, conflicts of interest, stockholder voting rights and codes of conduct. In addition, the recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act contains various provisions applicable to the corporate governance functions of public companies. Our management and other personnel devote a substantial amount of time to these compliance initiatives. Moreover, these rules and regulations have increased our legal and financial compliance costs and will make some activities more time-consuming and costly. For example, these rules and regulations could make it more difficult for us to attract and retain qualified persons to serve on our Board of Directors, our board committees or as executive officers.
While we believe that we currently have adequate internal controls over financial reporting, we are exposed to risks from legislation requiring companies to evaluate those internal controls.
The Sarbanes-Oxley Act requires that we test our internal controls over financial reporting and disclosure controls and procedures. In particular, for the year ended December 31, 2011, we performed system and process evaluation and testing of our internal controls over financial reporting to allow management and our independent registered public accounting firm to report on the effectiveness of our internal controls over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act. Our compliance with Section 404 requires that we incur substantial expense and expend significant management time on compliance-related issues. Moreover, if we are not able to comply with the requirements of Section 404 in the future, or if we or our independent registered public accounting firm identify deficiencies in our internal controls over financial reporting that are deemed to be material weaknesses, the market price of our stock may decline and we could be subject to sanctions or investigations by the Nasdaq Stock Market’s Global Select Market, the SEC or other regulatory authorities, which would require significant additional financial and management resources.
Changes in financial accounting standards may cause adverse unexpected revenue fluctuations and affect our reported results of operations.
A change in accounting policies can have a significant effect on our reported results and may even affect our reporting of transactions completed before the change is effective. New pronouncements and
varying interpretations of existing pronouncements have occurred with frequency and may occur in the future. Changes to existing rules, or changes to the interpretations of existing rules, could lead to changes in our accounting practices, and such changes could adversely affect our reported financial results or the way we conduct our business.
We are required to expense equity compensation given to our employees, which has reduced our reported earnings, will harm our operating results in future periods and may reduce our stock price and our ability to effectively utilize equity compensation to attract and retain employees.
We historically have used stock options, restricted stock units (RSU), and an employee stock purchase plan as significant components of our employee compensation program in order to align employees’ interests with the interests of our stockholders, encourage employee retention, and provide competitive compensation packages. The compensation charges that we are required to record related to these equity awards have reduced, and will continue to reduce, our reported earnings, will harm our operating results in future periods, and may require us to reduce the availability and amount of equity incentives provided to employees, which could make it more difficult for us to attract, retain and motivate key personnel. Moreover, if securities analysts, institutional investors and other investors adopt financial models that include stock option expense in their primary analysis of our financial results, our stock price could decline as a result of reliance on these models with higher expense calculations.
We may have exposure to greater than anticipated tax liabilities.
Our provision for income taxes is subject to volatility and could be adversely affected by nondeductible stock-based compensation, changes in the research and development tax credit laws, earnings being lower than anticipated in jurisdictions where we have lower statutory rates and being higher than anticipated in jurisdictions where we have higher statutory rates, transfer pricing adjustments, not meeting the terms and conditions of tax holidays or incentives, changes in the valuation of our deferred tax assets and liabilities, changes in actual results versus our estimates, or changes in tax laws, regulations, accounting principles or interpretations thereof. In addition, like other companies, we may be subject to examination of our income tax returns by the U.S. Internal Revenue Service and other tax authorities. While we regularly assess the likelihood of adverse outcomes from such examinations and the adequacy of our provision for income taxes, there can be no assurance that such provision is sufficient and that a determination by a tax authority will not have an adverse effect on our results of operations.
If we fail to successfully manage our exposure to the volatility and economic uncertainty in the global financial marketplace, our operating results could be adversely impacted.
We are exposed to financial risk associated with the global financial markets, including volatility in interest rates and uncertainty in the credit markets. Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. The primary objective of our investment activities is to preserve principal, maintain adequate liquidity and portfolio diversification while at the same time maximizing yields without significantly increasing risk. However, the valuation of our investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact its valuation include changes to credit ratings of the securities that we hold, interest rate changes, the ongoing strength and quality, and recent instability, of the global credit market, and liquidity. If the carrying value of our investments exceeds the fair value, and the decline in fair value is deemed to be other-than-temporary, we will be required to write down the value of our investments. Additionally, instability and uncertainty in the financial markets, as has been recently experienced, could result in the incurrence of significant realized or impairment losses associated with certain of our investments, which would reduce our net income.
If we need additional capital in the future, it may not be available to us on favorable terms, or at all.
We have historically relied on outside financing and cash flow from operations to fund our operations, capital expenditures and expansion. We may require additional capital from equity or debt financing in the future to fund our operations or respond to competitive pressures or strategic opportunities. We may not be able to secure timely additional financing on favorable terms, or at all. The terms of any additional financing may place limits on our financial and operating flexibility. If we raise additional funds through further issuances of equity, convertible debt securities or other securities convertible into equity, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. If we are unable to obtain adequate financing or financing on terms satisfactory to us, if and when we require it, our ability to grow or support our business and to respond to business challenges could be significantly limited.
Our business is subject to the risks of earthquakes, fire, floods, pandemics and other natural catastrophic events, and to interruption by manmade problems such as computer viruses, break-ins or terrorism.
Our main operations, including our primary data center, are located in the San Francisco Bay Area, a region known for seismic activity. A significant natural disaster, such as an earthquake, fire or a flood, could disrupt our operations and therefore harm our business, operating results and financial condition. A natural disaster could also impact our ability to manufacture and deliver our products to customers, or provide support to our customers, any of which would harm our business, operating results and financial condition. In addition, our servers are vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems, which could result in the theft of intellectual property, customer information or other sensitive data. Any of these incidents could result in both legal and reputational costs. Natural disasters, acts of unrest or terrorism or war could also cause disruptions in our or our customers’ business, our domestic and international markets, or the economy as a whole. To the extent that such disruptions result in delays or cancellations of customer orders or the deployment of our products, our business, operating results and financial condition would be adversely affected.
Risks Related to Ownership of Our Common Stock
The trading price of our common stock has been volatile and is likely to be volatile in the future.
The trading prices of the securities of technology companies, including our own, have been highly volatile. Further, our common stock has a limited trading history. Since our initial public offering in September 2006 through December 31, 2011, our stock price, after adjusting for our 2:1 stock split in the form of a stock dividend effected in November 2010, has fluctuated from a low of $3.55 to a high of $44.70. The market price of our common stock has at times reflected a higher multiple of expected future earnings than many other companies. As a result, even small changes in investor expectations regarding our future growth and earnings, whether as a result of actual or rumored financial or operating results, changes in the mix of products and services sold, acquisitions, industry changes, or other factors, could result in, and have recently resulted in, significant fluctuations in the market price of our common stock.
Factors that could affect the trading price of our common stock include, but are not limited to:

variations in our operating results;

announcements of technological innovations, new services or service enhancements, strategic alliances or significant agreements by us or by our competitors;

the gain or loss of significant customers;

recruitment or departure of key personnel;

providing estimates of our future operating results, or changes of these estimates, either by us or by any securities analysts who follow our common stock, or changes in recommendations by any securities analysts who follow our common stock;

significant sales or purchases, or announcement of significant sales or purchases, of our common stock by us or our stockholders, including our directors and executive officers;

announcements by or about us regarding events or news adverse to our business;

market conditions in our industry, the industries of our customers and the economy as a whole;

adoption or modification of regulations, policies, procedures or programs applicable to our business;

an announced acquisition of or by a competitor; and

an announced acquisition of or by us.
If the market for technology stocks or the stock market in general experiences loss of investor confidence, the trading price of our common stock could decline for reasons unrelated to our business, operating results or financial condition. The trading price of our common stock might also decline in reaction to announcements by, or events that affect, other companies in our industry, or the trading price might decline in reaction to events that affect the stock market generally even if these announcements or events do not directly affect us. Each of these factors, among others, could cause our stock price to decline. Some companies that have had volatile market prices for their securities have had securities class actions filed against them. If such a suit were filed against us, regardless of its merits or outcome, it could result in substantial costs and divert management’s attention and resources.
If securities or industry analysts do not publish research or publish inaccurate or unfavorable research about our business, our stock price and trading volume could decline.
The trading market for our common stock will continue to depend in part on the research and reports that securities or industry analysts publish about us or our business. If we do not continue to maintain adequate research coverage or if one or more of the analysts who covers us downgrades our stock or publishes inaccurate or unfavorable research about our business, our stock price would likely decline. If one or more of these analysts ceases coverage of our company or fails to publish reports on us regularly, demand for our stock could decrease, which could cause our stock price and trading volume to decline.
Anti-takeover provisions in our charter documents and Delaware law could discourage, delay or prevent a change in control of our company and may affect the trading price of our common stock.
We are a Delaware corporation and the anti-takeover provisions of the Delaware General Corporation Law may discourage, delay or prevent a change in control by prohibiting us from engaging in a business combination with an interested stockholder for a period of three years after the person becomes an interested stockholder, even if a change in control would be beneficial to our existing stockholders. In addition, our restated certificate of incorporation and amended and restated bylaws contain provisions that may discourage, delay or prevent a change in our management or control over us that stockholders may consider favorable.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
We lease approximately 102,358 square feet of office space in San Francisco, California pursuant to a lease that expires in 2014. In February 2012, we entered into a lease for approximately 167,000 square feet of office space in San Francisco, California for our new worldwide corporate headquarters. In addition, we lease approximately 46,000 square feet and 33,000 square feet of office space in Sunnyvale, California pursuant to leases that expire in 2013 and 2021, respectively. We maintain support centers in New York, the San Francisco Bay Area, Amsterdam, London, Singapore, Sydney and Tokyo, and sales offices in multiple locations worldwide. We believe that our current facilities are suitable and adequate to meet our current needs, and we intend to add new facilities or expand existing facilities as necessary.
Item 3.
Item 3. Legal Proceedings
On June 1, 2011, we served Silver Peak Systems, Inc. with a lawsuit, filed in the United States District Court for the District of Delaware, alleging infringement of certain patents. The lawsuit seeks unspecified damages and injunctive relief. On July 22, 2011, Silver Peak Systems denied the allegations and requested declaratory judgments of invalidity and non-infringement.
On August 17, 2011, Silver Peak Systems amended its counterclaims against us, alleging infringement by Riverbed of certain patents. The lawsuit seeks unspecified damages and injunctive relief. On September 20, 2011, we denied Silver Peak Systems’ allegations and requested declaratory judgments of invalidity and non-infringement.
On December 21, 2011, we amended our lawsuit against Silver Peak Systems to allege infringement of an additional patent.
At this time we are unable to estimate any range of reasonably possible loss relating to these actions. Discovery is ongoing, and trial is currently scheduled to begin on July 29, 2013. We believe that we have meritorious defenses to the counterclaims against us, and we intend to vigorously contest these counterclaims.
From time to time, we are subject to various legal proceedings, claims and litigation arising in the ordinary course of business. We do not believe we are party to any currently pending legal proceedings the outcome of which may have a material adverse effect on our financial position, results of operations or cash flows.
There can be no assurance that existing or future legal proceedings arising in the ordinary course of business or otherwise will not have a material adverse effect on our financial position, results of operations or cash flows.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
Part II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information for Common Stock
Our common stock has traded on Nasdaq under the symbol “RVBD” since our initial public offering on September 20, 2006, first on the Nasdaq Global Market and, since January 1, 2008, on the Nasdaq Global Select Market. Prior to our initial public offering, there was no public market for our common stock.
The following table sets forth for the indicated periods the high and low sales prices of our common stock as reported by the Nasdaq Global Select Market.
The last reported sale price for our common stock on the Nasdaq Global Select Market was $27.57 per share on February 8, 2012.
Dividend Policy
We have never paid any cash dividends on our common stock. Our board of directors currently intends to retain any future earnings to support operations and to finance the growth and development of our business and does not intend to pay cash dividends on our common stock for the foreseeable future. Any future determination related to our dividend policy will be made at the discretion of our board of directors.
Stockholders
As of January 26, 2012, there were 46 registered stockholders of record of our common stock. Because many of our shares of common stock are held by brokers or other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by the record holders.
Stock Performance Graph
The graph set forth below compares the cumulative total stockholder return on our common stock between September 21, 2006 (the date of our initial public offering) and December 31, 2011, with the cumulative total return of (i) the Nasdaq Computer Index and (ii) the Nasdaq Composite Index, over the same period. This graph assumes the investment of $100 on September 21, 2006 in our common stock, the Nasdaq Computer Index and the Nasdaq Composite Index, and assumes the reinvestment of dividends, if any. We have never paid dividends on our common stock and have no present plans to do so. The graph assumes the initial value of our common stock on September 21, 2006 was the closing sales price of $7.65 per share.
The comparisons shown in the graph below are based upon historical data and are not intended to suggest future performance. This performance graph shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the Exchange Act), or incorporated by reference into any filing of ours under the Securities Act of 1933, as amended, or the Exchange Act, except as shall be expressly set forth by specific reference in such filing.
Recent Sales of Unregistered Securities
None
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
The following table summarizes the stock repurchase activity for the three months ended December 31, 2011 and the approximate dollar value of shares that may yet be purchased pursuant to our stock repurchase program:
(1) On August 19, 2011, our Board of Directors authorized a Share Repurchase Program, which authorizes us to repurchase up to $150.0 million of our outstanding common stock. The Share Repurchase Program will expire in August 2013.
(2) During the fourth quarter of 2011, we repurchased 625,610 shares of common stock under this Program for an aggregate purchase price of approximately $15.0 million, or a weighted average
of $24.01 per share. These shares were purchased in open market transactions. The timing and amounts of these purchases were based on market conditions and other factors including price, regulatory requirements and capital availability. The share repurchases were financed by available cash balances and cash from operations.
Item 6.
Item 6. Selected Financial Data
The following selected consolidated financial data should be read in conjunction with our audited consolidated financial statements and related notes thereto and with Management’s Discussion and Analysis of Financial Condition and Results of Operations, which are included in this Annual Report on Form 10-K. The consolidated statement of operations data for the years ended December 31, 2011, 2010 and 2009, and the selected consolidated balance sheet data as of December 31, 2011 and 2010 are derived from, and are qualified by reference to, the audited consolidated financial statements included in this Annual Report on Form 10-K. The consolidated statement of operations data for the years ended December 31, 2008 and 2007, and the consolidated balance sheet data as of December 31, 2009, 2008 and 2007 are derived from audited consolidated financial statements, which are not included in this Annual Report on Form 10-K.
(1) Includes stock-based compensation and related payroll tax expenses as follows:
(2) “Other charges” consists of amounts paid in settlement of litigation with Quantum Corporation during fiscal 2008.
(3) Includes acquisition-related costs from amortization of purchased intangibles, retention bonuses for acquired employees, contingent consideration to be paid to employees recorded as compensation expense, adjustments to the fair value of contingent consideration to be paid to stockholders, foreign exchange losses on acquisition-related contingent consideration, and acquisition-related and integration costs as follows:
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. The information in this Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act, and Section 21E of the Exchange Act. Such statements are based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical facts may be deemed to be forward-looking statements, including statements under the headings “The Riverbed Strategy,” “Major Trends Affecting our Financial Results” and statements regarding our revenue, gross margin, expenses, and future liquidity requirements. For example, words such as “may,” “will,” “should,” “estimates,” “predicts,” “potential,” “continue,” “strategy,” “believes,” “anticipates,” “plans,” “expects,” “intends” and similar expressions are intended to identify forward-looking statements. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those discussed elsewhere in this Annual Report on Form 10-K in the section titled “Risk Factors” and the risks discussed in our other SEC filings. We undertake no obligation to publicly release any revisions to or otherwise update the forward-looking statements after the date of this Annual Report on Form 10-K.
Overview
We were founded in May 2002 by experienced industry leaders with a vision to improve the performance of wide-area distributed computing. We began commercial shipments of our Steelhead products in May 2004 and have since sold our products to over 17,000 customers worldwide. We offer several product lines including Steelhead appliances directed at the WAN optimization market, Cascade products in the network performance management market, our Stingray product line which competes in the virtual application delivery controller market, and our Whitewater cloud storage gateway directed at the cloud back up and disaster recovery solution market.
We are headquartered in San Francisco, California. Our personnel are located throughout the U.S. and in approximately thirty countries worldwide. We expect to continue to add personnel in the U.S. and internationally to provide additional geographic sales, research and development, general and administrative and technical support coverage.
The Riverbed Strategy
Our goal is to establish our solutions as the preeminent performance and efficiency standard for organizations relying on wide-area distributed computing. Key elements of our strategy include:

Build a unified performance platform - Riverbed is the performance company. Our vision is to give customers the tools to create the highest performing IT environment possible, enabling users everywhere to be more productive while giving IT teams greater control over their enterprises’ technology resources. Our vision focuses on the intersection of applications, networks, and storage, and brings customers a single, unified view of performance in their distributed environment;

Maintain and extend our technological advantages - We believe that we offer the broadest ability to enable rapid, reliable access to applications and data for our customers. We intend to enhance our position as a leader and innovator in the WAN optimization market. We also intend to continue to sell new capabilities, such as our new cloud solutions, into our installed base and to new customers. Continuing investments in research and development are critical to maintaining our technological advantage;

Enhance and extend our product lines - We plan to introduce enhancements to our product capabilities in order to address our customers’ size and application requirements. We also plan to introduce new products to extend our market and utilize our technology platform to extend our capabilities;

Extend our technology partner ecosystem - We plan to enhance our product capabilities via integration of partner technologies, in particular by increasing the selection of third-party applications on the Riverbed Services Platform;

Increase market awareness - To generate increased demand for our products, we will continue promoting our brand and the effectiveness of our comprehensive IT performance solutions;

Scale our distribution channels - Growth in revenue and increase in market share are key goals for us. We sell our products directly through our sales force and indirectly through channel partners. We derived 96% of our revenue through indirect channels in 2011. We intend to expand our direct sales force and leverage our indirect channels to extend our geographic reach and market penetration; and

Enhance and extend our support and services capabilities - On an ongoing basis, we plan to enhance and extend our support and services capabilities to continue to support our growing global customer base.
Major Trends Affecting Our Financial Results
Company outlook
We believe that our current value proposition, which enables customers to improve the performance of their applications and access to their data across WANs, while also offering the ability to simplify IT infrastructure and realize significant capital and operating cost savings, should allow us to continue to grow our business. Our product revenue growth rate will depend significantly on continued growth in the WAN optimization, network performance management, and the virtual application delivery controller markets, and our ability to continue to attract new customers in those markets and generate additional sales from existing customers. Our growth in support and services revenue is dependent upon increasing the number of products under support contracts, which is dependent on both growing our installed base of customers and renewing existing support contracts. Our future profitability and rate of growth will be directly affected by the continued acceptance of our products in the marketplace, as well as the timing and size of orders, product mix, average selling prices and costs of our products and general economic conditions. Our ability to achieve profitability in the future will also be affected by the extent to which we must incur additional expenses to expand our sales, support, marketing, development, and general and administrative capabilities to grow our business. The largest component of our expenses is personnel costs. Personnel costs consist of salaries, benefits and incentive compensation for our employees, including commissions for sales personnel and stock-based compensation.
Revenue
Our revenue has grown rapidly since we began shipping products in May 2004, increasing from $2.6 million in 2004 to $726.5 million in 2011. Revenue grew by 32% in 2011 from $551.9 million in 2010. We believe that our revenue growth in 2010 and 2011, is a positive sign that our products have a significant value proposition to our customers and that the markets that we compete in are still expanding.
Costs and Expenses
Operating expenses consist of sales and marketing, research and development, general and administrative expenses, and acquisition-related costs. Personnel-related costs, including stock-based
compensation, are the most significant component of each of these expense categories. As of December 31, 2011, we had 1,610 employees, an increase of 29% from the 1,244 employees at December 31, 2010. The increase in employees is the most significant driver behind the increase in costs and operating expenses in 2011. The increase in employees was required to support our increased revenue. The timing of additional hires has and could materially affect our operating expenses, both in absolute dollars and as a percentage of revenue, in any particular period.
Stock-based Compensation Expense
Stock-based compensation expense and related payroll taxes were $97.2 million, $73.9 million, and $56.7 million in the years ended December 31, 2011, 2010, and 2009 respectively. We expect to continue to incur significant stock-based compensation expense and anticipate further growth in stock-based compensation expense as our employee base grows because we expect stock-based compensation to continue to play an important part in the overall compensation structure for our employees.
Stock-based compensation expense and related payroll tax was as follows:
Acquisitions
In the third quarter of 2011, we acquired Zeus Technology Ltd. and Aptimize Ltd., to expand our product offerings in the virtual application delivery controller and web content optimization markets. Combined, the total acquisition date fair value of consideration transferred was approximately $136.7 million, which included initial payments of $121.5 million in cash, of which $22.8 million was placed in escrow to secure the sellers’ indemnification obligations, $0.8 million was paid upon delivery of the final Aptimize closing balance sheet, $1.4 million was paid upon the finalization of the Zeus closing balance sheet and the estimated fair value of acquisition-related contingent consideration of $14.6 million. Also included in the initial payments were $1.6 million of prepaid compensation costs. We have preliminarily recorded $95.8 million of goodwill, $52.5 million of identifiable intangible assets, including $2.6 million of in-process technology, deferred tax liabilities of $7.9 million and $3.7 million of net other tangible liabilities related to these acquisitions. The results of operations of these companies are included in our consolidated results for the period subsequent to the respective acquisition dates. In 2011, we recognized $6.8 million in revenue from the sale of these acquired companies’ products and services and we recognized $19.0 million of operating expenses, which included $4.3 million of acquisition-related intangible amortization, $1.0 million of stock-based compensation costs and $1.3 million of acquisition-related compensation costs.
During fiscal 2010, we acquired two companies to expand our product offerings. These acquisitions were not significant, individually or in the aggregate. Combined, the total purchase price for these acquisitions was approximately $26.8 million, which was paid in cash. We recorded $13.8 million of goodwill, $16.8 million of identifiable intangible assets, including $3.3 million of in-process technology intangible assets, $3.3 million of deferred tax liabilities, and $0.5 million of net tangible liabilities. The results of operations of these companies are included in our consolidated results for the
period subsequent to the respective acquisition dates. In the year ended December 31, 2010, we recognized $1.1 million in revenue from the sale of these acquired companies’ products and services, and we recognized $2.9 million of operating expenses, which included $0.6 million of acquisition-related intangible amortization, $0.6 million of transaction and integration costs, $0.5 million of acquisition-related compensation costs and $0.2 million of stock based compensation costs.
During 2009, we acquired Mazu Networks, Inc. (Mazu). The results of operations of Mazu are included in our consolidated results for the period subsequent to the acquisition date. In the years ended December 31, 2010 and 2009, we recognized $27.7 million and $9.7 million in revenue, respectively, from the sale of Mazu products and services. In the years ended December 31, 2010 and 2009, we recognized $1.4 million and $2.4 million, respectively, of acquisition-related compensation costs.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP). These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our consolidated financial statements could be adversely affected.
The accounting policies that reflect our more significant estimates, judgments and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following: revenue recognition, stock-based compensation, goodwill, intangible assets and impairment assessment, accounting for business combinations, accounting for income taxes and inventory valuation. Our critical accounting policies have been discussed with the Audit Committee of the Board of Directors.
Revenue Recognition
We recognize revenue when all of the following have occurred: (1) we have entered into a legally binding arrangement with a customer; (2) delivery has occurred; (3) customer payment is deemed fixed or determinable and free of contingencies and significant uncertainties; and (4) collection is reasonably assured.
The majority of our product revenue includes hardware appliances containing software components that function together to provide the essential functionality of the product. Therefore, our hardware appliances are considered non-software deliverables. Most non-software products and services qualify as separate units of accounting because they have value to the customer on a standalone basis and our revenue arrangements generally do not include a general right of return relative to delivered products. We account for non-software arrangements with multiple deliverables, which generally include support services sold with each of our hardware appliances, using the relative selling price method under the revenue recognition guidance for multiple deliverable arrangements.
Our product revenue also includes revenue from the sale of stand-alone software products. Stand-alone software may operate on our hardware appliance, but does not function with the hardware to deliver the product’s essential functionality. Stand-alone software products generally include a perpetual license to our software. Stand-alone software sales are subject to the industry specific software revenue recognition guidance.
Certain arrangements with multiple deliverables may have stand-alone software deliverables that are subject to the software revenue recognition guidance along with non-software deliverables. The revenue for these multiple deliverable arrangements is allocated to the stand-alone software deliverables as a group and the non-software deliverables based on the relative selling prices of all of the deliverables in the arrangement.
The amount of product and services revenue recognized for arrangements with multiple deliverables is impacted by our valuation of relative selling prices. We apply the selling price hierarchy using vendor specific objective evidence (VSOE) when available, third-party evidence of selling price (TPE) if VSOE does not exist, and estimated selling price (ESP) if neither VSOE nor TPE is available.
VSOE of fair value for elements of an arrangement is based upon the normal pricing and discounting practices for a deliverable when sold separately, and VSOE for support services is further measured by the renewal rate offered to the customer. In determining VSOE, we require that a substantial majority of the selling prices fall within a reasonably narrow pricing range, generally evidenced by a substantial majority of such historical stand-alone transactions falling within a reasonably narrow range of the median rates. In addition, we consider major service groups, geographies, customer classifications, and other variables in determining VSOE.
We are typically not able to determine TPE for our products or services. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, our go-to-market strategy differs from that of our peers and our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, we are unable to reliably determine what similar competitor products’ selling prices are on a stand-alone basis.
When we are unable to establish the estimated stand-alone value of our non-software deliverables using VSOE or TPE, we use ESP in our allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine ESP for a product or service by considering multiple factors including, but not limited to, cost of products, gross margin objectives, pricing practices, geographies, customer classes and distribution channels.
For stand-alone software sales, we recognize revenue based on software revenue recognition guidance. Under the software revenue recognition guidance, we use the residual method to recognize revenue when an agreement includes one or more elements to be delivered at a future date and VSOE of the fair value of all undelivered elements exists. In the majority of our contracts, the only element that remains undelivered at the time of delivery of the product is support services. Under the residual method, the fair value of the undelivered stand-alone software, which is typically support services, is deferred and the remaining portion of the contract fee is recognized as product revenue. If evidence of the fair value of one or more undelivered stand-alone software elements does not exist, all revenue is generally deferred and recognized when delivery of those elements occurs or when fair value can be established. When the undelivered stand-alone software for which we do not have VSOE of fair value is support, revenue for the entire arrangement is bundled and recognized ratably over the support period.
For our non-software deliverables, we allocate the arrangement consideration based on the relative selling price of the deliverables. For our hardware appliances we use the ESP of the deliverable. For our support and services, we generally use VSOE as our relative selling price. When we are unable to establish VSOE for our support and services, we use ESP in our allocation of arrangement consideration. We regularly review VSOE and ESP. As our go-to-market strategies evolve, we may modify our pricing practices in the future, which could result in changes in selling prices, including both VSOE and ESP.
For sales to direct end-users and channel partners, including value-added resellers, value-added distributors, service providers, and systems integrators, we recognize product revenue upon delivery, assuming all other revenue recognition criteria are met. For our hardware appliances, delivery occurs upon transfer of title and risk of loss, which is generally upon shipment. It is our practice to identify an end-user prior to shipment to a channel partner. For end-users and channel partners, we generally have no significant obligations for future performance such as rights of return or pricing credits. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue.
Support and services consist of support services, professional services, and training. Support services include repair and replacement of defective hardware appliances, software updates and access to technical support personnel. Software updates provide customers with rights to unspecified software product upgrades and to maintenance releases and patches released during the term of the support period. Revenue for support services is recognized on a straight-line basis over the service contract term, which is typically one to three years. Professional services are recognized upon delivery or completion of performance. Professional service arrangements are typically short term in nature and are largely completed within 90 days from the start of service. Training services are recognized upon delivery of the training.
Our fees are typically considered to be fixed or determinable at the inception of an arrangement, generally based on specific products and quantities to be delivered. Substantially all of our contracts do not include rights of return or acceptance provisions. To the extent that our agreements contain such terms, we recognize revenue once the acceptance provisions or right of return lapses. Payment terms to customers generally range from net 30 to 75 days. In the event payment terms are provided that differ from our standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payments become due, provided the remaining criteria for revenue recognition have been met.
We assess the ability to collect from our customers based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. If the customer is not deemed credit worthy, we defer revenue from the arrangement until payment is received and all other revenue recognition criteria have been met.
Stock-Based Compensation
Stock-based awards granted include stock options, restricted stock units (RSUs), and stock purchased under our Employee Stock Purchase Plan (the Purchase Plan). Stock-based compensation cost is measured at the grant date, based on the fair value of the awards, and is recognized as expense over the requisite service period only for those equity awards expected to vest.
The fair value of the RSUs is determined based on the stock price on the date of grant. The fair value of the RSUs is amortized on a straight-line basis over the requisite service periods of the awards, which is generally three to four years. We estimated the fair value of stock options and stock purchased under our Purchase Plan using the Black-Scholes model. This model utilizes the estimated fair value of common stock and requires that, at the date of grant, we use the expected term of the grant, the expected volatility of the price of our common stock, risk-free interest rates and expected dividend yield of our common stock. The fair value is amortized on a straight-line basis over the requisite service periods of the awards, which is generally three to four years for stock options, and six months to two years for stock purchased under our Purchase Plan.
The expected term represents the period that stock options are expected to be outstanding. During the first three quarters of 2010 and for the years ended December 31, 2009, we elected to use the simplified method of determining the expected term of stock options due to insufficient historical exercise data as a publicly traded company. For the year ended December 31, 2011 and during the
fourth quarter of 2010, we determined that we had sufficient historical information to use a method based on historical exercise patterns and post vesting termination behavior, which we believe is more representative of our expected term.
During the first three quarters of 2010 and for the years ended December 31, 2009, the computation of our expected volatility for stock options was based on the historical volatility of comparable companies from a representative peer group selected based on industry, financial and market capitalization data, due to insufficient historical volatility data as a publicly traded company. For the year ended December 31, 2011 and during the fourth quarter of 2010, we determined that we had sufficient historical volatility data to use a blended historical and implied volatility. The computation of expected volatility for the Purchase Plan for the years ended December 31, 2011, 2010 and 2009 is based on our historical volatility.
Accounting for Business Combinations
In our business combinations, we are required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. This process requires management to make significant estimates and assumptions, especially at acquisition date with respect to intangible assets, estimated contingent consideration payments and pre-acquisition contingencies.
Although we believe the assumptions and estimates we have made have been reasonable and appropriate, they are based in part on historical experience and information obtained from the management of the acquired company and are inherently uncertain. Examples of critical estimates in accounting for acquisitions include but are not limited to:

the estimated fair value of the acquisition-related contingent consideration, which is performed using a probability-weighted discounted cash flow model based upon the forecasted achievement of post-acquisition bookings targets;

the future expected cost to develop the in-process research and development into commercially viable products and the estimated cash flows from the products when completed;

the future expected cash flows from product sales, support agreements, consulting contracts, other customer contracts and acquired developed technologies and patents; and

the discount rates.
Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results. Additionally, any change in the fair value of the acquisition-related contingent consideration subsequent to the acquisition date, including changes from events after the acquisition date, such as changes in our estimate of the bookings that are expected to be achieved, will be recognized in earnings in the period of the estimated fair value change.
Goodwill, Intangible Assets and Impairment Assessments
Goodwill represents the excess of the purchase price in a business combination over the fair value of net tangible and intangible assets acquired. Goodwill is tested for impairment at least annually during the fourth quarter (and more frequently if certain indicators are present). In the event that we determine that the carrying value of our single reporting unit is less than the reporting unit’s fair value, we will incur an impairment charge for the amount of the difference during the quarter in which the determination is made. We performed our annual goodwill impairment test in the fourth quarter of 2011 and concluded that no impairment existed at December 31, 2011.
Intangible assets that have a finite life are amortized over their useful lives. On a periodic basis, we evaluate the estimated remaining useful life of purchased intangible assets and whether events or changes in circumstances warrant a revision to the remaining period of amortization. The carrying amounts of these assets are periodically reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable. Recoverability of these assets is measured by comparison of the carrying amount of each asset to the future undiscounted cash flows the asset is expected to generate. In the event that we determine certain assets are not fully recoverable, we will incur an impairment charge for those assets or portion thereof during the quarter in which the determination is made.
Recoverability of indefinite lived intangible assets is measured by comparison of the carrying amount of the asset to the future discounted cash flows the asset is expected to generate. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. We did not recognize any goodwill or intangible asset impairment charges in the years ended December 31, 2011, 2010 or 2009.
Accounting for Income Taxes
We use the asset and liability method of accounting for income taxes. Under this method, income tax expenses or benefits are recognized for the amount of taxes payable or refundable for the current year and for deferred tax liabilities and assets for the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. The measurement of current and deferred tax assets and liabilities are based on provisions of currently enacted tax laws. The effects of future changes in tax laws or rates are not contemplated.
As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax expense and tax contingencies in each of the tax jurisdictions in which we operate. This process involves estimating current income tax expense together with assessing temporary differences in the treatment of items for tax purposes versus financial accounting purposes that may create net deferred tax assets and liabilities. We rely on estimates and assumptions in preparing our income tax provision.
We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent earnings experience by jurisdiction, expectations of future taxable income, and the carryforward periods available to us for tax reporting purposes, as well as other relevant factors. We may establish a valuation allowance to reduce deferred tax assets to the amount we believe is more likely than not to be realized. Due to inherent complexities arising from the nature of our businesses, future changes in income tax law, or variances between our actual and anticipated operating results, we make certain judgments and estimates. Therefore, actual income taxes could materially vary from these estimates.
As part of our accounting for business combinations, a portion of the purchase price was allocated to goodwill and intangible assets. Amortization expenses associated with acquired intangible assets are generally not tax deductible; however, deferred taxes have been recorded for non-deductible amortization expenses as a part of the purchase price allocation. In the event of an impairment charge associated with goodwill, such charges are generally not tax deductible and would increase the effective tax rate in the quarter any impairment is recorded.
We are subject to periodic audits by the Internal Revenue Service and other taxing authorities. These audits may challenge certain tax positions we have taken, such as the timing and amount of deductions and allocation of taxable income to the various tax jurisdictions. Income tax contingencies are accounted for in accordance with authoritative guidance, and may require significant management judgment in estimating final outcomes. Actual results could materially differ from these estimates and could significantly affect the effective tax rate and cash flows in future years.
Inventory Valuation
Inventory consists of hardware and related component parts and is stated at the lower of cost (on a first-in, first-out basis) or market. A portion of our inventory relates to evaluation units located at customer locations, as some of our customers test our equipment prior to purchasing. Inventory that is obsolete or in excess of our forecasted demand is written down to its estimated realizable value based on historical usage, expected demand, and with respect to evaluation units, the historical conversion rate, the age of the units, and the estimated loss of utility. Inherent in our estimates of market value in determining inventory valuation are estimates related to economic trends, future demand for our products, the timing of new product introductions and technological obsolescence of our products. Inventory write-downs are recognized as cost of product and amounted to approximately $7.1 million, $4.8 million and $4.9 million for the years ended December 31, 2011, 2010 and 2009, respectively.
Results of Operations
Revenue
We derive our revenue from sales of our appliances and software licenses and from support and services. Product revenue primarily consists of revenue from sales of our Steelhead, Cascade and Stingray products and is typically recognized upon delivery. Support and services revenue includes unspecified software license updates and product support. Support revenue is recognized ratably over the contractual period, which is typically one year. Service revenue includes professional services and training, which to date has not been significant, and is recognized as the services are performed.
2011 Compared to 2010: Product revenue increased by 32% in 2011 due primarily to an increase in unit volume from increasing sales to existing customers and the addition of new customers. We believe the market for our products has grown due to increased market awareness of WAN optimization services and distributed organizations, which increases dependence on timely access to data and applications. Acquisitions in 2011 added $6.8 million in revenue, or 1%, of revenue growth
over 2010. As of December 31, 2011, our products had been sold to over 17,000 customers, compared to approximately 9,200 as of December 31, 2010.
Substantially all of our customers purchase support when they purchase our products. Support and services revenue increased 31% in 2011 as compared to 2010 which is consistent with our growth in product revenue. Support and services revenue as a percentage of total revenues remained relatively consistent with the prior year as our renewal rate of support contracts by existing customers remained stable. As our customer base grows, we expect our revenue generated from support and services to increase; however, we expect the renewal rate of support contracts by existing customers to remain level.
We generated 45% of our revenue in the year ended December 31, 2011 from international locations, compared to 47% in the year ended December 31, 2010. We continue to expand into international locations and introduce our products in new markets and expect international revenue to increase in dollar amount over time.
2010 Compared to 2009: Product revenue increased by 42% in 2010 due primarily to an increase in unit volume from increasing sales to existing customers and the addition of new customers. As of December 31, 2010, our products had been sold to over 9,200 customers, compared to approximately 7,300 as of December 31, 2009.
Support and services revenue increased 36% in 2010 as compared to 2009 which was consistent with our growth in product revenue. Support and services revenue as a percentage of total revenues remained relatively consistent with the prior year as our renewal rate of support contracts by existing customers remained stable.
Cost of Revenue and Gross Margin
Cost of product revenue consists of the costs of the appliance hardware, manufacturing, shipping and logistics costs, expenses for inventory obsolescence, warranty obligations and amortization of acquisition-related intangibles. We utilize third parties to assist in the design of and to manufacture our appliance hardware, embed our proprietary software and perform shipping logistics. Cost of support and service revenue consists of personnel costs of technical support and professional services personnel, spare parts and logistics services. As we expand internationally and into other sectors, we may incur additional costs to conform our products to comply with local laws or local product specifications. In addition, as we expand internationally, we will continue to hire additional technical support personnel to support our growing international customer base.
Our gross margin has been and will continue to be affected by a variety of factors, including the mix and average selling prices of our products, new product introductions and enhancements, the cost of our appliance hardware, expenses for inventory obsolescence and warranty obligations, cost of support and service personnel, and the mix of distribution channels through which our products are sold.
2011 Compared to 2010: The total cost of product revenue increased $23.2 million, or 28%, in the year ended December 31, 2011 compared to the year ended December 31, 2010. The cost of product sold increased $12.5 million, or 23%, primarily due to an increase in unit volume associated with higher revenue. The increase in cost of product revenue was also attributable to increased amortization of acquisition-related intangible assets of $6.0 million, increased expense for inventory obsolescence of $2.2 million, primarily due to excess inventory caused by anticipated new product introductions, $2.2 million related to increased personnel costs and $0.9 million due to increased cost of hard-drives in the fourth quarter of 2011 due to supply chain disruptions from flooding in Thailand. We expect the increase in cost of hard drives to continue into the first quarter of 2012.
Cost of support and services revenue increased $18.2 million, or 36%, as we added more technical support headcount domestically and abroad to support our growing customer base. Technical support and services headcount was 199 employees as of December 31, 2011 compared to 169 employees as of December 31, 2010. In addition, cost of support and services increased $3.6 million due to higher transportation, warehousing and duties costs to support a larger customer base.
Gross margins remained at 76% in the year ended December 31, 2011 compared to the year ended December 31, 2010. Product gross margins increased to 79% in the year ended December 31, 2011 from 78% in the year ended December 31, 2010 as a result of volume leverage and favorable product mix. Gross margins for support and services decreased slightly to 69% in the year ended December 31, 2011 compared to 70% in the year ended December 31, 2010, primarily due to certain redundant transportation and warehousing costs as we converted to a new logistics provider.
2010 Compared to 2009: The total cost of product revenue increased $20.9 million, or 34%, in the year ended December 31, 2010 compared to the year ended December 31, 2009. The cost of product sold increased $15.5 million, or 40%, primarily due to an increase in unit volume associated with higher revenue. The increase in cost of product revenue was also attributable to increased shipping costs of $1.8 million, or 50%, primarily due to an increase in unit volume, amortization of acquisition-related intangible assets of $1.0 million and $0.4 million related to the fair value adjustment
of inventory sold from our recently acquired entity. Cost of support and services revenue increased $12.8 million, or 34%, as we added more technical support headcount domestically and abroad to support our growing customer base. Technical support and services headcount was 169 employees as of December 31, 2010 compared to 136 employees as of December 31, 2009.
Gross margins increased to 76% in the year ended December 31, 2010 from 75% in the year ended December 31, 2009, primarily due to higher margins on product revenue as a result of lower unit product costs as well as a favorable product mix. Product gross margins increased to 78% in the year ended December 31, 2010 from 77% in the year ended December 31, 2009 as a result of volume leverage and favorable product mix. Gross margins for support and services remained at 70%.
Sales and Marketing Expenses
Sales and marketing expenses represent the largest component of our operating expenses and include personnel costs, sales commissions, marketing programs and facilities costs. Marketing programs are intended to generate revenue from new and existing customers, and are expensed as incurred. We plan to continue to make investments in sales and marketing with the intent to add new customers and increase penetration within our existing customer base by increasing the number of sales personnel worldwide, expanding our domestic and international sales and marketing activities, increasing channel penetration, building brand awareness and sponsoring additional marketing events. We expect future sales and marketing expenses to continue to increase and continue to be our most significant operating expense. Generally, sales personnel are not immediately productive and sales and marketing expenses do not immediately result in increased revenue. Hiring additional sales personnel reduces short-term operating margins until the sales personnel become productive and generate revenue. Accordingly, the timing of sales personnel hiring and the rate at which they become productive will affect our future performance.
2011 Compared to 2010: Sales and marketing expenses increased by $47.6 million, or 21%, in the year ended December 31, 2011 compared to the year ended December 31, 2010, primarily due to increases in personnel costs of $28.4 million. The increase in personnel costs, which include salaries, commissions, bonuses and related benefits and stock-based compensation, was primarily due to sales and marketing headcount increasing to 736 employees, which includes more than 50 employees from acquired companies, as of December 31, 2011 from 556 employees as of December 31, 2010. The sales and marketing expense increase is further attributed to higher travel and entertainment costs of $4.1 million, increased marketing-related activities of $3.8 million, and increased facilities and IT related costs of $1.3 million. In addition, in the year ended December 31, 2011, amortization of acquisition-related intangibles and compensation expense of acquisition-related contingent consideration and bonuses accounted for $1.7 million and $1.1 million of the increase, respectively.
2010 Compared to 2009: Sales and marketing expenses increased by $47.6 million, or 27%, in the year ended December 31, 2010 compared to the year ended December 31, 2009, primarily due to increases in personnel costs of $29.6 million, increased stock-based compensation and related payroll tax expense of $5.1 million, increased marketing-related activities of $4.7 million, increased facilities and IT related costs of $2.6 million, and higher travel and entertainment costs of $2.2 million. The increase in personnel costs, which include salaries, commissions, bonuses and related benefits and stock-based compensation, was primarily due to sales and marketing headcount increasing to 556 employees as of December 31, 2010 from 468 employees as of December 31, 2009 and higher commissions on increased revenue.
Research and Development Expenses
Research and development (R&D) expenses primarily include personnel costs and facilities costs. We expense R&D expenses as incurred. We are devoting substantial resources to the continued development of additional functionality for existing products and the development of new products. We intend to continue to invest significantly in our R&D efforts because we believe they are essential to maintaining our competitive position. Investments in R&D personnel costs are expected to increase in dollar amount.
2011 Compared to 2010: R&D expenses increased by $35.8 million, or 41%, in the year ended December 31, 2011 compared to the year ended December 31, 2010, primarily due to increases in personnel costs of $22.7 million, and compensation expense of acquisition-related contingent consideration and bonuses of $1.9 million. The increase in personnel costs, which include salaries, bonuses and related benefits and stock-based compensation, was primarily due to R&D headcount increasing to 466 employees, which includes more than 30 employees from acquired companies, as of December 31, 2011 from 357 employees as of December 31, 2010. Further, R&D expenses increased due to an increase in legal fees of $0.8 million in the year ended December 31, 2011 as compared to the year ended December 31, 2010, relating to the Silver Peak Systems litigation, which may become more significant in future periods. We plan to continue to invest in R&D as we develop new products and make further enhancements to existing products.
2010 Compared to 2009: R&D expenses increased by $18.0 million, or 26%, in the year ended December 31, 2010 compared to the year ended December 31, 2009, primarily due to increases in personnel costs of $13.9 million. The increase in personnel costs, which include salaries, bonuses and related benefits and stock-based compensation, was primarily due to R&D headcount increasing to 357 employees as of December 31, 2010 from 271 employees as of December 31, 2009, which includes 28 employees from acquisitions in the fourth quarter of 2010.
General and Administrative Expenses
General and administrative (G&A) expenses consist primarily of compensation for personnel and facilities costs related to our executive, finance, human resources, information technology and legal organizations, and fees for professional services. Professional services include outside legal, audit and information technology consulting costs.
2011 Compared to 2010: G&A expenses increased by $12.3 million, or 26%, in the year ended December 31, 2011 compared to the year ended December 31, 2010, primarily due to an increase in personnel costs of $8.0 million. The increase in personnel costs, which include salaries, bonuses and related benefits and stock-based compensation, was primarily due to G&A headcount increasing to 179 employees as of December 31, 2011 from 136 employees as of December 31, 2010.
2010 Compared to 2009: G&A expenses increased by $9.3 million, or 24%, in the year ended December 31, 2010 compared to the year ended December 31, 2009, primarily due to an increase in personnel costs of $6.9 million. The increase in personnel costs, which include salaries, bonuses and
related benefits and stock-based compensation, was primarily due to G&A headcount increasing to 136 employees as of December 31, 2010 from 120 employees as of December 31, 2009.
Acquisition-Related Costs
Acquisition-related costs include changes in the fair value of acquisition-related contingent consideration, transaction costs and integration-related costs.
The following table summarizes the acquisition-related costs, including changes in the fair value of the acquisition-related contingent consideration, transaction costs and integration-related costs, recognized in the years ended December 31, 2011, 2010 and 2009:
Other Income, Net
Other income, net consists primarily of interest income on our cash and marketable securities, interest expense, and foreign currency exchange losses. Cash has historically been invested in highly liquid investments such as time deposits held at major banks, commercial paper, U.S. government agency discount notes, money market mutual funds and other money market securities with maturities at the date of purchase of 90 days or less.
2011 Compared to 2010: Other income, net, decreased in the year ended December 31, 2011, primarily due to increased foreign exchange losses related to the revaluation of the acquisition-related transactions offset by increased interest income on higher cash and investment balanced in the year ended December 31, 2011 as compared to the year ended December 31, 2010. Weighted average interest rates applicable to our cash and investments balances remained consistent at 0.3% in the year ended December 31, 2011 compared to the year ended December 31, 2010.
2010 Compared to 2009: Other income, net, decreased in the year ended December 31, 2010 due to average interest rates. Weighted average interest rates applicable to our cash and investments balances decreased to 0.3% in the year ended December 31, 2010 compared to 0.7% in the year ended December 31, 2009.
Provision for Income Taxes
The provision for income taxes was $28.2 million, $22.8 million, and $4.3 million for the years ended December 31, 2011, 2010, and 2009, respectively. Our income tax provision consists of federal, foreign, and state income taxes. Our effective tax rate was 31%, 40%, and 38%, for the years ended December 31, 2011, 2010, and 2009, respectively.
For the year ended December 31, 2011, our effective tax rate differs from the federal statutory rate due to state taxes and significant permanent differences. Significant permanent differences arose primarily from the reversal of a valuation allowance, stock-based compensation expense, R&D tax credits, the amortization of deferred tax charges related to our intercompany sale of intellectual property rights, the benefits from a change in tax status of our United Kingdom (UK) subsidiaries, and taxes in foreign jurisdictions with a tax rate different than the U.S federal statutory rate.
For the year ended December 31, 2010, our effective tax rate differed from the federal statutory rate due to state taxes and significant permanent differences. Significant permanent differences arose primarily from stock-based compensation expense, R&D tax credits and acquisition related expenses.
For the year ended December 31, 2009, our effective tax rate differed from the federal statutory rate due to state taxes and significant permanent differences. Significant permanent differences arose primarily from stock-based compensation expense, R&D tax credits, the reversal of a valuation allowance and the manufacturing deduction.
As part of our accounting for the acquisition of Mazu in the first quarter of 2009, we established deferred tax assets for federal net operating loss carryforwards and R&D credit carryforwards that are subject to limitation under Section 382 of the Internal Revenue Code. We recorded a valuation allowance of $8.8 million related to a portion of the federal net operating loss carryforwards and R&D credit carryforwards that were not more likely than not to be realized. As of December 31, 2011, we reevaluated the need for a valuation allowance on these deferred tax assets by considering positive and negative evidence as required by the related accounting guidance. As a result of this evaluation, we concluded that it is more likely than not that we will have sufficient future taxable income to utilize the net operating loss carryforwards and credit carryforwards. Accordingly, we reversed the valuation allowance and recorded an income tax benefit of $8.8 million in 2011.
In the year ended December 31, 2010, management concluded that a valuation allowance was needed on our California income tax credit carryforwards. Due to a change in our forecasted income allocated to California for tax years after 2010, it is more likely than not the California income tax credits carryforwards will not be utilized in the foreseeable future. Accordingly, we have established a 100% valuation allowance against the tax credits. The amount of the valuation allowance against the California credits was $6.1 million and $3.1 million, net of federal benefits, for the years ended December 31, 2011 and 2010, respectively.
During the year ended December 31, 2011, we made an election to change the tax status of our UK subsidiaries to entities that are disregarded for federal and state income tax purposes. As a result of the change in tax status, we recorded a tax benefit of $2.9 million to record certain deferred tax assets resulting from the change.
We recorded deferred charges during the year ended December 31, 2011 related to the deferral of income tax expense on intercompany profits that resulted from the sale of our intellectual property rights (including intellectual property acquired during the current year) outside of North and South America to our Singapore subsidiary. The deferred charges are included in the Prepaid expenses and other current assets and the Other assets lines of the consolidated balance sheets in the amounts of $5.0 million and $15.6 million, respectively. The deferred charges are amortized as a component of income tax expense over the five year economic life of the intellectual property.
Beginning in the year ended December 31, 2011, we are subject to a reduced income tax rate in Singapore as a result of certain employment and spending commitments. The reduced tax rate is effective through 2020. We realized no tax savings in 2011 because of net local tax losses.
During 2011, we reduced our current federal, foreign and state taxes payable by $51.0 million for the excess tax benefits from stock option exercises and other employee stock programs, offsetting
additional paid-in capital. In addition, we have unrecorded excess tax benefits from stock option exercises and other employee stock programs of approximately $15.2 million as of December 31, 2011. These amounts will be credited to additional paid-in-capital when such amounts reduce cash taxes payable.
We are subject to income tax in the U.S. as well as numerous state and foreign jurisdictions. With the exception of several states, we are no longer subject to federal, state and local income tax examinations for years before 2008, although carryforward attributes that were generated prior to 2008 may still be adjusted upon examination by the Internal Revenue Service and the California Franchise Tax Board if the attributes either have been or will be used in a future period. In addition, we file tax returns in multiple foreign taxing jurisdictions. In our most significant foreign jurisdiction, the UK and Singapore, the open tax years range from 2007 to 2010.
Quarterly Results of Operations
The following table sets forth our unaudited quarterly consolidated statement of operations data for each of the eight quarters ended December 31, 2011. In management’s opinion, the data has been prepared on the same basis as the audited consolidated financial statements included in this Annual Report on Form 10-K, and reflects all necessary adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of this data. The results of historical periods are not necessarily indicative of the results of operations for a full year or any future period.
Our operating results may fluctuate due to a variety of factors, many of which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. You should not rely on our past results as an indication of our future performance. In addition, a significant portion of our quarterly sales typically occurs during the last month of the quarter,
which we believe reflects customer buying patterns of products similar to ours and other products in the technology industry generally. As a result, our quarterly operating results are difficult to predict even in the near term.
Commencing with the first shipment of our products in the second quarter of 2004, revenue has increased each quarter over the prior year quarter, due to increases in the number of products and support and services sold to new and existing customers and international expansion. Cost of revenue has increased each quarter over the prior year quarter in absolute dollars, but has decreased over time as a percentage of revenue. The increase in gross margins is primarily due to higher margins on product revenue as a result of lower unit product costs. Operating expenses have increased over time, as we continued to add headcount and related costs to accommodate our growing business.
Liquidity and Capital Resources
Cash and Cash Equivalents
Cash and cash equivalents consist of money market mutual funds, government-sponsored enterprise obligations, treasury bills, commercial paper and other money market securities with remaining maturities at date of purchase of 90 days or less.
Short and long-term investments consist of government-sponsored enterprise obligations, treasury bills and corporate bonds and notes. The fair value of investments is determined as the exit price in the principal market in which we would transact. The fair value of our investments has not materially fluctuated from historical cost. The accumulated unrealized gains (losses), net of tax, on investments recognized in accumulated other comprehensive income (loss) in our stockholders’ equity as of December 31, 2011 is a loss of $0.2 million.
Cash and cash equivalents, short-term investments and long-term investments increased by $92.2 million to $593.4 million in the year ended December 31, 2011.
Restricted cash primarily represents collateralized letters of credit established in connection with lease agreements for our facilities. Current restricted cash, which is included in the Prepaid expenses and other current assets in the consolidated balance sheets, totaled $1.1 million at December 31, 2011 and zero at December 31, 2010. Long-term restricted cash totaled $6.0 million at December 31, 2011 and $2.6 million at December 31, 2010. Long-term restricted cash is included in Other assets in the consolidated balance sheets and consists primarily of funds held as collateral for letters of credit for the security deposit on the leases of our corporate headquarters.
Since the fourth quarter of 2004, we have expanded our operations internationally. Our sales contracts are principally denominated in U.S. dollars and therefore changes in foreign exchange rates have not materially affected our cash flows from operations. As we fund our international operations, our cash and cash equivalents are affected by changes in exchange rates. In 2011, we concluded
acquisitions in international locations that increased our exposure to fluctuations in foreign currency exchange rates on certain foreign currency denominated assets and liabilities. To date, the foreign currency effect on our cash and cash equivalents has not been material.
Cash Provided by Operating Activities
Our largest source of operating cash flows is the cash collections from our customers. Our primary uses of cash from operating activities are for personnel related expenditures, product costs, outside services, and rent payments. Our cash flows from operating activities will continue to be affected principally by the extent to which we grow our revenue and spend on hiring personnel in order to grow our business. The timing of hiring sales personnel in particular affects cash flows as there is a lag between the hiring of sales personnel and the generation of revenue and related cash flows from their sales efforts.
Cash provided by operating activities increased by $63.4 million to $208.9 million in the year ended December 31, 2011 compared to $145.5 million in the year ended December 31, 2010. The increase in cash provided by operating activities was primarily due to an increase in cash flow of $21.2 million from operations after adjusting for non-cash items, including depreciation and amortization, and stock-based compensation, offset by cash used for excess tax benefits from employee stock plans and deferred taxes, and $42.2 million from the change in operating assets and liabilities.
Cash provided by operating activities was $145.5 million in the year ended December 31, 2010 compared to $96.5 million in the year ended December 31, 2009. The increase in cash flow from operating activities was due to an increase in cash flow of $20.1 million from operations after adjusting for non-cash items, including depreciation and amortization, and stock-based compensation, and $28.9 million from the change in operating assets and liabilities.
Cash Used in Investing Activities
Cash used in investing activities primarily relate to purchases of investments, net of sales and maturities, capital expenditures and cash used in acquisitions. Cash used in investing activities was $184.3 million in the year ended December 31, 2011 compared to $115.0 million in the year ended December 31, 2010. Cash used in investing activities in 2011 includes $120.5 million used for acquisitions, $18.1 million used for purchases of capital equipment, and $45.7 million used to purchase short-term and long-term investments. Cash used in investing activities in 2010 includes $26.9 million used for acquisitions, $10.7 million used for capital expenditures, and $77.4 million used to purchase short-term investments.
Cash used in investing activities decreased slightly to $115.0 million in the year ended December 31, 2010 compared to $115.4 million in the year ended December 31, 2009, primarily due to a $6.9 million decrease in cash used from lower capital expenditures and purchases of investments offset by a $6.4 million increase in cash used for acquisitions.
Cash provided by (used in) Financing Activities
Cash provided by financing activities was $23.8 million in the year ended December 31, 2011. Cash provided from the exercise of stock options was $55.8 million in the year ended December 31, 2011 compared to $64.3 million in the year ended December 31, 2010, and cash provided from the excess tax benefit relating to employee stock plans was $50.7 million in the year ended 2011 compared to $27.5 million in the year ended 2010. Cash used for repurchases of common stock was $35.0 million in the year ended December 31, 2011, whereas no repurchases of common stock occurred in the year ended December 31, 2010. Cash used to net share settle equity awards was $47.6 million in 2011 compared to $12.3 million in 2010. Of the $15.2 million used for the Mazu acquisition-related contingent consideration in the year ended December 31, 2010, $9.9 million was
estimated as of the acquisition date, and therefore recorded as a financing cash outflow. There were no acquisition-related contingent consideration payments in the year ended December 31, 2011. No debt was paid related to the 2011 acquisitions compared to $2.2 million of cash used in 2010 to pay down debt assumed in the Global Protocols LLC (GP) acquisition.
Cash provided by financing activities was $67.3 million in the year ended December 31, 2010 compared to $9.0 million of cash used by financing activities in the year ended December 31, 2009. No cash was used for repurchases of common stock in the year ended December 31, 2010 compared to $29.0 million of cash used to repurchase common stock in the year ended December 31, 2009. Cash provided from the exercise of stock options was $64.3 million in the year ended December 31, 2010 compared to $25.3 million in the year ended December 31, 2009. Cash used to pay down the debt acquired in the acquisition of GP was $2.2 million in the year ended December 31, 2010 compared to cash used to pay down the debt acquired in the acquisition of Mazu was $5.0 million in the year ended December 31, 2009.
We believe that our net proceeds from operations, together with our cash and investments balance at December 31, 2011, will be sufficient to fund our projected operating requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing and extent of expansion into new territories, the timing of introductions of new products and enhancements to existing products, and the continuing market acceptance of our products. In the third quarter of 2011, we acquired Zeus and Aptimize for approximately $120 million of cash. In the fourth quarter of 2010, we acquired CACE Technologies, Inc. and GP for approximately $27 million of cash. In the future, we may enter into other arrangements for potential investments in, or acquisitions of, complementary businesses, services or technologies, which could require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all.
Contractual Obligations
The following is a summary of our contractual obligations as of December 31, 2011:
(1) Represents amounts associated with agreements that are enforceable, legally binding and specify terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of payment. Obligations under contracts that we can cancel without a significant penalty are not included in the table above.
Off-Balance Sheet Arrangements
At December 31, 2011 and 2010, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes, nor did we have any undisclosed material transactions or commitments involving related persons or entities.
Other
At December 31, 2011 and 2010, we did not have commercial commitments under lines of credit, standby repurchase obligations or other such debt arrangements.
Recent Accounting Pronouncements
See Note 1 of “Notes to Consolidated Financial Statements” for recent accounting pronouncements that could have an effect on us.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Foreign Currency Risk
Our sales contracts are principally denominated in U.S. dollars and therefore our revenue and receivables are not subject to significant foreign currency risk. We do incur certain operating expenses in currencies other than the U.S. dollar and therefore are subject to volatility in cash flows due to fluctuations in foreign currency exchange rates, particularly changes in the British pound, Euro, Australian dollar and Singapore dollar. During the years ended December 31, 2011, 2010 and 2009, we did not enter into any hedging contracts since exchange rate fluctuations have had minimal impact on our operating results and cash flows. Starting in the first quarter of 2012, we entered into forward contracts to manage our exposure to foreign currency volatility that exists as part of our ongoing business operations. We utilize cash flow hedges to reduce the exchange rate impact on a portion of our operating expenses. Contracts are denominated primarily in British pounds, Euros and Singapore dollars. We do not enter into any foreign exchange derivative instruments for trading or speculative purposes.
Pursuant to the acquisition of Zeus, we recorded a U.S dollar-denominated liability of $14.8 million for the acquisition-related contingent consideration on our UK subsidiary, which has a British pound functional currency. This liability is subject to fluctuations in foreign currency exchange rates, which could have a negative impact on our statement of operations.
Interest Rate Sensitivity
We had unrestricted cash and cash equivalents, and investments totaling $593.4 million and $501.1 million at December 31, 2011 and 2010, respectively. Cash and cash equivalents of $215.5 million and $165.7 million at December 31, 2011 and December 31, 2010, respectively, are held for working capital purposes and include highly liquid investments with a maturity of ninety days or less at the time of purchase. Cash equivalents consist primarily of money market mutual funds, government-sponsored enterprise obligations, treasury bills, and other money market securities. Investments of $377.9 million and $335.4 million at December 31, 2011 and December 31, 2010, respectively, consist of government-sponsored enterprise obligations, treasury bills, FDIC-backed certificates of deposit and corporate bonds and notes.
We do not enter into investments for trading or speculative purposes. Due to the high investment quality and relatively short duration of these investments, we do not believe that we have any material exposure to changes in the fair market value as a result of changes in interest rates. Declines in interest rates, however, will reduce future investment income. Interest rates on highly liquid short-term investments such as U.S. Treasury bills declined from 2009 to 2010 and remained low in 2011. This has caused a significant reduction in our investment income. In addition, the volatility in the credit markets increases the risk of write-downs of investments to fair market value.
Item 8.
Item 8. Financial Statements and Supplementary Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
The following financial statements are filed as part of this Annual Report on Form 10-K
Page No.
Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
REPORT OF ERNST & YOUNG LLP,
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Riverbed Technology, Inc.
We have audited the accompanying consolidated balance sheets of Riverbed Technology, Inc. as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. Our audits also included the financial statement schedule listed in the index at Item 15(b). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Riverbed Technology, Inc. at December 31, 2011 and 2010, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects, the information set forth therein.
The Company changed its method of accounting for revenue recognition as a result of the adoption of amendments to the FASB Accounting Standards Codification resulting from Accounting Standards Update No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements, and Accounting Standards Update No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements, both effective January 1, 2010.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Riverbed Technology, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 10, 2012 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
San Francisco, California
February 10, 2012
REPORT OF ERNST & YOUNG LLP,
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Riverbed Technology, Inc.
We have audited Riverbed Technology, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Riverbed Technology, Inc’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in Part 1, Item 9a of this Annual Report on Form 10-K under the heading “Management’s Report on Internal Control Over Financial Reporting.” Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Riverbed Technology, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Riverbed Technology, Inc. as of December 31, 2011 and 2010, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011 of Riverbed Technology, Inc. and our report dated February 10, 2012 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
San Francisco, California
February 10, 2012
RIVERBED TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
See Notes to Consolidated Financial Statements.
RIVERBED TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
See Notes to Consolidated Financial Statements
RIVERBED TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the Years ended December 31, 2011, 2010 and 2009
(in thousands)
See Notes to Consolidated Financial Statements
RIVERBED TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
See Notes to Consolidated Financial Statements
RIVERBED TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Organization
Riverbed Technology, Inc. was founded on May 23, 2002 and has developed innovative and comprehensive solutions to the fundamental problems associated with IT performance across wide area networks (WANs). Our portfolio of IT performance products enable our customers to simply and efficiently improve the performance of their applications and access to their data over WANs, and provide global application performance, reporting and analytics, application delivery control, and cloud storage.
Significant Accounting Policies
Basis of Financial Statements
The consolidated financial statements include our accounts and the accounts of our wholly owned subsidiaries. Intercompany transactions and balances have been eliminated.
Use of Estimates
Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP). These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. Significant estimates and assumptions made by management include the determination of the fair value of stock awards issued, inventory valuation, the accounting for income taxes, including the determination of the timing of the establishment or release of our valuation allowance related to our deferred tax asset balances and reserves for uncertain tax positions, the accounting for business combinations and the accounting for acquisition-related contingent consideration. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our consolidated financial statements will be affected.
Effective November 8, 2010, we completed a two-for-one stock split of our outstanding shares of common stock. In accordance with GAAP, we have retroactively displayed the effect of the change in our consolidated financial statements.
Subsequent Events
We have evaluated subsequent events through the date these consolidated financial statements were issued.
Cash and Cash Equivalents
We consider all highly liquid investments purchased with original maturities at the date of purchase of three months or less to be cash equivalents. Cash and cash equivalents are stated at cost, which approximates fair value.
Investments
We determine the appropriate classification of short and long-term investments at the time of purchase and reevaluate such determination at each balance sheet date. The fair value of our
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investments is determined as the exit price in the principal market in which we would transact. Securities, which are classified as available for sale at December 31, 2011, 2010 and 2009, are carried at fair value, with the unrealized gains and losses, net of tax, reported as a separate component of stockholders’ equity. Unrealized gains and losses to date have not been material. Realized gains and losses and declines in value judged by us to be other-than-temporary on securities available for sale are included as a component of interest income (expense). The cost of securities sold is based on the specific-identification method. Interest on securities classified as available for sale is included as a component of interest income.
Inventory Valuation
Inventory consists of hardware and related component parts and is stated at the lower of cost (on a first-in, first-out basis) or market. A portion of our inventory relates to evaluation units located at customer locations, as some of our customers test our equipment prior to purchasing. Inventory that is obsolete or in excess of our forecasted demand is written down to its estimated realizable value based on historical usage, expected demand, and with respect to evaluation units, the historical conversion rate, the age of the units, and the estimated loss of utility. Inherent in our estimates of market value in determining inventory valuation are estimates related to economic trends, future demand for our products, the timing of new product introductions and technological obsolescence of our products. Inventory write-downs are recognized as cost of product and amounted to approximately $7.1 million, $4.8 million and $4.9 million for the years ended December 31, 2011, 2010 and 2009, respectively.
Service Inventory
We hold service inventory that is used to repair or replace defective hardware reported by our customers who purchase support services. We classify service inventory as Prepaid expenses and other current assets. At December 31, 2011 and 2010 our service inventory balance was $9.3 million and $7.0 million, respectively.
Internal-Use Software Development Costs
We capitalize qualifying costs for computer software developed for or obtained for internal-use, which are incurred during the application development stage, and amortize them over the software’s estimated useful life, which is generally two to five years.
We capitalized $6.5 million, $4.7 million and $5.3 million in internal use software during the years ended December 31, 2011, 2010 and 2009, respectively. Amortization expense related to these assets totaled $3.9 million, $3.1 million and $2.3 million during the years ended December 31, 2011, 2010 and 2009, respectively. Software development costs required to be capitalized for software sold, leased, or otherwise marketed have not been material to date.
Impairment of Long-Lived Assets
We review long-lived assets and identifiable intangible assets, excluding goodwill, for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. We assess these assets for impairment based on estimated undiscounted future cash flows from these assets. If the carrying value of the assets exceeds the estimated future undiscounted cash flows, a loss is recorded for the excess of the asset’s carrying value over the fair value. To date we have not recognized any impairment loss for long-lived assets.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Goodwill, Intangible Assets and Impairment Assessments
Goodwill represents the excess of the purchase price in a business combination over the fair value of net tangible and intangible assets acquired. Goodwill is tested for impairment at least annually during the fourth quarter (and more frequently if certain indicators are present). In the event that we determine that the carrying value of our single reporting unit is less than the reporting unit’s fair value, we will incur an impairment charge for the amount of the difference during the quarter in which the determination is made. We performed our annual goodwill impairment test in the fourth quarter of 2011 and concluded that no impairment existed at December 31, 2011.
Intangible assets that have a finite life are amortized over their useful lives. On a periodic basis, we evaluate the estimated remaining useful life of purchased intangible assets and whether events or changes in circumstances warrant a revision to the remaining period of amortization. The carrying amounts of these assets are periodically reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable. Recoverability of these assets is measured by comparison of the carrying amount of each asset to the future undiscounted cash flows the asset is expected to generate. In the event that we determine certain assets are not fully recoverable, we will incur an impairment charge for those assets or portion thereof during the quarter in which the determination is made.
Recoverability of indefinite lived intangible assets is measured by comparison of the carrying amount of the asset to the future discounted cash flows the asset is expected to generate. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. We did not recognize any goodwill or intangible asset impairment charges in the years ended December 31, 2011, 2010 or 2009.
Revenue Recognition
We recognize revenue when all of the following have occurred: (1) we have entered into a legally binding arrangement with a customer; (2) delivery has occurred; (3) customer payment is deemed fixed or determinable and free of contingencies and significant uncertainties; and (4) collection is reasonably assured.
The majority of our product revenue includes hardware appliances containing software components that function together to provide the essential functionality of the product. Therefore, our hardware appliances are considered non-software deliverables. Most non-software products and services qualify as separate units of accounting because they have value to the customer on a standalone basis and our revenue arrangements generally do not include a general right of return relative to delivered products. We account for non-software arrangements with multiple deliverables, which generally include support services sold with each of our hardware appliances, using the relative selling price method under the revenue recognition guidance for multiple deliverable arrangements.
Our product revenue also includes revenue from the sale of stand-alone software products. Stand-alone software may operate on our hardware appliance, but does not function with the hardware to deliver the product’s essential functionality. Stand-alone software products generally include a perpetual license to our software. Stand-alone software sales are subject to the industry specific software revenue recognition guidance.
Certain arrangements with multiple deliverables may have stand-alone software deliverables that are subject to the software revenue recognition guidance along with non-software deliverables. The
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
revenue for these multiple deliverable arrangements is allocated to the stand-alone software deliverables as a group and the non-software deliverables based on the relative selling prices of all of the deliverables in the arrangement.
The amount of product and services revenue recognized for arrangements with multiple deliverables is impacted by our valuation of relative selling prices. We apply the selling price hierarchy using vendor specific objective evidence (VSOE) when available, third-party evidence of selling price (TPE) if VSOE does not exist, and estimated selling price (ESP) if neither VSOE nor TPE is available.
VSOE of fair value for elements of an arrangement is based upon the normal pricing and discounting practices for a deliverable when sold separately, and VSOE for support services is further measured by the renewal rate offered to the customer. In determining VSOE, we require that a substantial majority of the selling prices fall within a reasonably narrow pricing range, generally evidenced by a substantial majority of such historical stand-alone transactions falling within a reasonably narrow range of the median rates. In addition, we consider major service groups, geographies, customer classifications, and other variables in determining VSOE.
We are typically not able to determine TPE for our products or services. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, our go-to-market strategy differs from that of our peers and our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, we are unable to reliably determine what similar competitor products’ selling prices are on a stand-alone basis.
When we are unable to establish the estimated stand-alone value of our non-software deliverables using VSOE or TPE, we use ESP in our allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine ESP for a product or service by considering multiple factors including, but not limited to, cost of products, gross margin objectives, pricing practices, geographies, customer classes and distribution channels.
For stand-alone software sales, we recognize revenue based on software revenue recognition guidance. Under the software revenue recognition guidance, we use the residual method to recognize revenue when an agreement includes one or more elements to be delivered at a future date and VSOE of the fair value of all undelivered elements exists. In the majority of our contracts, the only element that remains undelivered at the time of delivery of the product is support services. Under the residual method, the fair value of the undelivered stand-alone software, which is typically support services, is deferred and the remaining portion of the contract fee is recognized as product revenue. If evidence of the fair value of one or more undelivered stand-alone software elements does not exist, all revenue is generally deferred and recognized when delivery of those elements occurs or when fair value can be established. When the undelivered stand- alone software for which we do not have VSOE of fair value is support, revenue for the entire arrangement is bundled and recognized ratably over the support period.
For our non-software deliverables, we allocate the arrangement consideration based on the relative selling price of the deliverables. For our hardware appliances we use the ESP of the deliverable. For our support and services, we generally use VSOE as our relative selling price. When we are unable to establish VSOE for our support and services, we use ESP in our allocation of arrangement consideration. We regularly review VSOE and ESP. As our go-to-market strategies evolve, we may modify our pricing practices in the future, which could result in changes in selling prices, including both VSOE and ESP.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
For sales to direct end-users and channel partners, including value-added resellers, value-added distributors, service providers, and systems integrators, we recognize product revenue upon delivery, assuming all other revenue recognition criteria are met. For our hardware appliances, delivery occurs upon transfer of title and risk of loss, which is generally upon shipment. It is our practice to identify an end-user prior to shipment to a channel partner. For end-users and channel partners, we generally have no significant obligations for future performance such as rights of return or pricing credits. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue.
Support and services consist of support services, professional services, and training. Support services include repair and replacement of defective hardware appliances, software updates and access to technical support personnel. Software updates provide customers with rights to unspecified software product upgrades and to maintenance releases and patches released during the term of the support period. Revenue for support services is recognized on a straight-line basis over the service contract term, which is typically one to three years. Professional services are recognized upon delivery or completion of performance. Professional service arrangements are typically short term in nature and are largely completed within 90 days from the start of service. Training services are recognized upon delivery of the training.
Our fees are typically considered to be fixed or determinable at the inception of an arrangement, generally based on specific products and quantities to be delivered. Substantially all of our contracts do not include rights of return or acceptance provisions. To the extent that our agreements contain such terms, we recognize revenue once the acceptance provisions or right of return lapses. Payment terms to customers generally range from net 30 to 75 days. In the event payment terms are provided that differ from our standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payments become due, provided the remaining criteria for revenue recognition have been met.
We assess the ability to collect from our customers based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. If the customer is not deemed credit worthy, we defer revenue from the arrangement until payment is received and all other revenue recognition criteria have been met.
Stock-Based Compensation
Stock-based awards granted include stock options, restricted stock units (RSUs), and stock purchased under our Employee Stock Purchase Plan (the Purchase Plan). Stock-based compensation cost is measured at the grant date, based on the fair value of the awards, and is recognized as expense over the requisite service period only for those equity awards expected to vest.
The fair value of the RSUs is determined based on the stock price on the date of grant. The fair value of the RSUs is amortized on a straight-line basis over the requisite service periods of the awards, which is generally three to four years. We estimated the fair value of stock options and stock purchased under our Purchase Plan using the Black-Scholes model. This model utilizes the estimated fair value of common stock and requires that, at the date of grant, we use the expected term of the grant, the expected volatility of the price of our common stock, risk-free interest rates and expected dividend yield of our common stock. The fair value is amortized on a straight-line basis over the requisite service periods of the awards, which is generally three to four years for stock options, and six months to two years for stock purchased under our Purchase Plan.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The expected term represents the period that stock options are expected to be outstanding. During the first three quarters of 2010 and for the years ended December 31, 2009, we elected to use the simplified method of determining the expected term of stock options due to insufficient historical exercise data as a publicly traded company. For the year ended December 31, 2011 and during the fourth quarter of 2010, we determined that we had sufficient historical information to use a method based on historical exercise patterns and post vesting termination behavior, which we believe is more representative of our expected term.
During the first three quarters of 2010 and for the years ended December 31, 2009, the computation of our expected volatility for stock options was based on the historical volatility of comparable companies from a representative peer group selected based on industry, financial and market capitalization data, due to insufficient historical volatility data as a publicly traded company. For the year ended December 31, 2011 and during the fourth quarter of 2010, we determined that we had sufficient historical volatility data to use a blended historical and implied volatility. The computation of expected volatility for the Purchase Plan for the years ended December 31, 2011, 2010 and 2009 is based on our historical volatility.
Business Combinations
In our business combinations, we are required to recognize all the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs be recognized separately from the acquisition and expensed as incurred; that restructuring costs generally be expensed in periods subsequent to the acquisition date; that changes in the estimated fair value of contingent consideration after the initial measurement on the acquisition date be recognized in earnings in the period of the change in estimate; and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period be recognized as a component of provision for taxes. In addition, the fair value of in-process research and development is recorded as an indefinite-lived intangible asset until the underlying project is completed, at which time the intangible asset is amortized over its estimated useful life, or abandoned, at which time the intangible asset is expensed.
Accounting for business combinations requires management to make significant estimates and assumptions, especially at acquisition date with respect to intangible assets, estimated contingent consideration payments and pre-acquisition contingencies.
Although we believe the assumptions and estimates we have made have been reasonable and appropriate, they are based in part on historical experience and information obtained from management of the acquired company and are inherently uncertain. Examples of critical estimates in accounting for acquisitions include but are not limited to:

the estimated fair value of the acquisition-related contingent consideration, which is performed using a probability-weighted discounted cash flow model based upon the forecasted achievement of post-acquisition bookings targets;

the future expected cost to develop the in-process research and development into commercially viable products and the estimated cash flows from the products when completed;

the future expected cash flows from product sales, support agreements, consulting contracts, other customer contracts and acquired developed technologies and patents; and

the discount rates.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results.
Accounting for Income Taxes
We use the asset and liability method of accounting for income taxes. Under this method, income tax expenses or benefits are recognized for the amount of taxes payable or refundable for the current year and for deferred tax liabilities and assets for the expected tax consequences of temporary differences between the tax bases of assets and liabilities for financial reporting purposes and amounts recognized for income tax purposes. The measurement of current and deferred tax assets and liabilities are based on provisions of currently enacted tax laws. The effects of future changes in tax laws or rates are not contemplated.
As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax expense and tax contingencies in each of the tax jurisdictions in which we operate. This process involves estimating current income tax expense together with assessing temporary differences in the treatment of items for tax purposes versus financial accounting purposes that may create net deferred tax assets and liabilities. We rely on estimates and assumptions in preparing our income tax provision.
We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent earnings experience by jurisdiction, expectations of future taxable income, and the carryforward periods available to us for tax reporting purposes, as well as other relevant factors. We may establish a valuation allowance to reduce deferred tax assets to the amount we believe is more likely than not to be realized. Due to inherent complexities arising from the nature of our businesses, future changes in income tax law, or variances between our actual and anticipated operating results, we make certain judgments and estimates. Therefore, actual income taxes could materially vary from these estimates.
We are subject to periodic audits by the Internal Revenue Service and other taxing authorities. These audits may challenge certain tax positions we have taken, such as the timing and amount of deductions and allocation of taxable income to the various tax jurisdictions. The accounting for income tax contingencies may require significant management judgment in estimating final outcomes. Actual results could differ materially from these estimates and could significantly affect the effective tax rate and cash flows in future years. We have elected to record interest and penalties in the financial statements as a component of income taxes.
Concentrations of Risk
Financial instruments that are potentially subject to concentrations of credit risk consist primarily of cash, cash equivalents, marketable securities, and trade receivables. Investment policies have been implemented that limit investments to investment grade securities and the average portfolio maturity is less than a year. The risk with respect to trade receivables is mitigated by credit evaluations we perform on our customers and by the diversification of our customer base. One value-added distributor, Arrow Enterprise Computing Solutions, Inc. (Arrow), accounted for 14% of our trade receivable balance as of December 31, 2011. No single customer represented more than 10% of our trade receivable balance at December 31, 2010. One value-added distributor, Arrow, represented 15% and 10%, respectively, of our revenue for the years ended December 31, 2011 and 2010. No customer represented more than 10% of our revenue for the years ended December 31, 2009.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
We outsource the production of our inventory to third-party manufacturers. We rely on purchase orders or long-term contracts with our contract manufacturers. At December 31, 2011, we had no long-term contractual commitment with any manufacturer; however, we did have 90 day commitments totaling $13.8 million.
Comprehensive Income (loss)
Comprehensive income (loss) is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources. We include the components of comprehensive income (loss) as part of our consolidated statement of changes in equity. Accumulated other comprehensive income (loss) includes net unrealized gains (losses) on available-for-sale securities and net foreign currency translation gains (losses).
Foreign Currency Translation
While the majority of our revenue contracts are denominated in U.S. dollars, we incur certain operating expenses in various foreign currencies. The functional currency of our foreign operations is the local country’s currency. Consequently, expenses of operations outside the U.S. are translated into U.S. dollars using average exchange rates for the period reported while assets and liabilities of operations outside the U.S. are translated into U.S. dollars using end of period exchange rates. Foreign currency translation adjustments not affecting net income are included in stockholders’ equity as a component of accumulated other comprehensive income (loss) in the accompanying consolidated balance sheets. The revaluation effect of foreign currency fluctuations on intercompany balances is recorded to foreign currency gain (loss) and included in Other income in the accompanying consolidated statements of operations. Foreign currency losses included in Other income for the years ended December 31, 2011, 2010 and 2009, were $1.4 million, $0.5 million and $0.7 million, respectively.
Advertising
Advertising costs are expensed as incurred. Adverting expenses recorded as marketing expenses were $2.5 million, $1.7 million and $1.1 million for the years ended December 31, 2011, 2010 and 2009, respectively.
Cooperative advertising obligations with customers are accrued and the costs expensed at the time the related revenue is recognized. Cooperative advertising expenses are recorded as marketing expenses to the extent that an advertising benefit separate from the revenue transaction can be identified and the cash paid does not exceed the fair value of that advertising benefit received. Otherwise, such cooperative advertising obligations with customers are recorded as a reduction of revenue. Cooperative advertising expenses recorded as a reduction of revenue were $5.5 million, $6.3 million and $3.1 million in the years ended December 31, 2011, 2010 and 2009, respectively.
Research and Development
All costs to develop our products are expensed as incurred.
Recent Accounting Pronouncements
In September 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-08, Intangibles - Goodwill and Other (Topic 350) - Testing Goodwill for Impairment (ASU 2011-08), to simplify how entities, both public and nonpublic, test
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goodwill for impairment. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted. We early adopted ASU 2011-08 during the fourth quarter or the year ended December 31, 2011. Adoption of this standard impacted how we assessed goodwill for impairment but did not have significant impact on our consolidated financial statements.
In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220) - Presentation of Comprehensive Income (ASU 2011-05), to require an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of equity. ASU 2011-05 is effective for fiscal years and interim periods beginning after December 15, 2011 and should be applied retrospectively. We will adopt ASU 2011-05 in the first quarter or fiscal 2012 and do not expect this standard to have an impact on our consolidated financial statements.
In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (Topic 820) - Fair Value Measurement (ASU 2011-04), to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between U.S. GAAP and International Financial Reporting Standards. ASU 2011-04 changes certain fair value measurement principles and enhances the disclosure requirements particularly for level 3 fair value measurements (as defined in Note 4 below). ASU 2011-04 is effective for us in fiscal 2012 and should be applied prospectively. We are currently evaluating the impact of our pending adoption of ASU 2011-04 on our consolidated financial statements.
2. ACQUISITIONS
Fiscal 2011 Acquisitions
Zeus Technology, Ltd.
In July 2011, we acquired the outstanding securities of Zeus Technology, Ltd. (Zeus). The acquisition expanded our products and technology to compete in the virtual application delivery controller (ADC) market. Zeus pioneered the development of software-based highly scalable ADCs that deliver high-performance software-based load balancing and traffic management solutions for virtual and cloud environments. We have included the financial results of Zeus in our consolidated financial statements from the acquisition date.
Pursuant to the share purchase agreement with Zeus we made payments totaling $105.6 million in cash for all of the outstanding securities of Zeus on July 19, 2011. In addition, we will potentially make additional payments (acquisition-related contingent consideration) totaling up to $27.0 million in cash, based on achievement of certain bookings targets related to Zeus products for the period from July 20, 2011 through July 31, 2012 (the Zeus earn-out period). In addition, we may pay up to $3.0 million as an incentive bonus to former employees of Zeus, based on achievement of certain bookings targets related to Zeus products for the Zeus earn-out period.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Preliminary Fair Value of Consideration Transferred
The total acquisition date fair value of the consideration transferred was estimated at $119.1 million, which included the initial payments totaling $104.2 million in cash, of which $20.1 million was paid to escrow to secure the seller’s indemnification obligations, $1.4 million paid upon finalization of the closing balance sheet and net working capital statement, and the estimated fair value of acquisition-related contingent consideration to be paid to Zeus shareholders totaling $13.5 million. The total acquisition date fair value of consideration transferred is estimated as follows:
We recognized a liability of $13.5 million for the acquisition date fair value of the acquisition-related contingent consideration based on the probability of achievement of the bookings target. Any change in the fair value of the acquisition-related contingent consideration subsequent to the acquisition date, including changes from events after the acquisition date, such as changes in our estimate of the bookings targets, will be recognized in earnings in the period the estimated fair value changes. The fair value estimate is based on the probability weighted bookings to be achieved over the Zeus earn-out period. Actual achievement of bookings below $25.0 million would reduce the liability to zero and achievement of bookings of $40.0 million or more would increase the liability to $27.0 million. A change in fair value of the acquisition-related contingent consideration could have a material effect on the statement of operations and financial position in the period of the change in estimate.
We estimated the fair value of the acquisition-related contingent consideration using a probability-weighted discounted cash flow model. This fair value measurement is based on significant inputs not observed in the market and thus represents a Level 3 measurement. Level 3 instruments are valued based on unobservable inputs that are supported by little or no market activity and reflect our own assumptions in measuring fair value. The estimated fair value of acquisition-related contingent consideration of $13.5 million included amounts to be distributed directly to shareholders, discounted at 17.5%, but excluded a fair value estimate of $1.7 million to be paid to former employees of Zeus. During the year ended December 31, 2011, we recorded an expense of $0.5 million, in Acquisition-related costs, due to a change in the fair value of acquisition-related contingent consideration to be distributed directly to shareholders.
At the acquisition date, we estimated the fair value of an incentive bonus to be paid to the former employees of Zeus (Zeus incentive bonus) to be $1.7 million. This fair value was also estimated using a probability-weighted discounted cash flow model on the achievement of the bookings target. No liability for the Zeus incentive bonus was recorded as of the acquisition date, as this component is considered compensatory and is being recognized as compensation cost in operating expense ratably over the service period from July 20, 2011 to July 31, 2012. During the year ended December 31, 2011, we revised the estimated the fair value of an incentive bonus to be paid to the former employees of Zeus to $1.6 million and recorded related compensation cost for the year ended December 31, 2011 of $0.7 million.
In addition, we signed retention agreements for certain key employees of Zeus totaling $1.2 million, which will be recognized as compensation expense ratably over the two year period following the acquisition date.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Preliminary Allocation of Consideration Transferred
Under the acquisition method of accounting, the identifiable assets acquired and liabilities assumed were recognized and measured as of the acquisition date based on their estimated fair values as of the July 19, 2011, the acquisition date. The excess of the acquisition date fair value of consideration transferred over estimated fair value of the net tangible assets and intangible assets was recorded as goodwill.
Based on their estimated fair values, we have preliminarily recorded $82.8 million of goodwill, $47.8 million of identifiable intangible assets, including $2.6 million of in-process technology, $7.7 million of deferred tax liabilities and $3.7 million of net other tangible liabilities. These estimated fair values were based upon a preliminary valuation and our estimates and assumptions are subject to change as we obtain additional information for our estimates during the measurement period, which is up to one year from the acquisition date. The primary areas of the estimated fair values that are not yet finalized relate to income taxes and residual goodwill.
The following table summarizes the estimated fair values of the assets and liabilities assumed at the acquisition date. Estimates of both current and non-current deferred tax assets are subject to change, pending the finalization of certain tax returns.
Intangible Assets
In our determination of the fair value of the intangible assets we considered, among other factors, the best use of acquired assets, analyses of historical financial performance and estimates of future performance of Zeus’s products. The fair values of identified intangible assets were calculated using an income approach and estimates and assumptions provided by Zeus’s and our management. The rates utilized to discount net cash flows to their present values were based on a weighted average cost of capital of 14%. This discount rate was determined after consideration of the rate of return on debt capital and equity that typical investors would require in an investment in companies similar in size and operating in similar markets as Zeus.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Intangible assets acquired resulting from the Zeus acquisition as of December 31, 2011 are as follows:
The above table includes $2.6 million that was recorded as In-process technology at the acquisition date and was reclassified from In-process technology to Existing technology upon reaching technical feasibility and being placed in service during 2011.
We determined the useful life of intangible assets based on the expected future cash flows associated with the respective asset. Existing technology is comprised of products that have reached technological feasibility and are part of Zeus’s product line. In-process technology assets represent efforts spent through the acquisition date on projects that had yet to reach technical feasibility. Patents are related to the design and development of Zeus’s products and this proprietary know-how can be leveraged to develop new technology and products and improve existing products. Customer relationships and maintenance agreements represent the underlying relationships and agreements with Zeus’s installed customer base. Trademarks represent the fair value of the brand and name recognition associated with the marketing of Zeus’s products and services. Amortization of existing technology and patents is included in cost of revenue, and amortization expense for customer relationships and trademarks is included in operating expenses.
The expected future amortization expense related to the above intangible assets is as follows:
Actual amortization expense may differ from the amounts above due to, among other things, impairments, accelerated amortization and fluctuations in foreign currency exchange rates.
Goodwill
Of the total estimated purchase price, $82.8 million was allocated to goodwill, which represents the excess of the purchase price of an acquired business over the fair value of the underlying net tangible and intangible assets. The goodwill balance is primarily attributed to assembled workforce,
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expected synergies and expanded network opportunities when integrating Zeus’s technology with our current product offerings. A portion of the goodwill is expected to be deductible for federal and state income tax purposes. As of December 31, 2011, we recorded an adjustment of $0.4 million upon finalization of the closing balance sheet and net working capital statement. There was no other change in the recognized amounts of goodwill resulting from the acquisition of Zeus.
Deferred Revenues
In connection with the purchase price allocation, we estimated the fair value of the service obligations assumed from Zeus as a consequence of the acquisition. The estimated fair value of the service obligations was determined using a cost build-up approach. The cost build-up approach determines fair value by estimating the costs relating to fulfilling the obligations plus a normal profit margin. The sum of the costs and operating profit approximates, in theory, the amount that we would be required to pay a third party to assume the service obligations. The estimated costs to fulfill the service obligations were based on the historical direct costs and indirect costs related to Zeus’s service agreements with its customers. Direct costs include personnel directly engaged in providing service and support activities, while indirect costs consist of estimated general and administrative expenses based on normalized levels as a percentage of revenue. Profit associated with selling efforts was excluded because Zeus had concluded the selling efforts on the service contracts prior to the date of our acquisition. The estimated research and development costs associated with support contracts have not been included in the fair value determination, as these costs were not deemed to represent a legal obligation at the time of acquisition. We recorded $1.7 million of deferred revenue to reflect the estimate of the fair value of Zeus’s service obligations assumed.
Results of Operations
The revenue and operating loss of Zeus, which was included in our consolidated statement of operations from the acquisition date to the year ending December 31, 2011, was $6.7 million and $9.7 million, respectively. The results of operations of Zeus pre-acquisition were not significant, and therefore no pro forma results of operations were presented separately.
Aptimize Ltd.
In July 2011, we acquired the outstanding securities of Aptimize Ltd. (Aptimize) to expand our product offerings. We have included the financial results of Aptimize in our consolidated results from the acquisition date. This acquisition was not significant, and therefore the pro forma results of operations have not been presented.
Pursuant to the share purchase agreement with Aptimize we made payments totaling $17.3 million in cash for all of the outstanding securities of Aptimize. In addition, we will potentially make additional payments (Aptimize acquisition-related contingent consideration) totaling up to $17.0 million in cash to be paid to Aptimize shareholders, based on achievement of certain bookings targets related to Aptimize products for the period from September 1, 2011 through September 30, 2012 (the Aptimize earn-out period). As of December 31, 2011, the estimated fair value of the acquisition-related contingent consideration to be distributed directly to the Aptimize shareholders is $1.1 million.
Based on their estimated fair values, we have preliminarily recorded $13.0 million of goodwill, $4.7 million of identifiable intangible assets, $0.2 million of deferred tax liabilities and $0.1 million of net tangible assets.
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These estimated fair values were based upon a preliminary valuation and our estimates and assumptions are subject to change as we obtain additional information for our estimates during the measurement period, which is up to one year from the acquisition date. The primary areas of the estimated fair values that are not yet finalized relate to income taxes and residual goodwill.
Pre-Acquisition Contingencies
We have evaluated and continue to evaluate pre-acquisition contingencies related to our 2011 acquisitions that existed as of the respective acquisition dates. If these pre-acquisition contingencies that existed as of the acquisition date become probable in nature and estimable during the remainder of the measurement period, amounts recorded for such matters will be made in the measurement period and, subsequent to the measurement period, in our results of operations.
Fiscal 2010 Acquisitions
During the fourth quarter of fiscal 2010, we acquired CACE Technologies, Inc. (CACE) and Global Protocols, LLC (GP) to expand our product offerings. We have included the financial results of these companies in our consolidated results from their respective acquisition dates. Combined, the total fair value of the consideration transferred for these acquisitions was $26.8 million, which was paid in cash. Based on their estimated fair values, we recorded $13.8 million of goodwill, $16.8 million of identifiable intangible assets, including $3.3 million of in-process technology, $3.3 million of deferred tax liabilities and $0.5 million of net tangible liabilities.
Fiscal 2009 Acquisitions
We acquired Mazu Networks, Inc. (Mazu) on February 19, 2009 (the Mazu acquisition date) to, among other reasons, meet enterprise and service provider customer demands by extending our suite of WAN optimization products to include global application performance, reporting and analytics. The results of Mazu’s operations have been included in the consolidated financial statements since the acquisition date.
Mazu acquisition date estimated fair value
Upon closing, we made payments totaling $23.1 million in cash for all of the outstanding securities of Mazu. Pursuant to the merger agreement, additional cash payments were due to Mazu shareholders upon the achievement of certain bookings targets through March 31, 2010. At the Mazu acquisition date, we recorded a liability for the estimated fair value of the acquisition-related contingent consideration to be paid to Mazu shareholders (Mazu acquisition-related contingent consideration) of $9.9 million. This liability was estimated using a probability-weighted discounted cash flow model on the achievement of the bookings target. At the Mazu acquisition date, we estimated the fair value of the Mazu acquisition-related contingent consideration to be paid to the former employees of Mazu ( Mazu acquisition-related compensation costs) to be $3.8 million. This fair value was also estimated using a probability-weighted discounted cash flow model on the achievement of the bookings target. No liability for the Mazu acquisition-related compensation cost was recorded as of the Mazu acquisition date, as this component was considered compensatory and was recognized as compensation cost in operating expense ratably over the period from the Mazu acquisition date to March 31, 2010.
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As of the Mazu acquisition date, the fair value of consideration transferred and contingent consideration was estimated as follows:
Mazu acquisition-related contingent consideration
The final liability for the Mazu acquisition-related contingent consideration, which included the Mazu acquisition-related contingent consideration paid to Mazu shareholders and the Mazu acquisition-related compensation costs, was $15.2 million. This liability was paid during the third quarter of 2010.
The Mazu acquisition-related contingent consideration paid to Mazu shareholders was $11.4 million, based on the achievement of certain bookings targets through March 31, 2010. During the fiscal year ended 2010, we recognized $2.7 million of acquisition-related costs due to the change in fair value of the Mazu acquisition-related contingent consideration distributed directly to the Mazu shareholders. During the fiscal year 2009, we recorded a net charge of $0.1 million, which included the transaction costs such as legal, accounting, valuation and other professional services of $0.6 million and integration costs of $0.8 million, offset by the cumulative changes in fair value of the Mazu acquisition-related contingent consideration to be paid directly to the Mazu shareholders of $1.3 million.
The Mazu acquisition-related compensation costs component of the Mazu acquisition-related contingent consideration was $3.8 million, based on the achievement of certain bookings targets through March 31, 2010. During the fiscal years 2010 and 2009, we recognized $1.4 million and $2.4 million, respectively, of Mazu acquisition-related compensation costs.
Acquisition-related Costs
Acquisition-related costs include transaction costs, integration-related costs and changes in the fair value of the acquisition-related contingent consideration.
The following table summarizes the acquisition-related costs recognized:
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The following table shows the acquisition-related costs pursuant to the 2011, 2010 and 2009 acquisitions and the acquisition-related compensation costs that were recognized in operating expenses:
3. NET INCOME PER COMMON SHARE
Basic net income per common share is computed by dividing net income by the weighted average number of vested common shares outstanding during the period. Diluted net income per common share is computed by giving effect to all potential dilutive common shares, including stock awards and common stock subject to repurchase.
The following table sets forth the computation of net income per share:
The following weighted average outstanding options and RSUs were excluded from the computation of diluted net income per common share for the periods presented because including them would have had an anti-dilutive effect:
(1) Stock options outstanding with an exercise price higher than our average stock price for the periods presented, represent out-of-the-money awards and are excluded from the calculations of the diluted net income per share since the effect of including them would have been anti-dilutive under the treasury stock method.
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4. FAIR VALUE OF ASSETS AND LIABILITIES
As of December 31, 2011, the fair value measurements of our cash, cash equivalents, investments and acquisition-related contingent consideration consisted of the following:
As of December 31, 2010, the fair value measurements of our cash and cash equivalents, investments, and acquisition-related contingent consideration consisted of the following:
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The following tables present the gross unrealized gains and gross unrealized losses as of December 31, 2011 and 2010:
We have evaluated our investments as of December 31, 2011 and have determined that no investments with unrealized losses are other-than-temporarily impaired. No investments have been in a continuous loss position greater than one year.
Cash, Cash Equivalents and Investments
Cash and cash equivalents consist primarily of highly liquid investments in money market mutual funds, government-sponsored enterprise obligations, treasury bills, commercial paper and other money market securities with remaining maturities at date of purchase of 90 days or less. The carrying value of cash and cash equivalents at December 31, 2011 and 2010 was $215.5 million and $165.7 million, respectively, and the weighted average interest rates were 0.2%. The carrying value approximates fair value at December 31, 2011 and 2010.
Investments, which are classified as available for sale at December 31, 2011, are carried at fair value, with the unrealized gains and losses, net of tax, reported as a separate component of stockholders’ equity. Investments consist of government-sponsored enterprise obligations, treasury bills, FDIC-backed certificates of deposit and corporate bonds and notes. The fair value of our investments is determined as the exit price in the principal market in which we would transact. Level 1 instruments are valued based on quoted market prices in active markets and include treasury bills, money market funds. Level 2 instruments are valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency and include corporate bonds and notes and government-sponsored enterprise obligations and FDIC-backed certificates of deposit. Level 3 instruments are valued based on unobservable inputs that are supported by little or no market activity and reflect our own assumptions
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in measuring fair value. As of December 31, 2011 and 2010, we had no investments valued as Level 3 instruments. As of December 31, 2011 and 2010, the investments are recorded at amortized cost, which approximates fair market value. Generally our investments have maturity dates up to two years from our date of purchase and active markets for these investments exist.
Restricted Cash
Restricted cash primarily represents collateralized letters of credit established in connection with lease agreements for our facilities. Current restricted cash totaled $1.1 million as of December 31, 2011 and zero at December 31, 2010. Current restricted cash is included in Prepaid expenses and other current assets in the consolidated balance sheet. Long-term restricted cash totaled $6.0 million and $2.6 million at December 31, 2011 and 2010, respectively. Long-term restricted cash is included in Other assets in the consolidated balance sheets and consists primarily of funds held as collateral for letters of credit for the security deposit on the leases of our corporate headquarters.
Acquisition-related Contingent Consideration
We estimated the fair value of the acquisition-related contingent consideration using a probability-weighted discounted cash flow model. This fair value measure was based on significant inputs not observed in the market and thus represented a Level 3 instrument. Level 3 instruments are valued based on unobservable inputs that are supported by little or no market activity and reflect our own assumptions in measuring fair value.
The change in the acquisition-related contingent consideration liability consisted of the following:
The Mazu acquisition-related contingent consideration was paid during the third quarter of 2010.
5. INVENTORY
Inventories consist primarily of hardware and related component parts and evaluation units located at customer locations, and are stated at the lower of cost (on a first-in, first-out basis) or market. Inventory is comprised of the following:
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6. GOODWILL AND INTANGIBLE ASSETS
Goodwill
Goodwill represents the excess of the purchase price of an acquired business over the fair value of the underlying net tangible and intangible assets. We consider the acquired businesses as additions to our product portfolio and not additional reporting units or operating segments. We record goodwill adjustments pursuant to changes to net assets acquired during the measurement period, which is generally up to one year from the date of acquisition. Goodwill was $117.5 million and $25.7 million at December 31, 2011 and 2010, respectively. A portion of the goodwill associated with the acquisition of Global Protocols, Zeus and Aptimize, will be deductible for income tax purposes.
Goodwill consisted of the following:
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Intangible Assets
Intangible assets are recorded at their estimated fair value as of the acquisition date of the related acquired business. Intangible assets that have a finite life are amortized over their useful lives.
Intangible assets consisted of the following:
Amortization expense was $13.1 million, $5.4 million and $4.1 million for the years ended December 31, 2011, 2010 and 2009, respectively.
Estimated future amortization expense related to the above intangible assets at December 31, 2011 is as follows:
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7. FIXED ASSETS
Fixed assets are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of the respective assets, which is typically two to five years. Leasehold improvements are amortized using the straight-line method over the shorter of the lease term or estimated useful life of the asset. Repair and maintenance costs are expensed as incurred.
Fixed assets consisted of the following:
Depreciation and amortization expense of fixed assets was $11.2 million, $10.4 million and $10.1 million for the years ended December 31, 2011, 2010 and 2009, respectively.
8. CURRENT LIABILITIES
Accrued compensation and benefits consisted of the following:
Other accrued liabilities consisted of the following:
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9. DEFERRED REVENUE
Deferred revenue consisted of the following:
Deferred product revenue relates to arrangements where not all revenue recognition criteria have been met. Deferred support revenue represents customer payments made in advance for support contracts. Support contracts are typically billed on a per annum basis in advance and revenue is recognized ratably over the support period. Deferred revenue, non-current consists primarily of customer payments made in advance for support contracts with terms of more than 12 months.
10. GUARANTEES
Our agreements with customers, as well as our reseller agreements, generally include certain provisions for indemnifying customers and resellers and their affiliated parties against liabilities if our products infringe a third party’s intellectual property rights. To date, we have not incurred any material costs as a result of such indemnifications and have not accrued any liabilities related to such obligations in our consolidated financial statements.
As permitted or required under Delaware law and to the maximum extent allowable under that law, we have certain obligations to indemnify our officers, directors and certain key employees for certain events or occurrences while the officer, director or employee is or was serving at our request in such capacity. These indemnification obligations are valid as long as the director, officer or employee acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal proceeding, had no reasonable cause to believe his or her conduct was unlawful. The maximum potential amount of future payments we could be required to make under these indemnification obligations is unlimited; however, we have a director and officer insurance policy that mitigates our exposure and enables us to recover a portion of any future amounts paid.
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11. LEASE COMMITMENTS
We lease our facilities under non-cancelable operating lease agreements. Future minimum commitments for these operating leases in place as of December 31, 2011 with a remaining non-cancelable lease term in excess of one year are as follows:
The terms of certain lease agreements provide for rental payments on a graduated basis. We recognize rent expense on the straight-line basis over the lease period and have accrued for rent expense incurred but not paid. Rent expense under operating leases was $11.1 million, $8.5 million and $8.2 million for the years ended December 31, 2011, 2010 and 2009, respectively.
12. COMMON STOCK
Stock Plans
In July 2002, our Board of Directors adopted the 2002 Stock Plan (the 2002 Plan). In April and May 2006, our Board of Directors approved the 2006 Equity Incentive Plan (the 2006 Plan), the Purchase Plan and the 2006 Director Option Plan, which became effective upon our Initial Public Offering. In September 2006, all shares of common stock available for grant under the 2002 Plan transferred to the 2006 Plan.
The Plans provide for automatic replenishments as follows:

2006 Plan - increased on January 1 of each year for five years, beginning in 2007, by a number equal to the lesser of (i) 8,000,000 shares or (ii) 5% of the shares of common stock outstanding at that time or (iii) the number of shares determined by the Board.

2006 Employee Stock Purchase Plan - increased on January 1 of each year for the term of the 2006 Employee Stock Purchase Plan by a number of shares equal to the lesser of (i) 1,500,000 shares or (ii) 1% of the shares of common stock outstanding at that time or (iii) the number of shares determined by the Board.

2006 Director Option Plan - increased on January 1 of each year for the term of the 2006 Director Option Plan by 500,000 shares.
In February 2009, our Board of Directors adopted the 2009 Inducement Equity Inventive Plan (the 2009 Plan). The objective of the 2009 Plan is to provide incentives to attract, retain, and motivate eligible persons whose potential contributions are important to promote our long-term success and the creation of stockholder value. The 2009 Plan is intended to comply with NASDAQ Rule 4350(i)(1)(A)(iv), which governs granting certain awards as a material inducement to an individual entering into employment with us. The 2009 Plan may be used for new hire equity grants should the Board of Directors determine to do so in the future.
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As of December 31, 2011, 9,859,000 shares were available for grant under the 2006 Plan. As of December 31, 2011, 2,152,000 shares were available for grant under the 2006 Director Option Plan. As of December 31, 2011, 1,258,000 shares were available for grant under the 2009 Plan.
Stock-Based Compensation Expense
The following table summarizes stock-based compensation expense for stock options, RSUs and the Purchase Plan recorded in our statement of operations:
Share-Based Payments Valuation Assumptions
The fair value of options granted and Purchase Plan shares granted was estimated at the date of grant using the following assumptions:
We estimated the fair value of stock options granted using the Black-Scholes option-pricing formula and a single option award approach. This model utilizes the estimated fair value of common stock and requires that, at the date of grant, we use the expected term of the option, the expected volatility of the price of our common stock, risk-free interest rates and expected dividend yield of our common stock. The fair value is amortized on a straight-line basis over the requisite service periods of the awards, which is generally three to four years.
The expected term represents the period that stock options are expected to be outstanding. During the first three quarters of 2010 and for the years ended December 31, 2009, we elected to use the simplified method of determining the expected term of stock options due to insufficient historical exercise data as a publicly traded company. For the year ended December 31, 2011 and during the
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fourth quarter of 2010, we determined that we had sufficient historical information to use a method based on historical exercise patterns and post vesting termination behavior, which we believe is more representative of our expected term. During the first three quarters of 2010 and for the years ended December 31, 2009, the computation of our expected volatility for stock options was based on the historical volatility of comparable companies from a representative peer group selected based on industry, financial and market capitalization data, due to our insufficient historical volatility data as a publicly traded company. For the year ended December 31, 2011 and during the fourth quarter of 2010, we determined that we had sufficient historical volatility data to use a blended historical and implied volatility.
The computation of expected volatility for the Purchase Plan for the years ended December 31, 2011, 2010 and 2009 is based on our historical volatility.
Management estimated expected forfeitures and is recognizing compensation costs only for those equity awards expected to vest.
Stock Options
Options issued under our stock option plans are generally for periods not to exceed 10 years and are issued with an exercise price equal to the market value of our common stock on the date of grant, as determined by the last sale price of such stock on the Nasdaq Global Select Market. Options typically vest either 25% of the shares one year after the options’ vesting commencement date and the remainder ratably on a monthly basis over the following three years, or ratably on a monthly basis over four years. Options granted under the 2002 Plan prior to May 31, 2006 have a maximum term of ten years, and beginning May 31, 2006 have a maximum term of seven years. Options granted under the 2006 Plan have a maximum term of seven years. Options granted under the 2006 Director Option Plan prior to March 4, 2008 have a maximum term of ten years, and options granted beginning March 4, 2008 have a maximum term of seven years. Options granted under the 2009 Plan have a maximum term of seven years.
Options granted under the 2002 Plan to the employees in the U.S. prior to March 28, 2006 were immediately exercisable. For options granted beginning March 28, 2006, optionees may only exercise vested shares. Any unvested stock issued upon early exercise under the 2002 Plan were subject to repurchase by us. Grants made pursuant to the 2006 Plan do not provide for the early exercise of options. At December 31, 2011, no shares were subject to repurchase under the 2002 Plan.
As of December 31, 2011, total compensation cost related to stock options granted to employees and directors but not yet recognized was $49.6 million, net of estimated forfeitures. This cost will be recognized on a straight-line basis over the remaining weighted-average service period of 2.47 years. Amortization in the years ended December 31, 2011, 2010 and 2009 was $31.3 million, $37.4 million and $39.0 million, respectively.
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The following table summarizes information about stock options activity under all stock option plans:
The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying stock option awards and the closing price of our common stock at December 31, 2011. During the years ended December 31, 2011, 2010 and 2009, the aggregate intrinsic value of stock option awards exercised was $129.7 million, $102.0 million, and $15.9 million, respectively, determined at the date of option exercise.
The weighted average grant-date fair value of options granted for the years ended December 31, 2011, 2010 and 2009, was $15.66, $8.55, and $3.57 per share, respectively.
Stock Purchase Plan
Under the Purchase Plan, employees may purchase shares of common stock through payroll deductions at a price per share that is 85% of the lesser of the fair market value of our common stock as of the beginning of an applicable offering period or the applicable purchase date. Offering periods are generally 24 months with purchases generally every six months. Employees’ payroll deductions may not exceed 15% of their compensation. Employees may purchase up to 2,000 shares per purchase period provided that the value of the shares purchased in any calendar year does not exceed IRS limitations.
In the year ended December 31, 2011, there was $20.1 million of total compensation cost, net of estimated forfeitures, left to be amortized under our Purchase Plan, which will be amortized over the remaining Purchase Plan offering period, which is up to 19 months. Amortization in the years ended December 31, 2011, 2010 and 2009 was $8.7 million, $6.8 million and $7.1 million, respectively.
The weighted average fair value of grants for the years ended December 31, 2011, 2010 and 2009, was $11.34, $9.69, and $4.36 per share, respectively.
As of December 31, 2011, 1,086,000 shares were available under the Purchase Plan.
Restricted Stock Units
RSUs, which may include performance-based RSUs, are granted to our employees and eligible executives, under the 2006 Plan. We expense the cost of nonvested RSUs, which is determined to be the fair market value of the shares of our common stock at the date of grant, ratably over the service period.
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Performance-based RSUs that vest are generally variable based upon meeting certain annual performance targets, and require the eligible executives to be employed by us for up to three years from the date of grant. Annual performance targets for awards granted in the years ended December 31, 2011 and 2010 were earned and determined at December 31, 2011 and 2010, respectively.
RSUs generally vest over a period of three to four years from the date of grant. Until vested, RSUs do not have the voting rights of common stock and the shares underlying the awards are not considered issued and outstanding.
As of December 31, 2011, total unrecognized compensation cost related to nonvested RSUs to employees and directors but not yet recognized was $91.9 million, net of estimated forfeitures. This cost will be recognized over the remaining weighted-average service period of 2.20 years. Amortization in the years ended December 31, 2011, 2010 and 2009 was $49.7 million, $26.6 million, and $9.1 million, respectively.
The following table summarizes information about nonvested RSUs as of December 31, 2011:
The weighted average grant-date fair value of RSUs granted in the years ended December 31, 2011, 2010 and 2009 were $33.17, $19.12, and $7.61, respectively.
Share Repurchase Program
On August 19, 2011, our Board of Directors authorized a Share Repurchase Program (the Program), which authorized us to repurchase up to $150.0 million of our outstanding common stock. The Program does not require us to purchase a minimum number of shares, and may be suspended, modified or discounted at any time without prior notice. The Program will expire in August 2013.
For the year ended December 31, 2011, we repurchased 1,500,000 shares of common stock under the Program on the open market for an aggregate purchase price of $35.0 million, or a weighted average of $23.36 per share.
We did not repurchase any shares of common stock during the year ended December 31, 2010.
For the year ended December 31, 2009, we repurchased 1,955,000 shares of common stock under a stock repurchase program approved by the Board in April 2008, on the open market for an aggregate purchase price of $29.0 million, or a weighted average of $14.84 per share.
The timing and amounts of these purchases were based on market conditions and other factors including price, regulatory requirements and capital availability. The share repurchases were financed by available cash balances and cash from operations.
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13. INCOME TAXES
A geographical breakdown of income before provision for income taxes is shown in the following table:
The provision for income tax expense consists of the following:
Our effective tax rate was 31%, 40%, and 38%, for the years ended December 31, 2011, 2010, and 2009, respectively. We have not provided U.S. taxes for our foreign earnings because such earnings are intended to be indefinitely reinvested outside the U.S. Any U.S taxes not provided for would be immaterial.
The difference between the provision for income taxes and the amount computed by applying the federal statutory income tax rate to income before taxes is as follows:
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The components of the current and non-current deferred tax assets and liabilities consist of the following:
As of December 31, 2011, we had net operating loss carryforwards for federal, state and foreign income tax purposes of $31.2 million, $25.0 million and $0.9 million, respectively. The utilization of the federal loss carryforwards are subject to limitation under Section 382 of the Internal Revenue Code. We also had federal and state research and development tax credit carryforwards of approximately $10.4 million and $16.7 million, respectively. If not utilized, the federal net operating loss carryforwards will expire between 2022 and 2029, while the state net operating loss carryforwards will expire between 2017 and 2031. The majority of our federal tax credit carryforwards will begin to expire in 2030. The state tax credit carryforwards and foreign net operating loss carryforwards do not expire.
As part of our accounting for the acquisition of Mazu in the first quarter of 2009, we established deferred tax assets for federal net operating loss carryforwards and research and development credit carryforwards that are subject to limitation under Section 382 of the Internal Revenue Code. We recorded a valuation allowance of $8.8 million related to a portion of the federal net operating loss carryforwards and research and development credit carryforwards that were not more likely than not to be realized. As of December 31, 2011, we reevaluated the need for a valuation allowance on these deferred tax assets by considering positive and negative evidence as required by the related accounting guidance. As a result of this evaluation, we concluded that it is more likely than not that we will have sufficient future taxable income to utilize the net operating loss carryforwards and credit carryforwards. Accordingly, we reversed the valuation allowance and recorded an income tax benefit of $8.8 million in 2011.
In the year ended December 31, 2010, management concluded that a valuation allowance was needed on our California income tax credit carryforwards. Due to a change in the our forecasted
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income allocated to California for tax years after 2010, it is more likely than not the California income tax credits carryforwards will not be utilized in the foreseeable future. Accordingly, we have established a 100% valuation allowance against the tax credits. The amount of the valuation allowance against the California credits were $6.1 million and $3.1 million, net of federal benefit, for the years ended December 31, 2011 and 2010, respectively.
During the year ended December 31, 2011, we made an election to change the tax status of our United Kingdom (UK) subsidiaries to entities that are disregarded for federal and state income tax purposes. As a result of the change in tax status, we recorded a tax benefit of $2.9 million to record certain deferred tax assets resulting from the change.
We recorded deferred charges during the year ended December 31, 2011 related to the deferral of income tax expense on intercompany profits that resulted from the sale of our intellectual property rights (including intellectual property acquired during the current year) outside of North and South America to our Singapore subsidiary. The deferred charges are included in the Prepaid expenses and other current assets and the Other assets lines of the consolidated balance sheets in the amounts of $5.0 million and $15.6 million, respectively. The deferred charges are amortized as a component of income tax expense over the five year economic life of the intellectual property.
Beginning in the year ended December 31, 2011, we are subject to a reduced income tax rate in Singapore as a result of certain employment and spending commitments. The reduced tax rate is effective through 2020. We realized no tax savings in 2011 because of net local tax losses.
During 2011, we reduced our current federal, foreign and state taxes payable by $51.0 million for the excess tax benefits from stock option exercises and other employee stock programs, offsetting additional paid-in capital. In addition, we have unrecorded excess tax benefits from stock option exercises and other employee stock programs of approximately $15.2 million as of December 31, 2011. These amounts will be credited to additional paid-in-capital when such amounts reduce cash taxes payable.
Uncertain Income Tax Positions
A reconciliation of the beginning and ending amount of the consolidated liability for unrecognized income tax benefits during the year is as follows:
As of December 31, 2011, 2010 and 2009, the unrecognized tax benefits of $27.0 million, $6.9 million and $4.9 million, respectively, included tax benefits that, if recognized, would reduce our effective tax rate by $22.2 million, $6.1 million and $4.2 million, respectively. We accrued $0.1 million of interest and penalties associated with uncertain tax positions for each of the years ended December 31, 2011, 2010 and 2009. Over the next 12 months, we could potentially reverse up to $1.0 million of our unrecognized tax benefits due to the statute of limitations expiring in certain jurisdictions.
RIVERBED TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
We are subject to income tax in the U.S. as well as numerous state and foreign jurisdictions. With the exception of several states, we are no longer subject to federal, state and local income tax examinations for years before 2008, although carryforward attributes that were generated prior to 2008 may still be adjusted upon examination by the Internal Revenue Service and the California Franchise Tax Board if the attributes either have been or will be used in a future period. In addition, we file tax returns in multiple foreign taxing jurisdictions. In our most significant foreign jurisdictions, the UK and Singapore, the open tax years range from 2007 to 2010.
14. SEGMENT INFORMATION
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. While our Chief Executive Officer evaluates the financial information for certain of our product lines, the information for all of our product lines is aggregated for analysis on a consolidated level as the primary basis for the allocation of resources and assessment of financial results. Accordingly, the consolidated business is considered to be one operating segment.
Revenue by geography is based on the billing address of the customer. The following table sets forth revenue by geographic area.
Revenue
15. EMPLOYEE BENEFIT PLAN
We have a 401(k) plan covering all eligible employees. At our discretion, we may match a portion of the employees’ eligible contributions. Contributions to the plan during the years ended December 31, 2011, 2010 and 2009, were $2.0 million, $0.4 million and zero, respectively.
16. LEGAL MATTERS
On June 1, 2011, we served Silver Peak Systems, Inc. with a lawsuit, filed in the United States District Court for the District of Delaware, alleging infringement of certain patents. The lawsuit seeks unspecified damages and injunctive relief. On July 22, 2011, Silver Peak Systems denied the allegations and requested declaratory judgments of invalidity and non-infringement.
On August 17, 2011, Silver Peak Systems amended its counterclaims against us, alleging infringement by Riverbed of certain patents. The lawsuit seeks unspecified damages and injunctive relief. On September 20, 2011, we denied Silver Peak Systems’ allegations and requested declaratory judgments of invalidity and non-infringement.
RIVERBED TECHNOLOGY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
On December 21, 2011, we amended our lawsuit against Silver Peak Systems to allege infringement of an additional patent.
At this time we are unable to estimate any range of reasonably possible loss relating to these actions. Discovery is ongoing, and trial is currently scheduled to begin on July 29, 2013. We believe that we have meritorious defenses to the counterclaims against us, and we intend to vigorously contest these counterclaims.
From time to time, we are involved in various legal proceedings, claims and litigation arising in the ordinary course of business. There are no currently pending legal proceedings at December 31, 2011 that, in the opinion of management, might have a material adverse effect on our financial position, results of operations or cash flows.
17. RELATED PARTIES
No significant related party transactions occurred in the years ended December 31, 2011, 2010 and 2009.
18. SUBSEQUENT EVENTS
Acquisition of assets of Expand Networks
On January 11, 2012, we entered into an agreement to purchase certain assets of Expand Networks, including its intellectual property, out of liquidation in Israel for $6.0 million. We did not purchase the corporate entity of Expand Networks and have not assumed any of Expand Networks’ liabilities, obligations or contracts.
New Corporate Headquarters
On February 2, 2012, we entered into a lease agreement, pursuant to which we will lease office space for an initial term of ten years, located at 680 Folsom Street, San Francisco, California. Following the completion of certain construction, which we anticipate to be completed by August 2014, we intend to use the leased space as our new worldwide corporate headquarters. The base annual rent for the leased space will range from approximately $8.4 million to $9.0 million, none of which is expected to be due until construction has been completed and we have occupied the leased space. In addition to the base rent, we will be responsible for payment of certain operating expenses, including utilities and real estate taxes.
Item 9.
Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
There have been no disagreements with accountants on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedures required to be reported under this item.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2011, the end of the period covered by this Annual Report on Form 10-K. This controls evaluation was done under the supervision and with the participation of our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO) as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act.
Disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934, such as this Annual Report on Form 10-K, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed such that information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.
Based upon the controls evaluation, our CEO and CFO have concluded that as of December 31, 2011, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission and to ensure that material information relating to us and our consolidated subsidiaries is made known to management, including the CEO and CFO.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over our financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of our internal control over financial reporting as of December 31, 2011. In making this assessment, management used the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on our assessment, using those criteria, our management concluded that our internal control over financial reporting was effective as of December 31, 2011. The attestation report concerning the effectiveness of our internal control over financial reporting as of December 31, 2011, issued by Ernst & Young, LLP, Independent Registered Public Accounting Firm, appears in Part II, Item 8 of the Annual Report on Form 10-K.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the fourth quarter of 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act). Internal control over financial reporting means a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Inherent Limitations of Internal Controls
Our management, including our CEO and CFO, does not expect that our disclosure controls and procedures or our internal controls over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system will be met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or deterioration in the degree of compliance with the policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
Item 9B.
Item 9B. Other Information
None.
Part III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information regarding our directors required by this item is included under the caption “Election of Directors” in Riverbed’s Proxy Statement for its 2012 Annual Meeting of Stockholders to be filed within 120 days after the end of the fiscal year ended December 31, 2011 (the “2012 Proxy Statement”) and is incorporated herein by reference. The information regarding our executive officers required by this item is included under the caption “Executive Officers” in the 2012 Proxy Statement and is incorporated herein by reference. The information regarding compliance with Section 16(a) of the Exchange Act required by this item is included under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the 2012 Proxy Statement and is incorporated herein by reference. The information regarding our code of ethics, nominating committee and audit committee required by this item is included under the caption “Corporate Governance” in the 2012 Proxy Statement and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
The information regarding executive compensation required by this item is included under the caption “Compensation of Executive Officers” in the 2012 Proxy Statement and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information regarding securities authorized for issuance under equity compensation plans required by this item is included under the caption “Equity Compensation Plan Information” in the 2012 Proxy Statement and is incorporated herein by reference. The information regarding security ownership of certain beneficial owners and management required by this item is included under the caption “Security Ownership of Certain Beneficial Owners and Management” in the 2012 Proxy Statement and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information regarding transactions with related persons required by this item is included under the caption “Review, Approval or Ratification of Transactions with Related Persons” in the 2012 Proxy Statement and is incorporated herein by reference. The information regarding director independence required by this item is included under the caption “Corporate Governance” in the 2012 Proxy Statement and is incorporated herein by reference.
Item 14.
Item 14. Principal Accountant Fees and Services
The information required by this item is incorporated under the captions “Independent Registered Public Accounting Firm’s Fees” and “Pre-Approval Policies and Procedures” in the 2012 Proxy Statement and is incorporated herein by reference.
Part IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) Financial Statements
The financial statements filed as part of this report are listed on the index to financial statements on page 62.
(b) Financial Statement Schedules
The following financial statement schedule is filed as a part of this Annual Report on Form 10-K
Schedule II - Valuation and Qualifying Accounts
SCHEDULE II
Valuation and Qualifying Accounts
All other schedules are omitted because they are not required or the required information is shown in the financial statements or notes thereto.
(c) Exhibits
The following exhibits are incorporated by reference or filed herewith.
The certification attached as Exhibit 32.1 that accompanies this Annual Report on Form 10-K is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Riverbed Technology, Inc. under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date of this Annual Report on Form 10-K, irrespective of any general incorporation language contained in such filing.
* Management contract or compensatory plan or arrangement.
** Furnished and not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Riverbed Technology, Inc. under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date of this Annual Report on Form 10-K, irrespective of any general incorporation language contained in such filing.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.