UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

 

Commission file number: 001-31216

 

McAfee, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

 

Registrant’s telephone number, including area code:

(408) 988-3832

 

 

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

 

 

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

 

 

 

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

 

 

As of April 28, 2006, 159,524,329 shares of the registrant’s common stock, $0.01 par value, were outstanding.

 

 

MCAFEE, INC.

 

FORM 10-Q

March 31, 2006

 

 

CONTENTS

 

MCAFEE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

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

MCAFEE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

 

 

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

MCAFEE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

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

 

 

We and our wholly owned subsidiaries are a worldwide supplier of computer security solutions designed to prevent intrusions on networks and secure computer systems and other digital devices from the next generation of blended attacks and threats. We offer two families of products, McAfee System Protection Solutions and McAfee Network Protection Solutions. Our computer security solutions are offered primarily to large enterprises, governments, small and medium-sized businesses and consumers through a network of qualified partners. We operate our business in five geographic regions: North America; Europe, Middle East and Africa, or EMEA; Japan; Asia-Pacific, excluding Japan; and Latin America.

 

 

The accompanying condensed consolidated financial statements include our accounts as of March 31, 2006 and December 31, 2005 and for the three months ended March 31, 2006 and March 31, 2005. All significant intercompany accounts and transactions have been eliminated in consolidation. These condensed consolidated financial statements have been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, or SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The December 31, 2005 consolidated balance sheet was derived from audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. However, we believe that all disclosures are adequate to make the information presented not misleading. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto, included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005.

 

In the opinion of our management, all adjustments (which consist of normal recurring adjustments, except as disclosed herein) necessary to fairly present our financial position as of March 31, 2006, and results of operations and cash flows for the three months ended March 31, 2006 and March 31, 2005 have been included. The results of operations for the three months ended March 31, 2006 are not necessarily indicative of the results to be expected for the full fiscal year or for any future periods.

 

As of January 1, 2006, we changed the presentation of our net revenue and cost of net revenue to include three categories: (i) product, (ii) subscription and (iii) service and support. See Note 3 for further information.

 

Foreign Currency Translation

 

We have designated the U.S. dollar as the functional currency of McAfee, Inc. For the majority of our subsidiaries, we consider the local currency to be their functional currency. The assets and liabilities of subsidiaries that are denominated in functional currencies other than the U.S. dollar are translated using the exchange rate on the condensed consolidated balance sheet date. Revenues and expenses are translated at average exchange rates prevailing during the period. Translation adjustments resulting from this process are charged or credited to accumulated other comprehensive income, which is a component of stockholders’ equity. As of March 31, 2006, our stockholders’ equity included $3.0 million of net foreign currency translation losses for the three months ended March 31, 2006 and as of March 31, 2005, stockholders’ equity includes a $0.3 million gain for the three months ended March 31, 2005.

 

Occassionally, a subsidiary enters into transactions that are denominated in currencies other than its functional currency. In these cases, the assets and liabilities and revenues and expenses related to the transactions are translated into the functional currency and any resulting gains or losses are recorded in the condensed consolidated statements of income. During the three months ended March 31, 2006 and 2005, we recorded net foreign currency transaction losses of $1.6 million and $1.1 million, respectively, in our condensed consolidated statements of income.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Inventory

 

Inventory, which consists primarily of finished goods, is stated at lower of cost or market and is included in other current assets on our condensed consolidated balance sheet. Cost is computed using standard cost, which approximates actual cost on a first in, first out basis. Inventory balances were $1.2 million at both March 31, 2006 and December 31, 2005.

 

Stock-Based Compensation

 

On January 1, 2006, we adopted SFAS No. 123R, “Share-Based Payment,” or SFAS 123R, which is a revision of SFAS No. 123 “Accounting for Stock-Based Compensation,” or SFAS 123, and supersedes APB No. 25, “Accounting for Stock Issues to Employees,” or APB 25. Among other items, SFAS 123R requires companies to record compensation expense for share-based awards issued to employees and directors in exchange for services provided. The amount of the compensation expense is based on the estimated fair value of the awards on their grant dates and is recognized over the required service periods. Our share-based awards include stock options, restricted stock awards, restricted stock units and our Employee Stock Purchase Plan.

 

Prior to our adoption of SFAS 123R, we applied the intrinsic value method set forth in APB 25 to calculate the compensation expense for share-based awards. Historically, we have generally set the exercise price for our stock options equal to the market value on the grant date. As a result, the options generally had no intrinsic value on their grant dates, and we did not record any compensation expense unless the terms of the options were subsequently modified. In addition, we did not recognize any compensation expense for our Employee Stock Purchase Plan under APB 25. For restricted stock awards and units, the calculation of compensation expense under APB 25 and SFAS 123R is the same.

 

We adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard to all share-based awards issued on or after January 1, 2006 and any outstanding share-based awards that were issued but not vested as of January 1, 2006. Accordingly, our condensed consolidated financial statements as of March 31, 2005 and for the three months then ended have not been restated to reflect the impact of SFAS 123R. During the three months ended March 31, 2005, we recognized a benefit of approximately $3.7 million under APB 25 related to the exchange of McAfee.com options in 2002 and the re-pricing of options in 1999. This benefit was partially offset by an expense of approximately $0.4 million for restricted stock awards. See Note 4 for additional information.

 

In the three months ended March 31, 2006, we recognized stock-based compensation expense of $13.6 million in our condensed consolidated financial statements, which included $10.9 million for stock options, $1.9 million for restricted stock awards and units and $0.8 million for our Employee Stock Purchase Plan. These amounts include (i) compensation expense for stock options granted prior to January 1, 2006 but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the pro-forma provisions of SFAS 123, (ii) compensation expense for stock options granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R and (iii) compensation expense for restricted stock award and unit grants made both before and after January 1, 2006 that are not yet vested.

 

The estimated fair value underlying our calculation of compensation expense for stock options is based on the Black-Scholes pricing model. Upon adoption of SFAS 123R, we changed our method of attributing the value of stock-based compensation to the straight-line, single-option method. Compensation expense for all stock options granted prior to January 1, 2006 will continue to be recognized using the accelerated, single-option method. In addition, SFAS 123R requires forfeitures of share-based awards to be estimated at the time of grant and revised, if necessary, in subsequent periods if our estimates change based on the actual amount of forfeitures we have experienced. In the pro-forma information required under SFAS 123 for periods prior to January 1, 2006, we accounted for forfeitures as they occurred.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

SFAS 123R requires us to calculate the pool of excess tax benefits, or the APIC pool, available as of January 1, 2006 to absorb tax deficiencies recognized in subsequent periods, assuming we had applied the provisions of the standard in prior periods. Pursuant to the provisions of FASB Staff Position 123R-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards,” we adopted the alternative method for determining the tax effects of share-based compensation, which among other things, provides a simplified method for estimating the beginning APIC pool balance.

 

Accounting for Income Taxes

 

At the end of each interim period we make our best estimate of the effective tax rate expected to be applicable for the full fiscal year. This effective tax rate is used to determine income taxes on a current year-to-date basis. The effective tax rate may consider, as applicable, tax credits, foreign tax rates, and other available tax planning alternatives. It also includes the effect of any valuation allowance expected to be necessary at the end of the period for deferred tax assets related to originating deductible temporary differences and carryforwards. In arriving at this effective tax rate applied to interim periods no effect is included for the tax related to significant, unusual, or extraordinary items that may be separately reported or reported net of their related tax effect in reports for the interim period or for the fiscal year. The rate is revised, if necessary, as of the end of each successive interim period during the fiscal year to our best current estimate of our expected annual effective tax rate.

 

The effective tax rate is our best estimate of the tax expense (or benefit) that will be provided for the fiscal year, stated as a percentage of our estimated annual ordinary income (or loss). The tax expense (or benefit) related to ordinary income (or loss) for the interim period is determined using this estimated annual effective tax rate. The tax expense (or benefit) related to other items is individually computed and recognized when the items occur. The estimated tax rate applied to interim ordinary income (or loss) is reliant on our estimates of expected annual operating income (or loss) for the year as well as our projections of the proportion of income (or loss) earned in foreign jurisdictions which may have statutory tax rates significantly lower than tax rates applicable to our earnings in the United States. In each successive interim period, to the extent our operating results year to date and our estimates for the remainder of the fiscal year change from our original expectations regarding the proportion of earnings in various tax jurisdictions we expect that our effective tax rate will change accordingly, affecting tax expense (or benefit) for both that successive interim period as well as year-to-date interim results.

 

Tax returns are subject to audit by various taxing authorities. Although we believe that adequate accruals have been made each period for unsettled issues, additional benefits or expenses could occur in future years from resolution of outstanding matters. We record additional expenses each period on unsettled issues relating to the expected interest we would be required to pay a tax authority if we do not prevail on an unsettled issue. We continue to assess our potential tax liability included in accrued taxes in the condensed consolidated financial statements, and revise our estimates. Such revisions in our estimates could materially impact our results of operations and financial position. We have classified a portion of our tax liability as non-current in the condensed consolidated balance sheet based on the expected timing of cash payments to settle contingencies with taxing authorities.

 

Computation of Net Income per Share

 

Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of common shares and dilutive potential common shares outstanding during the period.

 

SFAS No. 128, “Earnings per Share,” requires that employee equity share options, nonvested shares and similar equity instruments granted by us be treated as potential common shares outstanding in computing diluted earnings per share. Diluted shares outstanding include the dilutive effect of in-the-money options which is calculated based on the average share price for each reported period using the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that we have not yet recognized and the amount of tax benefits that would be

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares. We calculate tax benefits that will be recorded in additional paid-in capital based on the portion of the fair value of the award that will be recognized in the financial statements, and exclude the portion of the award that was recognized under the SFAS 123 pro-forma disclosures prior to the implementation of SFAS 123R.

 

Recent Accounting Pronouncements

 

Electronic Equipment Waste Obligations

 

In June 2005, the FASB issued SFAS 143-1, “Accounting for Electronic Equipment Waste Obligations,” which provides guidance on the accounting for certain obligations associated with Directive 2002/96/EC on Waste Electrical and Electronic Equipment, or the Directive, which was adopted by the European Union, or EU. Under the Directive, the waste management obligation for historical equipment, defined as products put on the market on or prior to August 13, 2005, remains with the commercial user until the equipment is replaced. SFAS 143-1 is required to be applied to the later of the first fiscal period ending after June 8, 2005 or the date of the Directive’s adoption into law by the applicable EU member countries in which we have significant operations. We are currently evaluating the impact of FSP SFAS 143-1 on our financial position and results of operations. The effects will depend on the respective laws adopted by the EU member countries.

 

Accounting Changes and Error Corrections

 

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” or SFAS 154, a replacement of APB Opinion No. 20, “Accounting Changes,” and SFAS Statement 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle. Previously, most voluntary changes in accounting principles required recognition via a cumulative effect adjustment within net income of the period of the change. SFAS 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the Statement does not change the transition provisions of any existing accounting pronouncements. The adoption of SFAS 154 did not have a material effect on our consolidated financial position, results of operations or cash flows.

 

The Meaning of Other-Than-Temporary Impairment

 

In November 2005, the FASB issued Staff Position 115-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” or FSP 115-1, that addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary and the measurement of an impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in FSP 115-1 amends SFAS 115 “Accounting for Certain Investments in Debt and Equity Securities” and APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock”. The final FSP nullifies certain requirements of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”, and supersedes EITF Topic No. D-44, “Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value”. The guidance in FSP 115-1 is effective for reporting periods beginning after December 15, 2005. The adoption of FSP 115-1 did not have a material effect on our consolidated financial position, results of operations or cash flows.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

As disclosed in our 2005 Annual Report on Form 10-K, during the three months ended December 31, 2005, we made certain reclassifications from product revenue to service revenue, primarily related to online subscriptions. Total net revenue was not impacted by these reclassifications. The following table presents our 2005 quarterly net revenue, as reclassified in 2005, and cost of net revenue, as disclosed in our respective Quarterly Report on Form 10-Q (in thousands):

 

 

As of January 1, 2006, we changed the presentation of our net revenue and cost of net revenue to include three categories: (i) product, which includes hardware and perpetual licenses (ii) subscription, which includes subscription-based offerings and (iii) service and support, which includes maintenance, consulting and training. Previously, we chose to allocate our subscription business between product and services and support instead of presenting it as a separate category. We believe this new presentation is consistent with the way we currently manage our business as we grow the subscription component of both our corporate and consumer businesses. In the table below, we have applied the change in presentation retrospectively to the balances previously reported for each period during the year ended December 31, 2005. Total net revenues and cost of net revenues were not affected by the change.

 

The following table presents our revised 2005 quarterly net revenue and cost of net revenue presentation (in thousands):

 

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Employee Stock Purchase Plan

 

In April 2002, our board of directors adopted McAfee’s 2002 Employee Stock Purchase Plan, or the Employee Stock Purchase Plan, which reserved 2.0 million shares of our common stock for issuance to our employees. In December 2003 and May 2005, our stockholders approved an additional 2.0 million and 1.0 million shares for issuance, respectively, bringing the total number of shares reserved under the plan to 5.0 million. Generally, individuals who are employed for 30 days and perform at least 20 hours of service per week are eligible to participate in the Employee Stock Purchase Plan.

 

Prior to August 1, 2005, we offered shares of stock for purchase to eligible employees through a series of two-year offering periods. Each two-year offering period was comprised of four consecutive six-month purchase periods. Beginning August 1, 2005, the term of the offering period was changed to six months. Outstanding offering periods that commenced prior to August 1, 2005 will continue until the end of the two-year offering period.

 

During an offering period, employees make contributions to the Employee Stock Purchase Plan through payroll deductions. At the end of each purchase period, we use the accumulated contributions to issue shares of our stock to the participating employees. The issue price of those shares is equal to the lesser of (i) 85% of our stock price on the first day of the offering period, or (ii) 85% of our stock price on the purchase date. No participant may be issued more than $25,000 of common stock in any one calendar year and the maximum number of shares a participant may be issued during a single offering period is 10,000 shares. In both the three months ended March 31, 2006 and March 31, 2005, approximately 0.4 million shares were issued under the Employee Stock Purchase Plan at a weighted-average issue price of $17.22 and $13.93, respectively. The total intrinsic value of shares issued under the Employee Stock Purchase Plan during the three months ended March 31, 2006 and March 31, 2005 was $2.4 million and $4.8 million, respectively.

 

Company Stock Incentive Plans

 

Under the terms of our amended 1997 Stock Incentive Plan, or the 1997 Plan, we have reserved a total of 38.5 million shares for issuance to employees, officers, directors, third-party contractors and consultants through awards provided in the form of options, restricted stock awards, restricted stock units, or stock appreciation rights. As of March 31, 2006, we have no share-based issuances outstanding with third-party contractors or consultants.

 

For options granted to employees and officers under the 1997 Plan, the exercise price is no less than 100% of the fair value of our stock on the grant date. For options granted to all other parties, the exercise price is no less than 85% of the fair value of our common stock on the grant date. Although some of the options may be exercised immediately upon granting, the majority contain gradual vesting provisions, whereby 25% vest one year from the date of grant and thereafter in monthly increments over the remaining three years. All unexercised options expire ten years after the grant date. Restricted stock awards and restricted stock units also vest over a specified period, generally 50% two years from the grant date and 50% three years from the grant date. Restricted stock awards are common stock issued to the recipient that have not vested. Restricted stock units are promises to issue stock in the future.

 

Under the Stock Option Plan for Outside Directors, we have reserved 1.1 million shares of our common stock for issuance to certain members of our board of directors who are not employees of ours or any of our affiliated entities. The exercise price for these options is equal to the market value of our common stock on the grant date. Initial grants to each outside director generally vest ratably over a three-year period, while any subsequent grants are exercisable three years from the grant date. All unexercised options expire ten years after the grant date.

 

In connection with our acquisition of Foundstone, Inc. in October 2004, we assumed the obligations of their 2000 Stock Plan and converted their outstanding options into options to purchase 428,696 shares of our common stock. We have reserved 747,144 shares of our common stock for issuance under this plan. The plan provides for an

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

option price no less than 85% of the fair value of our common stock on the date of grant. The options contain gradual vesting provisions, whereby 25% vest one year from the date of grant and thereafter in monthly increments over the remaining three years. All unexercised options expire ten years after grant date.

 

Plan Activity

 

A summary of the activity of our employee stock options during the three months ended March 31, 2006 and details regarding the options outstanding and exercisable at March 31, 2006 are provided below (in thousands, except per share data):

 

 

The total intrinsic value of options exercised during the three months ended March 31, 2006 and March 31, 2005 was $8.7 million and $30.9 million, respectively.

 

The tax benefit realized from stock option exercises and employee stock purchase rights in the three months ended March 31, 2006 was $4.0 million. We realized no tax benefit in the three months ended March 31, 2005.

 

A summary of the activity for restricted stock awards and restricted stock units during the three months ended March 31, 2006 is provided below (in thousands except per share data):

 

 

The weighted-average remaining contractual life for unvested restricted stock units and restricted stock awards at March 31, 2006 was 2.5 years and 2.2 years, respectively. The 3.6 million of restricted stock units granted in the three months ended March 31, 2006 under the 1997 Plan were valued at $69.6 million when reduced by estimated forfeitures. The total fair value of restricted stock awards vested during the three months ended March 31, 2006 and March 31, 2005 was $0.7 million and $1.2 million, respectively.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Shares available for future grants to employees under our stock incentive plans totaled 3.9 million at March 31, 2006. Our management currently plans to issue new shares for the vesting of restricted stock awards and restricted stock units and exercises of stock options.

 

Valuation and Expense Information under SFAS 123R

 

As indicated in Note 2, we adopted the provisions of SFAS 123R on January  1, 2006. In the three months ended March 31, 2006, we recognized stock-based compensation expense of $13.6 million in our condensed consolidated financial statements, which included $10.9 million for stock options, $1.9 million for restricted stock awards and units and $0.8 million for our Employee Stock Purchase Plan. The following table summarizes the stock-based compensation expense by income statement line item that we recorded in accordance with the provisions of SFAS 123R (in thousands):

 

 

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

 

The adoption of SFAS 123R on January 1, 2006 decreased our pre-tax income by $13.6 million, decreased net income by $9.6 million, decreased our basic net income per share by $0.06 per share and decreased diluted net income per share by $0.05 per share. Cash provided by operating activities decreased and cash provided by financing activities increased $3.0 million, respectively, related to excess tax benefits from stock-based payment arrangements.

 

At March 31, 2006, the estimated fair value of all unvested stock options, restricted stock units, restricted stock awards and employee stock purchase rights that have not yet been recognized as compensation expense was $113.6 million, net of expected forfeitures. We expect to recognize this amount over a weighted-average period of 3.0 years.

 

As indicated in Note 2, under both SFAS 123R and SFAS 123 we used the Black-Scholes model to estimate the fair value of our option awards and employee stock purchase rights issued under the Employee Stock Purchase Plan.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The key assumptions used in the model during the three months ended March 31, 2006 and 2005 are provided below:

 

 

The fair value of the option awards and employee stock purchase rights were:

 

 

We derive the expected term of our options through the use of a lattice model that factors in historical data on employee exercise and post-vesting employment termination behavior. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. Since January 1, 2006, we have used the implied volatility of options traded on our stock with a term of one year or more to calculate the expected volatility of our option grants. Prior to that time, the expected volatility was based solely on the historical volatility of our stock. We changed our method of estimating volatility to using implied volatility, because we believe that using implied volatility of options traded on our stock is a better measure of volatility than historical volatility. We have not declared any dividends on our stock in the past and do not expect to do so in the foreseeable future.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Pro-forma Information under SFAS 123 for Periods Prior to January 1, 2006

 

As indicated in Note 2, we applied the provisions of APB 25 to determine our stock-based compensation expense for all periods prior to January 1, 2006. The following table illustrates the effect on net income and net income per share if we had applied the fair value recognition provision of SFAS 123 to our stock-based compensation plans during the three months ended March 31, 2005 (in thousands, except per share data):

 

 

Stock-based Compensation Recognized Prior to January 1, 2006

 

In the three months ended March 31, 2005, we recorded a stock-based compensation benefit under APB 25 which consisted of the following items (in thousands):

 

 

The pre-tax stock-based compensation benefit of $3.3 million in the three months ended March 31, 2005 is included in the following line items in our condensed consolidated statement of income (in thousands):

 

 

Exchange of McAfee.com options.  On September 13, 2002, we acquired the minority interest in McAfee.com. McAfee.com option holders received options for 0.675 of a share of our common stock plus $8.00 in cash, $11.85 after applying the option exchange ratio, which is paid to the option holder upon exercise of the option and without interest.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

McAfee.com options to purchase 4.1 million shares were converted into options to purchase 2.8 million shares of our common stock. The assumed options were subject to variable accounting treatment, which means that the compensation charge was measured initially at the date of the closing of the acquisition and was remeasured each reporting period based on our common stock fair market value at the end of each report period.

 

During the three months ended March 31, 2005, we recorded a benefit of approximately $2.0 million related to exchanged options subject to variable accounting. The stock-based compensation benefit in the three months ended March 31, 2005 was due to a decline in our stock price from $28.93 at December 31, 2004 to $22.56 as of March 31, 2005. Under SFAS 123R, variable accounting does not apply to the exchanged options.

 

Repriced options.  On April 22, 1999, we offered to substantially all of our employees, excluding executive officers, the right to cancel certain outstanding stock options and receive new options with an exercise price of $11.063, the then current fair value of the stock. Options to purchase a total of 9.5 million shares were cancelled and the same number of new options was granted. These new options vested at the same rate that they would have vested under previous option plans and were subject to variable accounting. Accordingly, we have remeasured compensation cost for these repriced options until these options were exercised, cancelled, or forfeited without replacement. The first valuation period began July 1, 2000.

 

The amount of stock-based compensation recorded was based on any excess of the closing stock price at the end of the reporting period or date of exercise, forfeiture or cancellation without replacement, if earlier, over the fair value of our common stock on July 1, 2000, which was $20.375.

 

During the three months ended March 31, 2005, we recorded a benefit of approximately $1.7 million. The stock-based compensation benefit for these options was based on closing stock price as of March 31, 2005 of $22.56. The benefit in the three months ended March 31, 2005 was due to a decline in our stock price from $28.93 at December 31, 2004 to $22.56 as of March 31, 2005. These options were fully vested as of December 31, 2005, therefore, no stock-based compensation expense will be recognized under SFAS 123R.

 

New and existing executives and employees.  In January 2005, our board of directors granted 75,000 shares of restricted stock to our chief financial officer. The price of the underlying shares is $0.01 per share. The shares will vest and our right to repurchase the shares will lapse over three years from the date of grant. The fair value of the restricted stock award was determined to be approximately $2.1 million and was based on the difference between the exercise price of the restricted stock award and the fair value of the common stock on the date of grant. We recorded expense of approximately $0.2 million during the three months ended March 31, 2005, related to the stock-based compensation associated with the chief financial officer’s restricted stock award grant.

 

In connection with the acquisition of Foundstone in October 2004, we exchanged options to purchase shares of our common stock for Foundstone stock options. A portion of the fair value of our stock options was included in the Foundstone purchase price. In accordance with FIN 44, we recorded $2.3 million of deferred stock-based compensation related to the exchange of unvested stock options which are subject to vesting provisions as employment services are provided to us by the former Foundstone employees. The unvested stock options granted to Foundstone employees vest over periods ranging through 2008. We recorded stock-based compensation of approximately $0.2 million in the three months ended March 31, 2005, related to the unvested stock options exchanged in the Foundstone acquisition.

 

In January 2002, our board of directors approved a grant of 50,000 shares of restricted stock to our chief executive officer. The price of the underlying shares is $0.01 per share. The shares vested and our right to repurchase such shares lapsed as follows: 3,000 vested as of the grant date and 47,000 were restricted until January 15, 2005. The fair value of the restricted stock was determined to be approximately $1.4 million and was determined based on the difference between the exercise price of the restricted stock and the fair value of the common stock on the date of grant. During the three months ended March 31, 2005, we recorded less than $0.1 million related to stock-based compensation associated with the chief executive officer’s restricted stock grant.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Wireless Security Corporation

 

In June 2005, we acquired 100% of the outstanding shares of Wireless Security Corporation, a provider of home and small business wireless network security products, for approximately $20.0 million in cash and $0.3 million of direct expenses, totaling $20.3 million. We acquired Wireless Security Corporation to continue to develop their patent-pending technology, introduce a new consumer offering and to utilize the technology in our small business managed solutions. The results of operations of Wireless Security Corporation have been included in our results of operations since the date of acquisition.

 

Our management determined the purchase price allocation based on estimates of the fair values of the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived at utilizing recognized valuation techniques. We recorded $13.2 million of goodwill (none of which is deductible for tax purposes). The following is a summary of the assets acquired and liabilities assumed in the acquisition of Wireless Security Corporation as adjusted during the current period for resolution of ongoing purchase price valuation procedures:

 

 

We recorded approximately $4.0 million for in-process research and development, which was fully expensed upon purchase because technological feasibility had not been achieved and there was no alternative use for the projects under development. The in-process research and development included the development of the consumer wireless security product that we introduced in the third quarter of 2005. In addition, the in-process research and development included existing wireless security offers that we plan to integrate in our small business managed solution. At the date of acquisition, we estimated that 60% of the development effort had been completed and that the remaining 40% of the development would take approximately three months to complete and would cost approximately $0.6 million. As of December 31, 2005, we had completed the remaining development efforts. The intangible assets, other than goodwill, are being amortized over their useful lives of 2.0 to 3.5 years or a weighted-average period of 3.2 years. As part of the acquisition, we did not assume any outstanding stock options or warrants. A performance and retention plan, which provides for payment of up to $1.8 million, was established at the close of the acquisition. At March 31, 2006, approximately $0.8 million had been expensed and $0.4 million had been paid related to this performance plan. The results of operations for Wireless Security Corporation prior to the acquisition would not have a material impact on our results of operations.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

McAfee Labs

 

In April 2005, we completed the sale of our McAfee Labs assets to SPARTA, Inc. for $1.5 million and recognized a gain on the sale of $1.3 million. The carrying value of McAfee Labs assets and liabilities, which were sold in this agreement, were not significant. The operations of McAfee Labs, which are not material to our consolidated results of operations, are included in income from operations for the three months ended March 31, 2005.

 

Revenues related to McAfee Labs were approximately $1.7 million in the three months ended March 31, 2005.

 

 

We account for goodwill and other intangible assets in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” Specifically, we perform an impairment review of our goodwill on at least an annual basis and amortize all other intangible assets over their estimated useful lives.

 

Our goodwill impairment review is conducted as of October 1 of each fiscal year or earlier if indicators of impairment exists. In 2005 and 2004, these analyses have indicated that goodwill was not impaired. The fair value of the reporting units was estimated using the average of the expected present value of future cash flows and of the market multiple value. We will continue to test for impairment on an annual basis and on an interim basis if an event occurs or circumstances change that would more likely than not reduce the fair value of our reporting units below their carrying amounts.

 

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

 

 

The adjustment to goodwill during the first quarter of 2006 related to Foundstone stock compensation and the realization of net deferred tax assets from the Foundstone acquisition.

 

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

 

 

The aggregate amortization expenses for the intangible assets listed above totaled $6.6 million and $7.4 million in the three months ended March 31, 2006 and 2005, respectively.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Expected future intangible asset amortization expense as of March 31, 2006 is as follows (in thousands):

 

 

 

2005 Restructuring

 

During 2005, we permanently vacated several leased facilities and recorded a $1.9 million accrual for estimated lease related costs associated with the permanently vacated facilities. The remaining costs associated with vacating the facilities are primarily comprised of the present value of remaining lease obligations, along with estimated costs associated with subleasing the vacated facility, net of estimated sublease rental income. We also recorded a restructuring charge of $0.2 million related to a reduction in headcount of approximately 14 employees.

 

The following table summarizes our restructuring accrual established in 2005 and activity through March 31, 2006 (in thousands):

 

 

As of March 31, 2006, $0.4 million of the restructuring accrual is due within 12 months and has been classified as current accrued liabilities, while less than $0.1 million has been classified as other long-term liabilities, and will be paid through July 2007. Lease termination costs are net of estimated sublease income of $0.1 million at March 31, 2006.

 

2004 Restructuring

 

During 2004, we recorded several restructuring charges related to the reduction of employee headcount. In the first quarter of 2004, we recorded a restructuring charge of approximately $2.2 million related to the severance of approximately 160 employees, of which $0.7 million and $1.5 million was related to our North America and EMEA operating segments, respectively. The workforce size was reduced primarily due to our sale of Magic in January

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

2004. In the second quarter of 2004, we recorded a restructuring charge of approximately $1.6 million related to the severance of approximately 80 employees in our sales, technical support and general and administrative functions. Approximately $0.6 million of the restructuring charge was related to the EMEA operating segment and the remaining $1.0 million was related to the North America operating segment. In the third quarter of 2004, we recorded a restructuring charge related to ten employees which totaled approximately $0.9 million, all of which related to the North America operating segment. In the fourth quarter of 2004, we recorded a restructuring charge of $1.3 million related to 111 employees, of which $0.7 million, $0.2 million, $0.2 million and $0.2 million related to the Latin America, North America, EMEA and Asia-Pacific (excluding Japan) operating segments, respectively. All employees were terminated at December 31, 2004. The reductions in the second, third and fourth quarters were part of the previously announced cost-savings measures being implemented by us.

 

In September 2004, we announced the move of our European headquarters to Ireland, which was substantially completed by the end of March 2005. In the third and fourth quarters of 2004, we recorded restructuring charges of $0.2 million and $2.2 million, respectively, related to the severance of approximately 80 employees.

 

Also in September 2004, we permanently vacated an additional two floors in our Santa Clara headquarters building. We recorded a $7.8 million accrual for the estimated lease related costs associated with the permanently vacated facility, partially offset by a $1.3 million write-off of deferred rent liability. The remaining costs associated with vacating the facility are primarily comprised of the present value of remaining lease obligations, net of estimated sublease income along with estimated costs associated with subleasing the vacated facility. The remaining costs will generally be paid over the remaining lease term ending in 2013. We also recorded a non-cash charge of approximately $0.8 million related to disposals of certain leasehold improvements.

 

In the fourth quarter of 2004, we permanently vacated several leased facilities and recorded a $2.2 million accrual for estimated lease related costs associated with the permanently vacated facilities. The remaining costs associated with vacating the facilities are primarily comprised of the present value of remaining lease obligations, along with estimated costs associated with subleasing the vacated facility.

 

During 2004, we adjusted the restructuring accruals related to severance costs and lease termination costs recorded in 2004. We recorded a $0.3 million adjustment to reduce the EMEA severance accrual for amounts that were no longer necessary after paying out substantially all accrued amounts to the former employees. We also recorded a $0.2 million reduction in lease termination costs due to changes in estimates related to the sublease income to be received over the remaining lease term of our Santa Clara headquarters building.

 

During 2005, we completed the move of our European headquarters to Ireland and vacated the remaining planned floors. We recorded an additional $1.4 million restructuring charge for estimated lease related costs associated with the permanently vacated facilities and a $1.4 million restructuring charge for severance costs. All of these restructuring charges were related to the EMEA operating segment. During 2005, we also made adjustments to our restructuring accrual totaling $0.8 million due to a change in assumptions related to utility costs and sublease income.

 

During the three months ended March 31, 2006, we made adjustments to our restructuring accrual totaling $0.3 million attributable to commissions owed on new subleases and a change in assumptions related to commissions on existing subleases.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following table summarizes our restructuring accruals established in 2004 and activity through March 31, 2006 (in thousands):

 

 

As of March 2006, $1.2 million of the restructuring accrual is due within 12 months and has been classified as current accrued liabilities, while the remaining balance of $4.3 million has been classified as other long-term liabilities, and will be paid through March 31, 2013. Lease termination costs are net of estimated sublease income of $4.9 million at March 31, 2006.

 

2003 Restructuring

 

In January 2003, as part of a restructuring effort to gain operational efficiencies, we consolidated operations formerly housed in three leased facilities in the Dallas, Texas area into our regional headquarters facility in Plano, Texas. The facility houses employees working in finance, information technology, legal, human resources, field sales and the customer support and telesales groups servicing the McAfee System Protection Solutions and McAfee Network Protection Solutions businesses.

 

As part of the consolidation of activities into the Plano facility, we relocated employees from the Santa Clara, California headquarters site. As a result of this consolidation, in March 2003, we recorded a $15.6 million accrual for estimated lease related costs associated with the permanently vacated facilities, partially offset by a $1.9 million write off of deferred rent liability. The remaining costs associated with vacating the facility are primarily comprised of the present value of remaining lease obligations, net of estimated sublease income, along with estimated costs associated with subleasing the vacated facility. The remaining costs will generally be paid over the remaining lease term ending in 2013. We also recorded a non-cash charge of approximately $2.1 million related to asset disposals and discontinued use of certain leasehold improvements and furniture and equipment. This restructuring charge was allocated to our North American segment.

 

During the second and third quarters of 2003, we recorded restructuring charges of $6.8 million and $0.6 million, respectively, which consisted of $6.7 million related to a headcount reduction of 210 employees

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

and $0.7 million related to other expenses such as legal expenses incurred in international locations in conjunction with the headcount reduction. The restructuring charge related to headcount reductions was $0.9 million and $5.8 million in our North American and EMEA operating segments, respectively. The employees were located in our domestic and international locations and were primarily in the sales, product development and customer support areas. In the third and fourth quarters of 2003, we reversed a total of $0.7 million of restructuring accrual in EMEA that was no longer necessary after paying out substantially all accrued amounts to the former employees.

 

In 2004, we adjusted the restructuring accrual related to lease termination costs previously recorded in 2003. The adjustments decreased the liability by approximately $0.6 million 2004, due to changes in estimates related to the sublease income to be received over the remaining lease term. Also in 2004, we recorded a $0.1 million adjustment to reduce the restructuring accrual for severance and benefits from our EMEA operating segment that would not be utilized.

 

During 2005, we made adjustments to our restructuring accrual totaling $1.0 million due to a change in assumptions related to utility costs and sublease income.

 

During the three months ended March 31, 2006, we made adjustments to our restructuring accrual totaling $0.1 million attributable to commissions owed on new subleases and a change in assumptions related to commissions on existing subleases.

 

The following table summarizes our restructuring accrual established in 2003 and activity through March 31, 2006 (in thousands):

 

 

As of March 31, 2006, $1.8 million of the restructuring accrual is due within 12 months and has been classified as current accrued liabilities, while the remaining balance of $8.4 million has been classified as other long-term liabilities and will be paid through March 31, 2013. Lease termination costs are net of estimated sublease income of $8.0 million at March 31, 2006.

 

MCAFEE, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Our estimate of the excess facilities charges recorded during 2005, 2004 and 2003 may vary significantly depending, in part, on factors which may be beyond our control, such as our success in negotiating with our lessor, the time periods required to locate and contract suitable subleases and the market rates at the time of such subleases. Adjustments to the facilities accrual will be made if actual lease exit costs or sublease income differ from amounts currently expected. The facility restructuring charges in 2005 were primarily allocated to the EMEA and Japan operating segments, and the facility restructuring charges in 2004 and 2003 were primarily allocated to the North America operating segment.

 

 

We have a $17.0 million credit facility with a bank. The credit facility is available on an offering basis, meaning that transactions under the credit facility will be on such terms and conditions, including interest rate, maturity, representations, covenants and events of default, as mutually agreed between us and the bank at the time of each specific transaction. The credit facility is intended to be used for short-term credit requirements, with terms of one year or less. The credit facility can be cancelled at any time. No balances were outstanding as of March 31, 2006 and December 31, 2005.

 

 

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