Isilon Systems, Inc.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
As of October 28, 2008, 63,835,960 shares of the registrant’s Common Stock were outstanding.
The accompanying notes are an integral part of these condensed consolidated financial statements.
The accompanying notes are an integral part of these condensed consolidated financial statements.
Isilon Systems, Inc
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Organization
Isilon Systems, Inc. (the “Company”) was incorporated in the State of Delaware on January 24, 2001. The Company designs, develops and markets enterprise scale-out clustered storage systems and software for storing, managing and delivering file-based data. The Company began selling its products and services in January 2003. The Company sells systems that generally include a software license, hardware, post-contract customer support, and, in some cases, additional elements.
Significant Accounting Policies
Accounting Principles
The consolidated financial statements and accompanying notes were prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements include the accounts of Isilon Systems, Inc. and its wholly owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 30, 2007. Certain information and disclosures normally included in financial statements prepared in conformity with GAAP have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).
These financial statements reflect all adjustments, which, in the opinion of the Company’s management are necessary for a fair statement of the financial position, results of operations and cash flows for the periods presented. Operating results for the three and nine months ended September 30, 2008, are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2008. During fiscal 2007, the Company operated on a 52/53-week fiscal year ending on the Sunday closest to December 31. Accordingly, the Company’s fiscal year 2007 ended on December 30, 2007. Beginning in fiscal 2008, the Company operates on a calendar year end with fiscal year 2008 ending on December 31, 2008.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Significant estimates are inherent in the preparation of the consolidated financial statements and include accounting for revenue, the allowance for doubtful accounts, obsolete and excess inventory, the valuation allowance for deferred tax assets, and the valuation of stock-based compensation expense. Some of these estimates require difficult, subjective or complex judgments about matters that are uncertain. Actual results could differ from those estimates.
Concentration of Risks
The Company’s cash and cash equivalents are invested with financial institutions in deposits that may exceed federally insured limits. The Company has not experienced any losses on its deposits of cash and cash equivalents. Management believes that the institutions are financially sound and, accordingly, that minimal credit risk exists.
The Company does not require collateral to support credit sales. Allowances are maintained for potential credit losses. During the three and nine months ended September 30, 2008, no single customer represented more than 10% of total revenue. During the three months ended September 30, 2007, no single customer represented more than 10% of total revenue and during the nine months ended September 30, 2007, only one customer represented more than 10% of total revenue, specifically 12%. Additionally, one customer represented 10% of total net accounts receivable for the period ended September 30, 2008 and no single customer represented more than 10% of total net accounts receivable for the period ended December 30, 2007.
The Company is dependent on a single contract manufacturer for its products, and some of the key components in the Company’s products come from single or limited sources of supply.
Isilon Systems, Inc
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(unaudited)
Revenue Recognition
The Company derives its revenue from sales of its products and services. Product revenue consists of revenue from sales of systems and software. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue.
The Company’s software is essential to the functionality of its integrated system products. The Company provides unspecified software updates and enhancements related to its products through service contracts. As a result, the Company accounts for revenue in accordance with AICPA Statement of Position No. 97-2, Software Revenue Recognition, or SOP 97-2, as amended by Statement of Position No. 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions , or SOP 98-9, for all transactions involving the sale of software. The Company recognizes product revenue when it has entered into an arrangement with a customer, delivery has occurred, the fee is deemed fixed or determinable and free of contingencies and significant uncertainties, and collection is reasonably assured.
On sales to channel partners, the Company evaluates whether fees are considered fixed or determinable by considering a number of factors, including the Company’s ability to estimate returns, the geography in which a sales transaction originates, payment terms and the Company’s relationship and past history with the particular channel partner. If fees are not considered fixed or determinable at the time of sale to a channel partner, revenue recognition is deferred until there is persuasive evidence indicating product has sold-through to an end-user. Persuasive evidence of sell-through may include reports from channel partners documenting sell-through activity, copies of end-user purchase orders, data indicating an order has shipped to an end-user, cash payments, or letters of credit guaranteeing cash payments or other similar information.
At the time of shipment, the Company records revenue reserves for estimated sales returns and stock rotation arrangements. Sales returns and stock rotation reserves are estimated based on historical activity and expectations of future experience. The Company monitors and analyzes actual experience and adjusts these reserves on a quarterly basis.
Substantially all of the Company’s products are sold in combination with services, which primarily consist of hardware and software support. Software support provides customers with rights to unspecified software updates and to maintenance releases and patches released during the term of the support period. Hardware support includes Internet access to technical content through Isilon Insight, the Company’s knowledge database, repair or replacement of hardware in the event of breakage or failure, and telephone and Internet access to technical support personnel during the term of the support period.
Sales generally consist solely of hardware and software products and support services. The Company has established vendor specific objective evidence, or VSOE, for the fair value of its support services as measured by the renewal prices offered to and paid by its customers. The Company uses the residual method, as allowed by SOP 98-9, to determine the amount of product revenue to be recognized. Under the residual method, the fair value of the undelivered element, support services, is deferred and the remaining portion of the sales amount is recognized as product revenue. This product revenue is recognized upon shipment, based on freight terms, assuming all other criteria for recognition discussed above have been met. The fair value of the support services is recognized as services revenue on the straight-line method over the term of the related support period, which is typically one to three years.
Accounting for Stock-Based Compensation
On January 2, 2006, the Company adopted SFAS No. 123(R), Share-Based Payment, or SFAS 123(R), using the prospective transition method. Under this method, the Company’s stock-based compensation costs recognized during 2006 were comprised of compensation costs for all share-based payment awards granted subsequent to January 1, 2006, based on their grant-date fair value estimated using the Black-Scholes model, in accordance with the provisions of SFAS 123(R).
The Company chose the straight-line method of allocating compensation cost over the requisite service period of the related award under SFAS 123(R). The Company calculated the expected term based on the provisions outlined in SFAS 123(R), which, for options granted in the three and nine months ended September 30, 2008, resulted in an expected term of approximately four years. The Company based its estimate of expected volatility on the estimated volatility of similar entities whose share prices are publicly available.
During the three and nine months ended September 30, 2008 and September 30, 2007, the Company incurred non-cash stock-based compensation expense of $1.6 million and $1.2 million and $4.4 million and $2.7 million, respectively. As of September 30, 2008, the Company’s total unrecognized compensation cost related to stock options granted since January 2, 2006 was $19.3 million, which will be recognized over the weighted-average remaining requisite service period of approximately 3.1 years. The Company recorded no tax benefit related to these options during the three and nine months ended September 30, 2008 since the Company currently maintains a full valuation allowance on its net deferred tax assets. In future periods, stock-based compensation expense is expected to increase as the Company records expense related to previously issued stock-based compensation awards and issues additional equity-based awards to continue to attract and retain key employees.
Isilon Systems, Inc
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(unaudited)
Recent Accounting Pronouncements
In October 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (FSP) No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active, or FSP 157-3. FSP 157-3 clarifies the application of Statement of Financial Accounting Standards No. 157, Fair Value Measurements, or SFAS 157, in determining the fair values of assets or liabilities in a market that is not active. FSP 157-3 became effective upon issuance, including prior periods for which financial statements have not been issued. The Company has adopted FSP 157-3 for the period ended September 30, 2008; however, the adoption did not result in a material impact on its consolidated financial statements.
In June 2008, the FASB issued FASB Staff Position (FSP) No. EITF 03-6-1, Determining Whether Instruments Granted in Share-based Payment Transactions Are Participating Securities, or FSP 03-6-1, which requires entities to apply the two-class method of computing basic and diluted earnings per share for participating securities that include awards that accrue cash dividends (whether paid or unpaid) any time common stockholders receive dividends and those dividends do not need to be returned to the entity if the employee forfeits the award. The Company believes that the adoption of FSP 03-6-1 will not have a material effect on its consolidated financial statements.
In February 2008, the FASB issued FASB Staff Position (FSP) No. FAS 157-2, Fair Value Measurements, or FSP 157-2, which delayed the effective date of SFAS 157 one year, for all nonfinancial assets and liabilities, except those recognized or disclosed at fair value in the financial statements on a recurring basis. The Company will adopt FSP 157-2 in the first quarter of fiscal year 2009 and believes that it will not have a material effect on its consolidated financial statements.
2. Restatement of Consolidated Financial Statements
Restatement of Previously Issued Consolidated Financial Statements
On February 29, 2008, the Company announced that its Board of Directors, based upon the recommendation of the Audit Committee, determined that the Company should restate its financial statements for the fiscal year ended December 31, 2006, and for the first and second quarters of fiscal 2007, ended April 1, 2007, and July 1, 2007, respectively. As announced on November 8, 2007, the Company's Audit Committee, assisted by independent forensic accountants and legal advisors, had been conducting an independent investigation of certain of its sales to resellers and other customers to determine whether commitments were made that have an impact on the timing and treatment of revenue recognition, and whether the Company's internal controls relating to revenue recognition were sufficient.
The Company filed its Annual Report on Form 10-K for the year ended December 30, 2007, in which the Company restated its consolidated financial statements for the fiscal year ended December 31, 2006 and the quarterly periods ended April 1 and July 1, 2007 as a result of errors in those financial statements. The Company did not amend any of its Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q that were filed prior to the filing of its 2007 Form 10-K and Form 10-Q for the period ended September 30, 2007, with the Securities and Exchange Commission on April 2, 2008. These previously filed annual or quarterly reports covering the periods affected by its restatement should not be relied upon.
Isilon Systems, Inc
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(unaudited)
3. Net Loss Per Share
Basic and diluted net loss per share was the same for all periods presented as the impact of all potentially dilutive securities outstanding was anti-dilutive. Basic net loss per share is calculated by dividing net loss by the weighted-average shares of common stock outstanding during the period that are not subject to vesting provisions. The following table presents the potentially dilutive securities outstanding that were excluded from the computation of diluted net loss per share for the periods presented because their inclusion would have had an anti-dilutive effect:
| | | As of | |
| | | September 30, | |
| | | 2008 | | | 2007 | |
| | | | | | | |
| Options to purchase common stock | | | 9,644,109 | | | | 8,578,890 | |
| Common stock subject to vesting provisions | | | 106,643 | | | | 235,212 | |
| Common stock purchaseable under Employee Stock Purchase Plan | | | 33,225 | | | | 24,402 | |
| Warrants to purchase common stock | | | 129,992 | | | | 129,992 | |
| | | | 9,913,969 | | | | 8,968,496 | |
| | | | | | | | | |
4. Comprehensive Loss
Comprehensive loss is as follows:
| |
| | | Three Months Ended | | Nine Months Ended |
| | | September 30, | | September 30, |
| | | 2008 | | 2007 | | 2008 | | 2007 |
| | | (in thousands) | | (in thousands) |
| Net loss | | $ | (4,828 | ) | | $ | (7,183 | ) | | $ | (20,745 | ) | | $ | (19,061 | ) |
| Unrealized gain/(loss) on marketable securities | | | (97 | ) | | | 63 | | | | (183 | ) | | | 60 | |
| Foreign currency translation adjustment | | | (87 | ) | | | (55 | ) | | | (121 | ) | | | (106 | ) |
| Total comprehensive loss | | $ | (5,012 | ) | | $ | (7,175 | ) | | $ | (21,049 | ) | | $ | (19,107 | ) |
| | | | | | | | | | | | | | | | | |
5. Marketable Securities
At their date of acquisition, the Company’s marketable securities are classified into categories in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities. During the periods presented, the Company had securities classified as available-for-sale, which were reported at fair value with the related unrealized gains and losses included as a separate component in stockholders’ equity. Realized gains and losses and declines in value of securities judged to be other than temporary are included in other income (expense), net. Realized and unrealized gains and losses are based on the specific identification method. The Company’s investments in marketable securities are diversified among high-credit quality securities in accordance with the Company’s investment policy.
Marketable securities totaled $29.8 million as of September 30, 2008, and consisted of investments in commercial paper, corporate bonds and notes, and U.S. government securities. There were no realized gains or losses on the sales of marketable securities for the three and nine months ended September 30, 2008.
The fair value of the Company’s marketable securities fluctuates based on changes in market conditions and interest rates; however, given the short-term maturities, management believes that these instruments are not subject to significant market or interest rate risk. Investments in fixed rate, interest-earning instruments carry a degree of interest rate risk. Fixed rate securities may have their market value adversely impacted due to rising interest rates. In a declining interest rate environment, as short-term investments mature, reinvestment occurs at less favorable market rates. Given the short-term nature of the Company's investments, anticipated declining interest rates will negatively impact the Company’s investment income.
Isilon Systems, Inc
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(unaudited)
Fair Value Measurements
The Company adopted SFAS No. 157 as of December 31, 2008, which clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, SFAS No. 157 establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require the Company to develop its own assumptions. This hierarchy requires companies to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. On a recurring basis, the Company measures certain financial assets and liabilities at fair value, including its marketable securities.
The Company’s cash equivalents and marketable securities instruments are classified within Level 1 and Level 2 of the fair value hierarchy because they are valued using quoted market prices, or broker-dealer quotations, or alternative pricing sources with reasonable levels of price transparency. The types of instruments valued based on quoted market prices in active markets include most U.S. government and agency securities, and money market securities. Such instruments are generally classified within Level 1 of the fair value hierarchy. The types of instruments valued based on other observable inputs include investment-grade corporate bonds, mortgage-backed and asset-backed products, commercial paper, and state, municipal and provincial obligations. Such instruments are generally classified within Level 2 of the fair value hierarchy.
As of September 30, 2008, the fair value hierarchy of our cash equivalents and marketable securities is as follows:
| | | Quoted Prices | | | Significant | |
| | | in Active | | | Other | |
| | | Markets for | | | Observable | |
| | | Identical Assets | | | Inputs | |
| | | (Level 1) | | | (Level 2) | |
| | | (in thousands) | |
| Cash Equivalents: | | | | | | |
| Money market fund | | $ | 24,656 | | | $ | — | |
| U.S. government agencies | | | — | | | | 11,787 | |
| Commercial paper | | | — | | | | 498 | |
| | | $ | 24,656 | | | $ | 12,285 | |
| Marketable securities: | | | | | | | | |
| U.S. government agencies | | $ | — | | | $ | 25,448 | |
| Corporate debt securities | | | — | | | | 2,370 | |
| Commercial paper | | | — | | | | 1,988 | |
| | | $ | — | | | $ | 29,806 | |
6. Inventories
The Company outsources the manufacturing of its products to a contract manufacturer that assembles each product to the Company’s specifications. As protection against component shortages and to provide replacement parts for its service teams, the Company also stocks limited supplies of certain key product components. The Company reduces inventory to its estimated net realizable value by reserving for excess and obsolete inventories determined primarily based on historical usage, forecasted demand, and evaluation unit conversion rate and age. Inventories have been reduced by $1.7 million and $934,000 as of September 30, 2008, and December 30, 2007, respectively.
Isilon Systems, Inc
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(unaudited)
Inventories consist of the following:
| | | As of | |
| | | September 30, | | December 30, | |
| | | 2008 | | 2007 | |
| | | (in thousands) | |
| Component parts | | $ | 51 | | | $ | 154 | |
| Finished goods | | | 6,752 | | | | 5,989 | |
| Evaluation units | | | 3,733 | | | | 3,287 | |
| | | $ | 10,536 | | | $ | 9,430 | |
| | | | | | | | | |
7. Property and Equipment
Property and equipment, net, consist of the following:
| | | As of | |
| | | September 30, | | December 30, | |
| | | 2008 | | 2007 | |
| | | (in thousands) | |
| Software and computer equipment | | $ | 16,496 | | | $ | 12,820 | |
| Furniture, office equipment and other | | | 7,605 | | | | 6,356 | |
| Leasehold improvements | | | 5,151 | | | | 5,040 | |
| | | | 29,252 | | | | 24,216 | |
| | | | | | | | | |
| Less: accumulated depreciation and amortization | | | (18,260 | ) | | | (13,645 | ) |
| | | $ | 10,992 | | | $ | 10,571 | |
| | | | | | | | | |
Depreciation and amortization expense was $1.6 million and $4.7 million for the three and nine months ended September 30, 2008, respectively, and $1.4 million and $3.8 million for the three and nine months ended September 30, 2007, respectively.
8. Stockholders’ Equity
Stock Options and Unvested Common Stock
The Company accounts for cash received for the purchase of unvested shares of common stock or the early-exercise of unvested stock options as a current liability, included as a component of accrued liabilities. As of September 30, 2008 and December 30, 2007, there were 106,643 and 187,952 unvested shares, respectively, of the Company’s common stock outstanding and $118,000 and $189,000, respectively, of the related recorded liability.
Detail related to activity of unvested shares of common stock is as follows:
| | | Number of | | Weighted-Average | |
| | | Unvested Shares | | Exercise/Purchase | |
| | | Outstanding | | Price | |
| Balance as of December 30, 2007 | | | 187,952 | | | | $ | 1.00 | |
| Issued | | | — | | | | $ | — | |
| Vested | | | (65,331 | ) | | | $ | 0.87 | |
| Repurchased | | | (15,978 | ) | | | $ | 0.82 | |
| Balance as of September 30, 2008 | | | 106,643 | | | | $ | 1.11 | |
| | | | | | | | | | |
Isilon Systems, Inc
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(unaudited)
Detail related to stock option activity is as follows:
| | | | | Weighted- | |
| | | Number of | | Average | |
| | | Shares | | Exercise | |
| | | Outstanding | | Price | |
| Balance as of December 30, 2007 | | | 8,366,297 | | | | $ | 6.24 | |
| Options granted | | | 3,956,250 | | | | $ | 4.85 | |
| Options exercised | | | (913,457 | ) | | | $ | 0.50 | |
| Options forfeited | | | (1,764,981 | ) | | | $ | 7.10 | |
| Balance as of September 30, 2008 | | | 9,644,109 | | | | $ | 6.06 | |
| | | | | | | | | | |
The total intrinsic value for options exercised during the nine months ended September 30, 2008, and September 30, 2007, was $4.0 million and $10.2 million, respectively, representing the difference between the estimated fair value of the Company’s common stock underlying these options at the dates of exercise and the exercise prices paid.
The fair value of each employee option on the date of grant was estimated using the Black-Scholes option pricing model under SFAS 123(R). The following assumptions were used for the valuations of options granted to employees during the three and nine months ended September 30, 2008, and September 30, 2007:
| | | | | | |
| | | Three Months Ended | | Nine Months Ended | |
| | | September 30, | | September 30, | |
| | | 2008 | | 2007 | | 2008 | | 2007 | |
| Risk-free interest rate | | 2.2% - 3.1% | | 4.2% - 4.9% | | 1.9% - 3.5% | | 4.2% - 5.1% | |
| Expected term | | 4 years | | 4 years | | 4 years | | 4 years | |
| Dividend yield | | None | | None | | None | | None | |
| Volatility | | 47% - 49% | | 40% | | 44% - 49% | | 39% - 41% | |
The Company estimated its expected volatility based on reported market value data for a group of publicly traded companies, which were selected from certain market indices that the Company believes were relatively comparable after consideration of their size, industry, stage of lifecycle, profitability, growth, and risk and return on investment.
The estimated weighted-average grant date fair value of options granted during the nine months ended September 30, 2008, and September 30, 2007, with exercise prices that equaled the estimated per share fair value of the Company’s common stock at the date of grant, was $1.89 and $4.99, respectively.
The Company adopted an Employee Stock Purchase Plan (the “2006 ESPP”) in the fourth quarter of 2006. A total of 750,000 shares of the Company’s common stock have been reserved for sale under the 2006 ESPP. Under the 2006 ESPP, employees may purchase shares of common stock through payroll deductions at a price per share that is 85% of the fair market value of the Company’s common stock on the applicable purchase date. The total liability for the 2006 ESPP, for the purchase period commencing in August 2008, including the related 15% discount, is $147,000 as of September 30, 2008 and is included in accrued compensation and related benefits in the Company’s condensed consolidated balance sheet.
9. Income Taxes
As of September 30, 2008, the Company had total net operating loss carryforwards for federal and state income tax purposes of $76.9 million, which excludes windfall tax benefits for which a benefit would be recorded in additional paid-in capital when realized, and $30.9 million, respectively. The benefits of net operating losses and other deferred tax assets are dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the Company’s gross deferred tax assets have been fully offset by a valuation allowance. If not utilized, these net operating loss carryforwards will expire for federal purposes between 2021 and 2028 and for state purposes between 2009 and 2027. Utilization of these net operating loss carryforwards is subject to an annual limitation due to provisions of the Internal Revenue Code of 1986, as amended. Events that cause limitations in the amount of net operating losses that the Company may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50%, as defined, over a three-year period.
Isilon Systems, Inc
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(unaudited)
For the three and nine months ended September 30, 2008, and September 30, 2007, the Company recorded income tax expense of $70,000 and $41,000, and $243,000 and $116,000, respectively, comprised primarily of foreign taxes. The actual expense recorded for each of these respective periods differs from the federal tax benefit at 34% primarily due to current tax expense in foreign jurisdictions and the valuation allowance applied to the tax benefit of U.S. losses.
On January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, or FIN 48. FIN 48 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosures, and transition issues. The Company elected to include interest on tax positions as a component of interest expense and penalties as a component of income tax expense. The Company did not have any unrecognized tax benefits as of January 1, 2007 or September 30, 2008.
10. Segment Information
SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise for which separate financial information is available and evaluated regularly by the chief operating decision-maker, or decision-making group, in deciding how to allocate resources and in assessing performance. The Company is organized as, and operates in, one reportable segment: the development and sale of clustered storage solutions. The Company’s chief operating decision-maker is its chief executive officer. The Company’s chief executive officer reviews financial information presented on a consolidated basis, accompanied by information about revenue by geographic region, for purposes of evaluating financial performance and allocating resources. The Company and its chief executive officer evaluate performance based primarily on revenue in the geographic locations in which the Company operates. Revenue is attributed by geographic region based on the location of the end customer. The Company’s assets are primarily located in the United States of America and not allocated to any specific region; therefore, geographic information is presented only for total revenue.
The following presents total revenue by geographic region:
| |
| | | Three Months Ended | | Nine Months Ended | |
| | | September 30, | | September 30, | |
| | | 2008 | | 2007 | | 2008 | | 2007 | |
| | | (in thousands) | | (in thousands) | |
| North America | | $ | 20,283 | | $ | 17,393 | | $ | 57,023 | | $ | 46,856 | |
| Asia | | | 7,021 | | | 1,974 | | | 15,807 | | | 8,616 | |
| EMEA (Europe, Middle East and Africa) | | | 3,028 | | | 2,078 | | | 9,808 | | | 6,247 | |
| Other | | | — | | | 198 | | | — | | | 681 | |
| Total | | $ | 30,332 | | $ | 21,643 | | $ | 82,638 | | $ | 62,400 | |
| | | | | | | | | | |
11. Commitments and Contingencies
Purchase Obligations
The Company typically maintains, with its contract manufacturer, a rolling 90-day firm order for products it manufactures for the Company, and these orders may only be rescheduled, modified, or cancelled by its contract manufacturer under certain circumstances. The remaining amount on the open purchase order with its contract manufacturer and other partners and suppliers at September 30, 2008, was approximately $7.3 million.
The Company will transition its third party customer servicing functions to a new provider during the fourth quarter of 2008. In concurrence with the transition, the Company has agreed to repurchase, at cost, approximately $1.4 million in inventory that was previously sold, at cost, to its current provider.
Isilon Systems, Inc
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(unaudited)
Legal Proceedings
On November 1, 2007, a putative class action complaint was filed in the U.S. District Court for the Western District of Washington against the Company and certain of its current and former directors and officers. The complaint asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated there under, as well as under Sections 11 and 15 of the Securities Act of 1933. Substantially similar complaints were filed later in the same court and all of these cases were subsequently consolidated. On April 18, 2008, lead plaintiffs filed a consolidated amended complaint against the Company, certain of its current and former directors and officers, underwriters, and venture capital firms. The consolidated complaint purports to be brought on behalf of a class of persons who purchased or otherwise acquired the Company's stock during the period December 16, 2006 to October 3, 2007. Plaintiffs allege that defendants violated the federal securities laws by issuing a false and misleading registration statement and prospectus in connection with the Company's December 16, 2006 initial public offering and by thereafter misrepresenting the Company's current and prospective business and financial results, thereby causing the Company's stock price to be artificially inflated during the purported class period. Plaintiffs seek unspecified compensatory damages, interest, attorneys' fees and costs, and injunctive relief. On September 30, 2008, the Company and the other defendants moved to dismiss the consolidated amended complaint and that motion is pending.
In addition, on March 18 and 24, 2008, shareholder derivative actions were filed in the Superior Court of the State of Washington (King County), allegedly on behalf of and for the benefit of the Company, against certain of the Company’s current and former directors and officers. The Company was named as a nominal defendant. On April 17, 2008, the court consolidated these actions and appointed lead counsel. The derivative complaints arise out of many of the factual allegations at issue in the class action, and generally allege that the individual defendants breached fiduciary duties owed to the Company by publicly misrepresenting Isilon’s business prospects and by failing to properly account for certain revenues recognized in the Company’s fiscal year ended December 31, 2006, and first and second quarters in fiscal 2007. The complaints seek unspecified damages and equitable relief, disgorgement of compensation, attorneys’ fees, costs, and expenses. Because the complaints are derivative in nature, they do not seek monetary damages from the Company. However, the Company may be required to advance the legal fees and costs incurred by the individual defendants. On August 27, 2008, at the request of the parties, the court stayed the consolidated derivative action pending resolution of the motion to dismiss in the securities class action.
The Company is unable to predict the outcome of these cases. A court determination against the Company in the class action, and its indemnity obligations in the derivative actions, could result in significant liability and could have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.
As previously disclosed, the Company has been cooperating on a voluntary basis in an informal inquiry being conducted by the SEC concerning the Company's prior financial restatement. The SEC has recently issued a formal order of nonpublic investigation and has issued subpoenas to certain of the Company’s former officers. The SEC’s investigation is a nonpublic, fact-finding inquiry to determine if there have been violations of the federal securities laws. The Company is continuing to cooperate voluntarily with the SEC.
In the ordinary course of business, the Company may be a party to litigation and claims, including disputes involving intellectual property rights, commercial agreements and employment rights. Such matters, even if without merit, could result in the expenditure of significant resources.
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Act”) and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to them. In some cases you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “potential,” and similar expressions intended to identify forward-looking statements. Examples of these statements include, but are not limited to, statements regarding our competitive environment and the health of the overall storage sector and impact of U.S. and global macro-economic conditions; the anticipated growth of digital content and unstructured data; the expected demand for and benefits of our storage products; our future business plans and growth strategy; pricing pressures and fluctuations; our ability to improve existing products and to develop new and future products; our ability to attract new customers; our anticipated revenue and expenses; our ability to add value-added resellers and distributors and to sell our products domestically and internationally; our ability to realize operating leverage and realize efficiencies in our sales model by leveraging partners and distributors to sell to new and existing customers; seasonality in our business; anticipated results of potential or actual litigation or regulatory proceedings; statements relating to our financial restatement and the remediation of our internal controls; the anticipated sufficiency of our current office space and ability to find additional space as needed; anticipated development or acquisition of intellectual property and resulting benefits; expected impacts of changes in accounting rules, including the impact on deferred tax benefits; the impact of governmental regulation; employee hiring and retention, including anticipated reductions in force and headcount; the future payment of dividends, use of cash, cash needs and ability to raise capital; and potential liability from contractual relationships. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in Part II, Item 1A of this Quarterly Report on Form 10-Q and our other filings with the SEC. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. You should read this Quarterly Report on Form 10-Q completely and with the understanding that our actual future results may be materially different from what we expect. Except as required by law, we assume no obligation to update these forward-looking statements, whether as a result of new information, future events, or otherwise.
The following discussion and analysis should be read in conjunction with the unaudited financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q.
Restatement of Previously Issued Consolidated Financial Statements
On February 29, 2008, we announced that our Board of Directors, based upon the recommendation of the Audit Committee, determined that we should restate our financial statements for the fiscal year ended December 31, 2006, and for the first and second quarters of fiscal 2007, ended April 1, 2007 and July 1, 2007, respectively, as a result of errors in those financial statements. As announced on November 8, 2007, our Audit Committee, assisted by independent forensic accountants and legal advisors, conducted an independent investigation of certain of our sales to resellers and other customers to determine whether commitments were made that have an impact on the timing and treatment of revenue recognition, and whether our internal controls relating to revenue recognition were sufficient.
As a result of our Audit Committee’s investigation, we identified errors in our previous recognition of revenue. The restatement adjustments did not affect our previously reported cash, cash equivalents, or short-term investment balances in any of the periods being restated. Selected information about the impact of the restatement on our previously filed financial statements for fiscal year ended December 31, 2006, and the first and second quarters of fiscal 2007, is provided in Part I, Explanatory Note of the Company’s Annual Report on Form 10-K for the year ended December 30, 2007.
Overview
We were founded in January 2001 specifically to create a solution that addressed the unique challenges associated with the storage and management of digital content and unstructured data. From January 2001 to January 2003, we were focused on designing and developing our OneFS® operating system software used in all of our storage systems. We began commercial shipments of our first systems in January 2003, and since then we have been focused on optimizing our solution to meet our customers’ needs and establishing development, manufacturing and marketing partnerships. Today, our solution includes a suite of systems, software and services.
We believe we are the leading provider of clustered storage systems for digital content and unstructured data. We sell clustered storage systems that consist of three or more storage nodes. Each node is comprised of our proprietary OneFS operating system software and industry standard hardware components integrated into a self-contained, 3.5-inch or 1.75-inch high, rack-mountable chassis. Customers can scale our clustered storage systems incrementally as their needs grow by purchasing additional nodes or clusters of nodes from us to enhance storage capacity, performance or both. Our future revenue growth will depend upon further penetration of our existing customers as well as expansion of our customer base in existing and other industries that depend upon digital content and unstructured data. We consider the development of direct and indirect sales channels in domestic and international markets a key to our future revenue growth and the global acceptance of our products. We also are dependent on the development, adoption and acceptance of new software and systems to increase our overall margins and achieve profitability.
Our product revenue growth rate will depend significantly on continued growth in our target industries and our ability to continue to attract new customers in those industries. Our growth in services revenue will depend upon increasing the number of systems under service contracts. Any such increases will depend on a growing customer base and on our customers renewing existing service contracts.
Key Business Metrics
We monitor a number of key metrics to help forecast growth, establish budgets, measure the effectiveness of our sales and marketing efforts, and measure operational effectiveness.
New Customers and Repeat Sales Orders. Our goal is to attract a significant number of new customers and to encourage existing customers to purchase additional products, specifically our higher margin software applications, SyncIQ®, SnapshotIQ™, SmartConnect™, Migration IQ™, and SmartQuotas™. Many of our customers buy our storage systems and later add additional nodes or software applications as the need arises under our ‘pay-as-you-grow’ model.
Channel Leverage. We are actively growing our relationships with channel partners to further penetrate our targeted markets domestically and internationally. We track our sales orders by direct or indirect customers with the goal of increasing revenue from channel partners.
Gross Margin. Our goal is to grow our gross margin to increase the profitability of our business. Some of the key factors affecting our gross margin are average sales prices of our systems, the revenue attributable to software applications as a percentage of total revenue, the rate at which our customers adopt our higher margin products, the timing of component cost reductions through product redesign, the timing of supplier cost reductions, the ability to manage inventory levels, the ability to control costs associated with servicing our customers, and overall market conditions. We consider our ability to monitor and manage these factors to be a key aspect of attaining and expanding our profitability.
Operating Cash Flow. We closely monitor operating cash flow as a measure of our business performance. Two of the key factors affecting operating cash flow are our ability to generate net income and manage working capital. Increasing inventory turns and reducing days sales outstanding in accounts receivable are both contributors to improving working capital. Our goal is to maximize cash flows while continuing to invest in our business. Our close tracking of operating cash flow allows us to better manage the cash needs of our business.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with United States generally accepted accounting principles, or 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 dates of the consolidated financial statements, the disclosure of contingencies as of the dates of the consolidated financial statements, and the reported amounts of revenue and expenses during the periods presented. We believe the following to be our critical accounting policies because they are important to the portrayal of our financial condition and results of operations and they require critical management estimates and judgments about matters that are uncertain: revenue recognition, allowance for doubtful accounts, stock-based compensation, inventory valuation, and accounting for income taxes. See “Risk Factors” for certain matters that may affect our future financial condition or results of operations. Although we believe that our estimates and judgments are reasonable under the circumstances, actual results may differ from those estimates. These critical accounting policies are consistent with those disclosed in our Annual Report on Form 10-K for the fiscal year ended December 30, 2007.
Results of Operations
The following discussion and analysis should be read in conjunction with our consolidated financial statements, related notes and risk factors included elsewhere in this Quarterly Report on Form 10-Q.
Revenue. We derive our revenue from sales of our products and services. Our customers typically purchase a cluster of our storage devices comprised of three or more nodes and related support services. Each node includes our OneFS® operating system software and industry standard hardware. We offer various systems to meet customer-specific storage capacity and performance requirements. In addition, customers may purchase separate additional software applications for enhanced functionality. Pricing of our products depends, in part, on our cost of goods at the time we determine the overall pricing of our products and the size of the cluster and software modules purchased. We may periodically change the list prices of our storage system products.
| | | | | | | |
| | | Three Months Ended | | | Nine Months Ended | |
| | | September 30, | | | September 30, | |
| | | 2008 | | 2007 | | | 2008 | | 2007 | |
| | | (dollars in thousands) | | |
| Revenue by type: | | | | | | | | | | | | | | | | | |
| Product | | $ | 24,418 | | | $ | 17,627 | | | | $ | 66,827 | | | $ | 52,197 | | |
| Services | | | 5,914 | | | | 4,016 | | | | | 15,811 | | | | 10,203 | | |
| Total revenue | | $ | 30,332 | | | $ | 21,643 | | | | $ | 82,638 | | | $ | 62,400 | | |
| | | | | | | | | | | | | | | |
| % revenue by type: | | | | | | | | | | | | | | | | | | |
| Product | | | 81 | % | | | 81 | % | | | | 81 | % | | | 84 | % | |
| Services | | | 19 | | | | 19 | | | | | 19 | | | | 16 | | |
| Total | | | 100 | % | | | 100 | % | | | | 100 | % | | | 100 | % | |
| | | | | | | | | | | | | | |
| Revenue by geography: | | | | | | | | | | | | | | | | | | |
| Domestic | | $ | 20,283 | | | $ | 17,393 | | | | $ | 57,023 | | | $ | 46,856 | | |
| International | | | 10,049 | | | | 4,250 | | | | | 25,615 | | | | 15,544 | | |
| Total revenue | | $ | 30,332 | | | $ | 21,643 | | | | $ | 82,638 | | | $ | 62,400 | | |
| | | | | | | | | | | | | | |
| % revenue by geography: | | | | | | | | | | | | | | | | | | |
| Domestic | | | 67 | % | | | 80 | % | | | | 69 | % | | | 75 | % | |
| International | | | 33 | | | | 20 | | | | | 31 | | | | 25 | | |
| Total | | | 100 | % | | | 100 | % | | | | 100 | % | | | 100 | % | |
| | | | | | | | | | | | | | |
| Revenue by sales channel: | | | | | | | | | | | | | | | | | | |
| Direct | | $ | 13,711 | | | $ | 9,077 | | | | $ | 38,597 | | | $ | 28,142 | | |
| Indirect | | | 16,621 | | | | 12,566 | | | | | 44,041 | | | | 34,258 | | |
| Total revenue | | $ | 30,332 | | | $ | 21,643 | | | | $ | 82,638 | | | $ | 62,400 | | |
| | | | | | | | | | | | | | |
| % revenue by sales channel: | | | | | | | | | | | | | | | | | | |
| Direct | | | 45 | % | | | 42 | % | | | | 47 | % | | | 45 | % | |
| Indirect | | | 55 | | | | 58 | | | | | 53 | | | | 55 | | |
| Total | | | 100 | % | | | 100 | % | | | | 100 | % | | | 100 | % | |
| | | | | | | | | | | | | | |
Total revenue increased 40% and 32% for the three and nine months ended September 30, 2008, from the comparable periods in the prior year. This growth was primarily due to reorders from our existing customer base, expanded product offerings and contribution from our recently established international markets, particularly in Asia. Reorder revenue from existing customers increased to 86% and 80%, for the three and nine months ended September 30, 2008, respectively, from 52% and 58% in the comparable periods in the prior year. Since the third quarter of 2007, our total number of customers has increased 43%.
The number of new customers added for the three and nine months ended September 30, 2008 was 56 and 179, representing a 26% and 24% decrease, respectively, from the number of new customers added in the comparable periods in the prior year. We believe our ability to obtain new customers during the first half of 2008 was hampered by the uncertainty created by our internal investigation and related matters, including our delayed SEC filings and the status of our NASDAQ listing. In the third quarter of 2008, we believe typical seasonality and capacity limitations in our sales, channel, and marketing organizations impacted our ability to acquire new customers. We experience seasonality in our revenue growth based on historical customer demand and therefore expect revenue growth to be higher during the second and fourth quarters of the fiscal year.
The increase in indirect channel revenue dollars was due to the growing market for our products and our focus on enhancing our relationships with our channel partners. No reseller accounted for more than 10% of our revenue during the first nine months of 2008 and 2007. We plan to continue to expand our relationships with channel partners and over time expect the percent of revenue generated through the channel to grow.
The percentage of our total revenue derived from support services was 19% for both the three and nine months ended September 30, 2008, and 19% and 16% for the three and nine months ended September 30, 2007. The increase in services revenue was a result of increased product sales and first-year technical support sales combined with the renewal of service contracts by existing customers. As our installed customer base grows and since a majority of our customers continue to renew their service contracts, we expect services revenues to continue to grow.
Cost of Revenue and Gross Margin. Cost of product revenue consists primarily of amounts paid to our contract manufacturer in connection with the procurement of hardware components and assembly of those components into our systems, costs of shipping and logistics, and valuation reserves taken for excess and obsolete inventory. Cost of services revenue is primarily comprised of salaries and employee benefits and third-party costs in providing technical support. Our gross margin has been and will continue to be affected by a variety of factors, including average sales prices of our systems, the revenue attributable to sales of software applications as a percentage of total revenue, the rate at which our customers adopt our higher margin products and software applications, the timing of component cost reductions, the timing of supplier cost reductions, and overall market conditions.
| | | | | | | | | | | | | | | | | | |
| | | Three Months Ended | | | Nine Months Ended | | |
| | | September 30, | | | September 30, | | |
| | | 2008 | | 2007 | | | 2008 | | | 2007 | | |
| | | (dollars in thousands) | | |
| Cost of revenue: | | | | | | | | | | | | | | | | | | |
| Product | | $ | 9,176 | | | $ | 7,059 | | | | $ | 26,740 | | | $ | 24,365 | | |
| Services | | | 3,810 | | | | 2,524 | | | | | 9,623 | | | | 5,794 | | |
| Total cost of revenue | | $ | 12,986 | | | $ | 9,583 | | | | | 36,363 | | | $ | 30,159 | | |
| | | | | | | | | | | | | | | |
| Gross margin: | | | | | | | | | | | | | | | | | | |
| Product | | | 62 | % | | | 60 | % | | | | 60 | % | | | 53 | % | |
| Services | | | 36 | | | | 37 | | | | | 39 | | | | 43 | | |
| Total gross margin | | | 57 | | | | 56 | | | | | 56 | | | | 52 | | |
Overall gross margin increased one percentage point and four percentage points for the three and nine months ended September 30, 2008, respectively, from the comparable periods in the prior year. Gross margin for product revenue increased two percentage points and seven percentage points for the three and nine months ended September 30, 2008, from the comparable periods in the prior year. These increases were primarily due to increased customer adoption of our new generation of software applications and lower product discounting together with a reduction in component costs. Additionally, after restating our first quarter 2007 results, gross margin for the nine months ended September 30, 2007, included product COGS for transactions for which no revenue was recorded, reducing margins by approximately 1.5 %. Also, all of our software applications carry a higher gross margin than our overall product margin. During the first nine months of 2008, approximately 60% of our customers purchased one or more of our five software applications compared to approximately 50% in the comparable period in the prior year.
We have experienced and expect to continue to experience pricing pressures within our industry as the price per terabyte of storage decreases year-over-year. This downward pricing pressure is primarily due to the decreasing prices of disk drives and other industry standard hardware components. Depending on the product type, disk drives can represent approximately one-third of our material cost. Historically, disk drives have decreased in price approximately 30% from year to year. The decline in product prices that we experienced was more than offset by a greater percentage decrease in cost of product revenue on a per unit basis. This added to the overall increase in product gross margin in the third quarter and the first nine months of 2008 from the comparable periods in the prior year.
Gross margin for services revenue decreased one percentage point and four percentage points for the three and nine months ended September 30, 2008, from the comparable periods in the prior year. Services revenue includes support services for both our software and our hardware products and professional services fees. Software support provides customers with software updates, maintenance releases and patches, which have minimal costs. Hardware support includes Internet access to our technical knowledge database and to technical support personnel, and third-party costs in providing technical support. During the first nine months of 2008, we continued to make investments in our customer service and support structure, including hiring new personnel, and expanding our service organization geographically to enhance the reliability and responsiveness for our customers. As a result, gross margin for services revenue for the third quarter and first nine months ended September 30, 2008 decreased from the comparable period in the prior year.
As our customer base continues to grow, it will be necessary for us to continue to make significant upfront investments in our customer service and support structure to support this growth. The rate at which we add new customers will affect the amount of these upfront investments. The timing of these additional expenditures could materially affect our cost of revenue, both in absolute dollars and as a percentage of total revenue, in any particular period. This could cause downward pressure on services and total gross margins. We believe that we will experience increases in gross margin as our supply chain reaches economies of scale and as software revenue, which has a higher gross margin, increases as a percent of our total revenue.
Research and Development Expenses. Research and development expenses primarily include personnel costs, prototype expenses, facilities expenses and depreciation of equipment used in research and development. In addition to our United States development teams, we used an offshore development team from a third-party contract engineering provider in Moscow, Russia through the end of fiscal 2007. Research and development expenses are recorded when incurred. We are devoting substantial resources to the development of additional functionality for existing products and the development of new systems and software products. We intend to continue to invest significantly in our research and development efforts because we believe they are essential to maintaining and improving our competitive position. However, we expect research and development expenses to decrease as a percent of revenue in the next several quarters.
| | |
| | Three Months Ended | | | Nine Months Ended | |
| | September 30, | | | | | | | September 30, | | | | |
| | 2008 | | 2007 | | $ change | | | | | 2008 | | 2007 | | $ change | | % change | |
| | (dollars in thousands) | | | (dollars in thousands) | |
| Research and development expenses | $ | 6,318 | | | $ | 5,374 | | | $ | 944 | | 18 | % | | | $ | 17,788 | | | $ | 14,778 | | | $ | 3,010 | | 20 | % | |
| Percent of total revenue | | 21 | % | | | 25 | % | | | | | | | | | | 22 | % | | | 24 | % | | | | | | | |
Research and development expenses increased primarily due to an increase in employee headcount to 130 at September 30, 2008 from 106 at September 30, 2007. Stock-based compensation expense related to research and development increased to $376,000 in the third quarter of 2008 from $167,000 in the third quarter of 2007 and to $788,000 in the first nine months of 2008 from $488,000 in the first nine months of 2007.
Sales and Marketing Expenses. Sales and marketing expenses primarily include personnel costs, sales commissions, professional services fees, trade shows, marketing programs, facilities and depreciation expenses. We plan to continue to invest heavily in sales and marketing by increasing the size of our field sales force and the number of our channel partners to allow us to expand into existing and new geographic and vertical markets. We also plan to continue to invest in expanding our domestic and international sales and marketing activities and building brand awareness. We expect that sales and marketing expenses will increase in absolute dollars and remain our largest expense category. However, we expect sales and marketing expenses to decrease as a percentage of total revenue in the future due to our expected revenue growth and attainment of economies of scale. Generally, sales personnel are not immediately productive and thus sales and marketing expenses do not immediately result in revenue. Hiring additional sales personnel reduces short-term operating margins until the sales personnel become fully productive. Accordingly, the timing of sales personnel hiring and the rate at which they become productive will affect our future performance.
| | |
| | Three Months Ended | | | Nine Months Ended | |
| | September 30, | | | | | | | September 30, | | | | |
| | 2008 | | 2007 | | $ change | | | | | 2008 | | 2007 | | $ change | | % change | |
| | (dollars in thousands) | | | (dollars in thousands) | |
| Sales and marketing expenses | $ | 11,341 | | | $ | 11,282 | | | $ | 59 | | 1 | % | | | $ | 35,546 | | | $ | 30,111 | | | $ | 5,435 | | 18 | % | |
| Percent of total revenue | | 37 | % | | | 52 | % | | | | | | | | | | 43 | % | | | 48 | % | | | | | | | |
Sales and marketing expenses during the three months ended September 30, 2008 were relatively unchanged from the comparable period in the prior year. Sales and marketing headcount increased to 143 at September 30, 2008 from 140 at September 30, 2007. During the nine months ended September 30, 2008, sales and marketing expenses increased primarily due to variable compensation associated with higher revenues, professional services and a continued increase in stock-based compensation expense. Stock-based compensation expense related to sales and marketing decreased to $470,000 in the third quarter of 2008 from $509,000 in the third quarter of 2007 and increased to $1.7 million in the first nine months of 2008 from $1.1 million in the first nine months of 2007.
General and Administrative Expenses. General and administrative expenses primarily include personnel costs; facilities expenses related to our executive, finance, human resources, information technology and legal organizations; bad debt expense; public company related expenses; and fees for professional services such as legal, accounting, compliance and information systems. Also included in general and administrative expenses are attorneys’ fees and costs for the legal proceedings described in more detail in Part 1, Note 11 in Notes to Condensed Consolidated Financial Statements, as well as costs associated with our completed Audit Committee’s investigation. We expect general and administrative expenses to continue to increase in total dollars although we expect these expenses to decrease as a percentage of total revenue over the next several years. For fiscal 2008, we expect general and administrative expenses to potentially increase as a percentage of revenue as we incur attorneys’ fees and costs in the legal proceedings described in more detail in Part 1, Note 11 in Notes to Condensed Consolidated Financial Statements.
| | |
| | Three Months Ended | | | Nine Months Ended | |
| | September 30, | | | | | | | September 30, | | | | |
| | 2008 | | 2007 | | $ change | | | | | 2008 | | 2007 | | $ change | | % change | |
| | (dollars in thousands) | | | (dollars in thousands) | |
| General and administrative expenses | $ | 4,843 | | | $ | 3,687 | | | $ | 1,156 | | 31 | % | | | $ | 15,303 | | | $ | 9,769 | | | $ | 5,534 | | 57 | % | |
| Percent of total revenue | | 16 | % | | | 17 | % | | | | | | | | | | 19 | % | | | 16 | % | | | | | | | |
For the three months ended September 30, 2008, general and administrative expenses increased from the comparable period in the prior year primarily due to an increase in professional services fees for attorneys and costs for the legal proceedings described in more detail in Part 1, Note 11 and stock-based compensation. For the nine months ended September 30, 2008 general and administrative expenses increased from the comparable period in the prior year primarily due to professional services fees, which included attorneys’ fees and costs for legal proceedings and $2.9 million in fees associated with our Audit Committee investigation and restatement of financial statements; stock-based compensation; and salaries and benefits. The additional personnel and professional services fees were primarily the result of our ongoing efforts to build the legal, financial, human resources and information technology functions required of a public company, including costs to comply with the Sarbanes-Oxley Act of 2002. We expect total general and administrative costs to decrease as a percentage of revenue over time. Stock-based compensation expense related to general and administrative increased to $681,000 in the third quarter of 2008 from $522,000 in the third quarter of 2007 and to $1.8 million in the first nine months of 2008 from $1.1 million, in the first nine months of 2007.
Interest income and other. Interest income and other primarily includes interest income on cash, cash equivalents and marketable securities balances.
| | |
| | Three Months Ended | | | Nine Months Ended | |
| | September 30, | | | | | September 30, | | |
| | 2008 | | 2007 | | $ change | | | 2008 | | 2007 | | $ change | |
| | (dollars in thousands) | | | (dollars in thousands) | |
Interest income and other | $ | 398 | | $ | 1,141 | | $ | (743 | ) | | | $ | 1,860 | | $ | 3,472 | | $ | (1,612 | ) | |
Interest income and other decreased by $743,000 and $1.6 million during the three and nine months ended September 30, 2008 from the comparable periods in the prior year. The decrease in interest income resulted from a decrease in market interest rates on our investments as well as a lower cash, cash equivalents and marketable securities balance.
Liquidity and Capital Resources
As of September 30, 2008, our principal sources of liquidity consisted of cash, cash equivalents and marketable securities of $76.7 million and net accounts receivable of $15.2 million.
The following table shows our working capital and cash and cash equivalents as of the stated dates:
| | As of | |
| | September 30, | | December 30, | |
| | 2008 | | 2007 | |
| | | (in thousands) | |
| Working capital | | $ | 72,558 | | | $ | 87,251 | |
| Cash, cash equivalents and marketable securities | | | 76,717 | | | | 85,861 | |
The following table shows our cash flows from operating activities, investing activities and financing activities for the stated periods:
| | | Nine Months Ended | |
| | | September 30, | |
| | | 2008 | | | 2007 | |
| | | (in thousands) | |
| Net cash used in operating activities | | $ | (4,899 | ) | | $ | (1,862 | ) |
| Net cash provided by (used in) investing activities | | | 12,418 | | | | (40,013 | ) |
| Net cash provided by (used in) financing activities | | | 440 | | | | (424 | ) |
Cash Flows from Operating Activities
Net cash used in operating activities was $4.9 million and $1.9 million during the nine months ended September 30, 2008 and September 30, 2007. Net cash used in operating activities during the first nine months of 2008 consisted primarily of our net loss of $20.7 million, offset by depreciation and amortization expense of $4.7 million, stock-based compensation expense of $4.4 million, and net changes in operating assets and liabilities of $6.9 million. Included in operating cash outflows for the first nine months of 2008 was $3.9 million in professional service fees related to our Audit Committee’s investigation and our restatement of financial statements.
Net cash used in operating activities during the first nine months of 2007 consisted primarily of our net loss of $19.1 million, offset by $10.7 million in net changes in operating assets and liabilities, depreciation and amortization expense of $3.8 million and stock-based compensation expense of $2.7 million.
Cash Flows from Investing Activities
Cash flows from investing activities primarily relate to capital expenditures to support our growth and net maturities and purchases of marketable securities. Net cash provided by investing activities during the first nine months of 2008 was comprised of $17.0 million of net proceeds from maturities of marketable securities offset by $4.6 million of capital expenditures, primarily related to increased research and development lab equipment and purchases of computer and office equipment to support continued growth. Net cash used in investing activities during the first nine months of 2007 related to $34.6 million in net purchases of marketable securities and net capital expenditures of $5.7 million.
Cash Flows from Financing Activities
During the first nine months of 2008, the net cash provided by financing activities primarily related to $453,000 in proceeds from issuance of common stock during the period. During the first nine months of 2007, the net cash used in financing activities primarily related to payments of previously accrued public offering costs of $1.1 million, offset by $789,000 in proceeds from issuance of common stock.
We believe that our $76.7 million of cash, cash equivalents and marketable securities at September 30, 2008, will be sufficient to fund our projected operating requirements for at least twelve months. However, we may need to raise additional capital or incur indebtedness to continue to fund our operations in the future. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the cost of legal defense related to our shareholder lawsuits, the timing and extent of our expansion into new territories, the timing of introductions of new products and enhancements to existing products, potential acquisitions of new businesses, and the continuing market acceptance of our products.
Contractual Obligations
As of September 30, 2008, our principal commitments consisted of obligations outstanding under operating leases. We lease our facilities under operating leases that expire at various dates through 2014. There have been no material changes in our principal lease commitments compared with those discussed in our Annual Report on Form 10-K for the year ended December 30, 2007.
We outsource the manufacturing of our products to a contract manufacturer for which we typically maintain a rolling 90-day firm order based on production forecast. These orders may only be rescheduled, modified, or cancelled by the contract manufacturer under certain circumstances. The remaining amount on the open purchase order with our contract manufacturer and other partners and suppliers at September 30, 2008, was approximately $7.3 million.
We will transition its third party customer servicing functions to a new provider during the fourth quarter of 2008. In concurrence with the transition, we have agreed to repurchase approximately $1.4 million in inventory that was previously sold to our current provider.
Off-Balance Sheet Arrangements
During the periods presented, 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.
Recent Accounting Pronouncements
In October 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (FSP) No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active, or FSP 157-3. FSP 157-3 clarifies the application of Statement of Financial Accounting Standards No. 157, Fair Value Measurements, or SFAS 157, in determining the fair values of assets or liabilities in a market that is not active. FSP 157-3 became effective upon issuance, including prior periods for which financial statements have not been issued. We adopted FSP 157-3 for the period ended September 30, 2008; however, the adoption did not result in a material impact on our consolidated financial statements.
In June 2008, the FASB issued FASB Staff Position (FSP) No. EITF 03-6-1, Determining Whether Instruments Granted in Share-based Payment Transactions Are Participating Securities, or FSP 03-6-1, which requires entities to apply the two-class method of computing basic and diluted earnings per share for participating securities that include awards that accrue cash dividends (whether paid or unpaid) any time common stockholders receive dividends and those dividends do not need to be returned to the entity if the employee forfeits the award. We believe that the adoption of FSP 03-6-1 will not have a material effect on our consolidated financial statements.
In February 2008, the FASB issued FSP No. FAS 157-2, Fair Value Measurements, or FSP 157-2, which delayed the effective date of SFAS 157 one year, for all nonfinancial assets and liabilities, except those recognized or disclosed at fair value in the financial statements on a recurring basis. We will adopt FSP 157-2 in the first quarter of fiscal year 2009 and believe that it will not have a material effect on our consolidated financial statements.
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
A description of our quantitative and qualitative disclosures about market risks is set forth in Part II, Item 7A, of our Annual Report on Form 10-K for the year ended December 30, 2007, filed with the Securities and Exchange Commission on April 2, 2008.
a) Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of our management, including our chief executive officer and chief financial officer (together, our “certifying officers”), of the effectiveness of the design and operation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the “Exchange Act.” Disclosure controls and procedures are controls and other procedures designed to ensure that information required to be disclosed by us in our reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms, and that the information is accumulated and communicated to our management, including our certifying officers, to allow timely decisions regarding required disclosure. Based upon this evaluation, our certifying officers concluded that our disclosure controls and procedures were effective as of September 30, 2008.
b) Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended September 30, 2008, that our certifying officers concluded materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II – OTHER INFORMATION
On November 1, 2007, a putative class action complaint was filed in the U.S. District Court for the Western District of Washington against us and certain of our current and former directors and officers. The complaint asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated there under, as well as under Sections 11 and 15 of the Securities Act of 1933. Substantially similar complaints were filed later in the same court and all of these cases were subsequently consolidated. On April 18, 2008, lead plaintiffs filed a consolidated amended complaint against us, certain of our current and former directors and officers, underwriters, and venture capital firms. The consolidated complaint purports to be brought on behalf of a class of persons who purchased or otherwise acquired our stock during the period December 16, 2006 to October 3, 2007. Plaintiffs allege that defendants violated the federal securities laws by issuing a false and misleading registration statement and prospectus in connection with our December 16, 2006 initial public offering and by thereafter misrepresenting our current and prospective business and financial results, thereby causing our stock price to be artificially inflated during the purported class period. Plaintiffs seek unspecified compensatory damages, interest, attorneys' fees and costs, and injunctive relief. On September 30, 2008 we, and the other defendants, moved to dismiss the consolidated amended complaint and that motion is pending.
In addition, on March 18 and 24, 2008, shareholder derivative actions were filed in the Superior Court of the State of Washington (King County), allegedly on behalf of and for the benefit of the Company, against certain of our current and former directors and officers. We were named as a nominal defendant. On April 17, 2008, the court consolidated these actions and appointed lead counsel. The derivative complaints arise out of many of the factual allegations at issue in the class action, and generally allege that the individual defendants breached fiduciary duties owed to the Company by publicly misrepresenting Isilon’s business prospects and by failing to properly account for certain revenues recognized in our fiscal year ended December 31, 2006, and first and second quarters in fiscal 2007. The complaints seek unspecified damages and equitable relief, disgorgement of compensation, attorneys’ fees, costs, and expenses. Because the complaints are derivative in nature, they do not seek monetary damages from the Company. However, we may be required to advance the legal fees and costs incurred by the individual defendants. On August 27, 2008, at the request of the parties, the court stayed the consolidated derivative action pending resolution of the motion to dismiss in the securities class action.
We are unable to predict the outcome of these cases. A court determination against us in the class action, and our indemnity obligations in the derivative actions, could result in significant liability and could have a material adverse effect on our consolidated financial position, results of operations or cash flows.
As previously disclosed, we have been cooperating on a voluntary basis in an informal inquiry being conducted by the SEC concerning our prior financial restatement. The SEC has recently issued a formal order of nonpublic investigation and has issued subpoenas to certain of our former officers. The SEC’s investigation is a nonpublic, fact-finding inquiry to determine if there have been violations of the federal securities laws. We are continuing to cooperate voluntarily with the SEC.
In the ordinary course of business, we may be a party to litigation and claims, including disputes involving intellectual property rights, commercial agreements and employment rights. Such matters, even if without merit, could result in the expenditure of significant resources.
Risks Related to Our Restatement
Matters relating to or arising from our recent restatement and weaknesses in our internal controls, including adverse publicity and potential concerns from our customers and prospective customers, regulatory inquiries, and litigation matters, could have a material adverse effect on our business, revenues, operating results, or financial condition.
As more fully described in the Explanatory Note in Part 1 of our Annual Report on Form 10-K, in November 2007, our Audit Committee initiated an independent investigation of certain of our sales to resellers and other customers to determine whether commitments were made that have an impact on the timing and treatment of revenue recognition, and whether our internal controls relating to revenue recognition were sufficient. Our Audit Committee conducted its investigation and review with the assistance of independent counsel and an independent forensic accounting advisor.
On April 2, 2008, we announced the completion of the investigation and filed our Annual Report on Form 10-K for the year ended December 30, 2007, which includes our restated financial statements for the fiscal year ended December 31, 2006, and our restated financial information for the first and second quarters of fiscal 2007, ended April 1, 2007 and July 1, 2007, respectively. The circumstances and findings of our Audit Committee’s investigation are more fully described in the Explanatory Note in Part 1 of our Annual Report on Form 10-K.
The investigation and resulting restatement could have a material adverse effect on our relationships with customers and customer prospects, has already resulted in the initiation of securities class action litigation, derivative litigation, and an SEC investigation, and could result in other litigation or regulatory proceedings, any of which could have a material adverse effect on our business, revenues, operating results, or financial condition. Under Delaware law, our bylaws, and certain indemnification agreements, we may have an obligation to indemnify certain current and former officers and directors in relation to these matters. Such indemnification may have a material adverse effect on our business, results of operations, and financial condition to the extent insurance does not cover our costs. The insurance carriers that provide our directors’ and officers’ liability policies may seek to rescind or deny coverage with respect to those pending investigations or actions in whole or in part, or we may not have sufficient coverage under such policies, in which case our business, results of operations, and financial condition may be materially and adversely affected.
Impact on our Business
As a result of the investigation, we filed our Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, approximately five months late. We believe that our competitors have sought and will continue to seek to leverage the restatement and investigation and related litigation and regulatory matters to try and raise concerns about us in the minds of our customers and customer prospects. Our restatement and related litigation and regulatory matters and other adverse publicity has affected and could continue to affect our relationships with customers and customer prospects and has and could continue to have a material adverse effect on our business, revenues, operating results, and financial condition and cash flows.
Litigation and Regulatory Matters
As further described in this Form 10-Q at Note 11, Commitments and Contingencies / Legal Proceedings and Part II, Other Information / Legal Proceedings, we and certain of our executive officers, directors, underwriters and venture capital firms are defendants in a consolidated federal securities class action. The amended consolidated complaint filed April 18, 2008, asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder, as well as under Section 11 and 15 of the Securities Act of 1933. On September 30, 2008, the Company and the other defendants moved to dismiss the consolidated amended complaint and that motion is pending. In addition, on March 18 and 24, 2008, shareholder derivative actions were filed in the Superior Court of the State of Washington (King County), allegedly on behalf of and for the benefit of the Company, against certain of our current and former directors and officers. The Company was also named as a nominal defendant. The derivative complaints arise out of many of the factual allegations at issue in the class action, and generally allege that the individual defendants breached fiduciary duties owed to the Company by publicly misrepresenting Isilon’s business prospects, and by failing to properly account for certain revenues recognized in our fiscal year ended December 31, 2006, and first and second quarters in fiscal 2007. On August 27, 2008, at the request of the parties, the court stayed the consolidated derivative action pending resolution of the motion to dismiss in the securities class action. Also, as previously disclosed, we have been cooperating on a voluntary basis in an informal inquiry being conducted by the SEC concerning our prior financial restatement. The SEC has recently issued a formal order of nonpublic investigation and has issued subpoenas to certain of our former officers. The SEC’s investigation is a nonpublic, fact-finding inquiry to determine if there have been violations of the federal securities laws. We are continuing to cooperate voluntarily with the SEC.
These matters are in preliminary stages and we cannot predict the claims, allegations, class period, or outcome of these matters. In addition, we cannot provide any assurances that the final outcome of the securities lawsuit or the derivative lawsuits will not have a material adverse effect on our business, results of operations, or financial condition. We may become subject to additional litigation or regulatory proceedings or actions arising out of our Audit Committee’s investigation and the related restatement of our historic financial statements. Litigation and regulatory proceedings can be time-consuming and expensive and could divert management time and attention from our business, which could have a material adverse effect on our revenues and results of operations. The adverse resolution of any specific lawsuit or regulatory action or proceeding could have a material adverse effect on our business, results of operations, financial condition, and cash flows.
If we fail to establish and maintain proper and effective internal controls, our ability to produce accurate financial statements on a timely basis could be impaired, which would adversely affect our consolidated operating results, our ability to operate our business and investors’ views of us.
Ensuring that we have adequate internal financial and accounting controls and procedures in place to produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. Failure on our part to have effective internal financial and accounting controls would cause our financial reporting to be unreliable, could have a material adverse effect on our business, operating results, and financial condition and could cause the trading price of our common stock to fall dramatically. In our Quarterly Report on Form 10-Q for the period ended September 30, 2007, our Chief Executive Officer and Chief Financial Officer determined that our internal control over financial reporting was not effective.
Our Audit Committee's investigation of revenue recognition issues identified internal control weaknesses relating primarily to the failure to communicate complete information regarding certain sales transactions containing non-standard terms among finance, accounting, legal, sales and senior management personnel and an ineffective risk assessment process. This material weakness was remediated as of December 30, 2007. Remedying our material weakness has required substantial management time and attention and incremental expenses. Any failure to maintain the remediation of our identified control deficiencies or any additional errors or delays in our financial reporting, whether or not resulting from a failure to remedy the deficiencies that resulted in the current restatement, would have a material adverse effect on our business and results of operations and could have a substantial adverse impact on the trading price of our common stock and our relationships with customers.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting to ensure that information regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States. Our management does not expect that our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system's objectives will be met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company will have been detected.
We will continue to be required to comply with Section 404 of the Sarbanes-Oxley Act of 2002. In complying with the Act in connection with our Annual Report on Form 10-K for our year ended December 30, 2007, we have expended significant resources in developing the necessary documentation and testing procedures required by Section 404 of the Sarbanes-Oxley Act and expect to continue to expend significant resources in maintaining this compliance. We cannot be certain that the actions we have taken to improve our internal control over financial reporting will be sufficient or that we will be able to maintain and continue to implement and improve our processes and procedures in the future, which could cause us to be unable to produce accurate financial statements on a timely basis. Any of the foregoing could cause investors to lose confidence in the reliability of our consolidated financial statements, which could cause the market price of our common stock to decline and make it more difficult for us to finance our operations and growth.
Risks Related to Our Business and Industry
Changes in economic conditions in the United States and globally could adversely affect our business.
Since mid-2007, global credit and other financial markets have suffered substantial stress, volatility, illiquidity and disruption. These forces reached unprecedented levels in September and October 2008, resulting in the bankruptcy or acquisition of, or government assistance to, several major domestic and international financial institutions. The financial crisis has resulted in a tightening in the credit markets, a low level of liquidity in many financial markets, and extreme volatility in fixed income, credit and equity markets. There could be a number of follow-on effects from the credit crisis on our business, including insolvency of key suppliers resulting in product delays; and inability of customers to obtain credit to finance purchases of our products and/or customer insolvencies.
Moreover, the current uncertainty in global economic conditions poses a risk to the overall economy as consumers and businesses may defer purchases in response to negative financial or economic news and events, which could negatively affect product demand and other related matters. Consequently, demand could be different from our current expectations due to factors including negative changes in general business and economic conditions and/or further tightening or deterioration in global credit markets, either of which could affect consumer confidence, customer acceptance of our and our competitors’ products and changes in customer order patterns including order cancellations.
We have a history of losses, and we may not achieve profitability in the future.
We have not been profitable in any fiscal period since we were formed. We experienced a net loss of $4.8 million and $20.7 million for the three and nine months ended September 30, 2008, and $7.2 million and $19.1 million for the three and nine months ended July 1, 1007. As of September 30, 2008, our accumulated deficit was $123.3 million. We expect to make significant expenditures related to the development of our products and expansion of our business, including expenditures for additional sales and marketing and research and development personnel. We may encounter unforeseen difficulties, complications and delays and other unknown factors that require additional expenditures. As a result of these increased expenditures, we will have to generate and sustain substantially increased revenue to achieve profitability. Our revenue growth trends in prior periods are not likely to be sustainable. Accordingly, we may not be able to achieve or maintain profitability and we may continue to incur significant losses in the future.
We face intense competition and expect competition to increase in the future, which could reduce our revenue and customer base.
The storage market is highly competitive and we expect competition to intensify in the future. This competition could make it more difficult for us to sell our products, and result 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. For instance, the decrease in the price of disk drives and other industry standard hardware components has resulted in increased pricing pressure and a reduction in the price per megabyte of storage.
Currently, we face competition from a number of established companies, including EMC Corporation, Hewlett-Packard Company, Hitachi Data Systems Corporation, International Business Machines Corporation, Network Appliance, Inc. and Sun Microsystems, Inc. We also face competition from a large number of private companies and recent market entrants. Many of our current competitors have, and some of our potential competitors could have, longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, sales, marketing and other resources than we have. Potential customers may prefer to purchase from their existing suppliers rather than a new supplier regardless of product performance or features.
We expect increased competition from other established and emerging companies, including companies such as networking infrastructure and storage management companies that provide complementary technology and functionality. In addition, third parties currently selling our products could market products and services that compete with ours. Some of our competitors, including EMC and Network Appliance, have made acquisitions of businesses that allow them to offer more directly competitive and comprehensive solutions than they had previously offered. Our current and potential competitors may also establish cooperative relationships among themselves or with third parties. If so, new competitors or alliances that include our competitors may emerge that could acquire significant market share. We expect these trends to continue as companies attempt to strengthen or maintain their market positions in an evolving industry. In addition, large operating system and application vendors, such as Microsoft Corporation, have introduced and may in the future introduce products or functionality that include some of the same functions offered by our products. In the future, further development by these vendors could cause our products to become obsolete. In addition, we compete against internally developed storage solutions as well as combined third-party software and hardware solutions. Any of these competitive threats, alone or in combination with others, could seriously harm our business, operating results and financial condition.
Our operating results may fluctuate significantly, which makes our future results difficult to predict and could cause our operating results to fall below expectations.
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 near the end of the quarter. As a result, small delays can make our operating results difficult to predict. If our revenue or operating results fall below the expectations of investors or any securities analysts that follow our company, the price of our common stock would likely decline.
Factors that may affect our operating results include:
| | · | the timing and magnitude of shipments and timing of installations of our products in each quarter; |
| | · | our ability to build and expand our direct sales operations and reseller distribution channels; |
| | · | our ability to build sales backlogs and improve sales linearity; |
| | · | our ability to attract new customers; |
| | · | reductions in customers’ budgets for information technology purchases, delays in their purchasing cycles or deferments of their product purchases in anticipation of new products or updates from us or our competitors; |
| | · | the rates at which customers purchase additional storage systems from us and renew their service contracts with us; |
| | · | the timing of recognizing revenue as a result of revenue recognition rules; |
| | · | fluctuations in demand, sales cycles and prices for our products and services; |
| | · | our ability to develop, introduce and ship in a timely manner new products and product enhancements that meet customer requirements; |
| | · | the timing of product releases, upgrades or announcements by us or our competitors; |
| | · | any change in competitive dynamics, including new entrants or discounting of product prices; |
| | · | our ability to control costs, including our operating expenses and the costs of the components we use in our products; |
| | · | the possibility of seasonality of demand for our products; |
| | · | volatility in our stock price, which may lead to higher stock compensation expenses pursuant to Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, or SFAS 123(R), which first became effective for us in the first quarter of 2006 and requires that employee stock-based compensation be measured based on its fair value on the grant date and recorded as an expense in our financial statements over the recipient’s service period; |
| | · | changes in general economic conditions and specific economic conditions in the computer and storage industries; |
| | · | general decrease in global corporate spending on information technology leading to a decline in demand for our products; |
| | · | the ability of our customers, channel partners, and suppliers to obtain financing or to fund capital expenditures and their ability to continue as a going concern; |
| | · | increased customer uncertainty due to the credit crisis and general weakness in the markets; |
| | · | future accounting pronouncements and changes in accounting policies; and |
| | · | geopolitical events such as war or incidents of terrorism. |
Our limited operating history in an emerging market sector makes it difficult to evaluate our current business and future prospects, and may increase the risk of your investment.
Our company has only been in existence since January 2001. We first began shipping products in January 2003 and much of our growth has occurred since October 2005. Our limited operating history in an emerging market sector makes it difficult to evaluate our current business and our future prospects. We have encountered and will continue to encounter risks and difficulties frequently experienced by growing companies in rapidly changing industries, such as the risks described in this report. If we do not address these risks successfully, our business will be harmed.
Our future financial performance depends on growth in the storage of unstructured, digital content. If growth in the storage of unstructured, digital content does not continue at the rate that we forecast, our operating results would be materially and adversely impacted.
Our products are designed to address the growth in storage of unstructured, digital content. This is a new and emerging category. Accordingly, our future financial performance will depend in large part on growth in this new category and on our ability to adapt to emerging demands. Changes in technologies could adversely affect the demand for storage systems. For example, advances in file compression technology could result in smaller file sizes and reduce the demand for storage systems. A reduction in demand for storage of unstructured, digital content caused by lack of customer acceptance, weakening economic conditions, competing technologies and products, decreases in corporate spending or otherwise, would result in decreased revenue or a lower revenue growth rate. We cannot assure you that growth in the storage of unstructured, digital content will continue or that we will be able to respond adequately to changes in the future. If we are unable to maintain or replace our relationships with customers or to increase the diversification of our customer base, it would be more difficult to maintain or grow our revenue and our growth might be limited.
Historically, a significant portion of our total revenue has come from a limited number of customers in a small number of industries, particularly media and entertainment and Internet companies. For example, our largest customer for 2007, Eastman Kodak Company, accounted for approximately 10% of our total revenue, and our two largest customers for 2006, Comcast Corporation, which purchased through one of our resellers, and Eastman Kodak Company, together accounted for approximately 25% of our total revenue. Because of concentrated purchases by certain new and existing customers, our largest customers have historically varied from quarter to quarter. As a consequence of the concentrated nature of our customers’ purchasing patterns, the proportion of our total revenue derived from a small number of customers may be even higher in any future quarter. We cannot provide any assurance that we will be able to sustain our revenue from these customers because our revenue has largely been generated in connection with these customers’ decisions to deploy large-scale storage installations and their capacity requirements may have been met. In addition, our customers, including Comcast Corporation and Eastman Kodak Company, generally buy systems on a purchase order basis and generally do not enter into long-term contracts or minimum purchase commitments. If we are unable to sustain our revenue from these customers or to replace it with revenue from new or existing customers, our growth may be limited. If economic conditions change for the industries in which our largest customers do business, or if we are unable to attract significant numbers of customers in other targeted industries, including government, oil and gas, and life sciences, our ability to maintain or grow our revenue would be adversely affected.
If we are unable to develop and introduce new products and respond to technological changes, if our new products do not achieve market acceptance or if we fail to manage product transitions, we may fail to increase, or may lose, market share.
Our future growth depends on the successful development and introduction of new systems and software products. Due to the complexity of storage systems, these products are subject to significant technical risks that may impact our ability to introduce these products successfully. Our new products also may not achieve market acceptance. In addition, our new products must respond to technological changes and evolving industry standards. If we are unable, for technological or other reasons, to develop and introduce new products in a timely manner in response to changing market conditions or customer requirements, or if these products do not achieve market acceptance, our operating results could be materially and adversely affected.
Product introductions by us in future periods may also reduce demand for our existing products. As new or enhanced products are introduced, we must successfully manage the transition from older products in order to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories and ensure that sufficient supplies of new products can be delivered to meet customer demand.
We rely on value-added resellers and other distribution partners to sell our products, and disruptions to, or our failure to develop and manage, our distribution channels and the processes and procedures that support them could result in these resellers and partners discontinuing the marketing and distribution of our products and services.
Our future success is highly dependent upon establishing and maintaining successful relationships with a variety of value-added resellers and other distribution partners, which we collectively refer to as channel partners. A substantial portion of our total revenue is currently sold through our channel partners. Therefore, our ability to maintain or grow our revenue will likely depend, in part, on our ability to maintain our arrangements with our existing channel partners and to establish and expand arrangements with new channel partners, and any failure to do so could have a material adverse effect on our future revenue. Additionally, by relying on channel partners, we may have less 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.
Recruiting and retaining qualified channel partners and training them in our technology and product offerings require 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 channel partners, including investments in systems and training. Those processes and procedures may become increasingly complex and difficult to manage.
We typically enter into non-exclusive, written distribution agreements with our channel partners that generally have a one-year term, have no minimum sales commitment and do not prohibit them from offering products and services that compete with ours. Accordingly, our channel partners may choose to discontinue offering our products and services or may not devote sufficient attention and resources toward selling our products and services. Our competitors may provide incentives to our existing and potential channel partners to use or purchase their products and services or to prevent or reduce sales of our products and services. Some of our channel partners possess significant resources and advanced technical abilities and may, either independently or jointly with our competitors, develop and market products and related services that compete with our offerings. If this were to occur, these channel partners might discontinue marketing and distributing our products and services. In addition, these channel partners would have an advantage over us when marketing their competing products and related services because of their existing customer relationships. The occurrence of any of these events would likely materially adversely affect our business, operating results and financial condition.
Claims by others that we infringe their proprietary technology could cause us to incur substantial costs, distract our management and, if these claims are successful, require us to pay substantial damages or prevent us from offering our products.
Third parties could claim that our products or technologies infringe their proprietary rights. The data storage industry is characterized by the existence of a large number of patents, trademarks and copyrights and by frequent litigation based on allegations of infringement or other violations of intellectual property rights. We expect that infringement claims may further increase as the number of products and competitors in our sector increases. Although we have not to date been involved in any litigation related to intellectual property, we received a letter on July 31, 2006, from counsel to SeaChange International, Inc. suggesting that our products may be infringing certain SeaChange patents. Since that time we have exchanged some correspondence with SeaChange’s legal counsel, the latest of which was our letter of August 31, 2007, which pointed out that there appears to be no reasonable basis for SeaChange to claim that Isilon infringes any of the SeaChange patents. We have received no further correspondence from SeaChange. If we are unable to reach an amicable resolution of this dispute, it is possible that litigation with SeaChange may result. The outcome of any litigation is inherently unpredictable, and accordingly, we cannot assure you that, in the future, a court would not find that our products infringed these patents. We cannot assure you that we do not currently infringe, or that we will not in the future infringe, upon any third-party patents or other proprietary rights.
Any claim of infringement by a third party, even one without merit, could cause us to incur substantial costs defending against the claim, and could distract our management from our business. Further, a party making such a claim, if successful, could secure a judgment that requires us to pay substantial damages. A judgment could also include an injunction or other court order that could prevent us from offering our products. In addition, we might be required to seek a license for the use of the infringed intellectual property, which might not be available on commercially reasonable terms or at all. Alternatively, we might be required to develop non-infringing technology, which could require significant effort and expense and might ultimately be unsuccessful. 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 succeeds, we might 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 sales cycles can be long and unpredictable, and our sales development efforts require considerable time and expense. As a result, our sales are difficult to predict and may vary substantially from quarter to quarter, which may cause our operating results to fluctuate significantly.
The timing of our revenue is difficult to predict. Our sales efforts involve building and expanding our direct sales operations and reseller distribution channels, improving our ability to build sales backlogs and improve sales linearity, and educating our customers about the use and benefits of our products, including their technical capabilities and potential cost savings to an organization. Customers typically undertake a significant evaluation process that in the past has resulted in a lengthy sales cycle, in some cases more than 12 months. We spend substantial time and resources on our sales efforts without any assurance that our efforts will produce any sales. In addition, product purchases are frequently subject to budget constraints, multiple approvals and unplanned administrative processing and other delays. If we do not realize expected sales from a specific customer for a particular quarter in that quarter or at all, our business, operating results and financial condition could be harmed.
We derive substantially all of our total revenue from sales of our Isilon IQ product family and related services, and a decline in demand for our Isilon IQ product family would cause our revenue to grow more slowly or to decline.
We derive substantially all of our total revenue from sales of our Isilon IQ product family and customer and technical support services associated with this product family. As a result, we are vulnerable to fluctuations in demand for this product family, whether as a result of competition, product obsolescence, technological change, customer budgetary constraints or other factors. If demand for our Isilon IQ product family were to decline, our financial condition would be harmed.
If we are unable to continue to create valuable innovations in software, we may not be able to generate additional high-margin revenue to increase our gross margins.
Our industry has a history of declining storage hardware prices as measured on a cost per gigabyte of storage capacity basis. In order to maintain or increase our gross margins, we will need to continue to create valuable software that is included with our clustered storage systems and/or sold as separate standalone software applications. Any new feature or application that we develop or acquire may not be introduced in a timely or cost-effective manner and may not achieve the broad market acceptance necessary to help increase our overall gross margin. If we are unable to successfully develop or acquire, and then market and sell, additional software functionality, such as our SmartConnect, SnapshotIQ, Migration IQ, SmartQuotas and SyncIQ software applications, our ability to maintain or increase our high-margin revenue and gross margin will be adversely affected.
We currently rely on a single contract manufacturer to assemble our products, and our failure to forecast demand for our products accurately or manage our relationship with our contract manufacturer successfully could negatively impact our ability to sell our products.
We currently rely on a single contract manufacturer. On December 7, 2007, we provided notice to our initial contract manufacturer, Sanmina-SCI Corporation, of our intent to terminate for convenience the Manufacturing Services Agreement we entered into on February 17, 2006. On September 26, 2008, Sanmina filed a complaint alleging certain contract rights under the agreement. On September 29, 2008, we answered the complaint, denying the operative allegations and asserting a claim for declaratory relief that we have no further obligations under the agreement. We believe that Sanmina’s claims are without merit and we intend to vigorously defend ourselves against such claims.
In an agreement dated August 30, 2007, we established a contract manufacturing relationship with Solectron Corporation, subsequently acquired by Flextronics International Ltd. This agreement provides current terms and operating conditions while we are continuing to negotiate a master services agreement. Since that time, we have utilized Flextronics to manufacture and assemble our products, procure components for our systems and help manage our supply chain, perform testing and manage delivery of our products. Our reliance on Flextronics reduces our control over the assembly process, exposing us to risks, including reduced control over quality assurance, production costs and product supply. If we fail to manage our relationship with Flextronics effectively, or if Flextronics experiences delays, disruptions, capacity constraints or quality control problems in its operations, our ability to ship products to our customers could be impaired and our competitive position and reputation could be harmed. If we and Flextronics are unable to negotiate with suppliers for reduced component costs, our operating results would be harmed. If we are unable to finalize the master services agreement or are otherwise required to change contract manufacturers or assume internal manufacturing operations, we may lose revenue, incur increased costs and damage our customer relationships. Qualifying a new contract manufacturer and commencing volume production are expensive and time-consuming. We provide forecasts to Flextronics regarding product demand and production levels. If we inaccurately forecast demand for our products, we may have excess or inadequate inventory or incur cancellation charges or penalties, which could adversely impact our operating results.
We intend to introduce new products and product enhancements, which could require us to achieve volume production rapidly by coordinating with Flextronics and component suppliers. We may need to increase our component purchases, contract manufacturing capacity, and internal test and quality functions if we experience increased demand. The inability of Flextronics to provide us with adequate supplies of high-quality products, or an inability to obtain adequate quantities of components, could cause a delay in our order fulfillment, and our business, operating results and financial condition would be adversely affected.
We rely on a limited number of suppliers, and in some cases single-source suppliers, and any disruption or termination of these supply arrangements could delay shipments of our products and could materially and adversely affect our relationships with current and prospective customers.
We rely on a limited number of suppliers for several key components utilized in the assembly of our products. We purchase several of our required components, such as chassis and disk drives, from a single supplier. This reliance on a limited number of suppliers involves several risks, including:
| | · | supplier capacity constraints; |
Component quality is particularly significant with respect to our suppliers of disk drives. In order to meet product capacity requirements, we must obtain disk drives of extremely high quality and capacity. We cannot assure you that we will be able to obtain enough of these components in the future or that prices of these components will not increase. In addition, problems with respect to yield and quality of these components and timeliness of deliveries could occur. Disruption or termination of the supply of these components could delay shipments of our products and could materially and adversely affect our relationships with current and prospective customers. These delays could also materially and adversely affect our operating results.
If we fail to manage future growth effectively, we may not be able to market and sell our products and services successfully.
We have expanded our operations significantly since inception and anticipate that further significant expansion will be required. Our future operating results depend to a large extent on our management’s ability to manage expansion and growth successfully, including, but not limited to, hiring, training and developing our sales personnel to become productive and generate revenue, forecasting revenue, controlling expenses, implementing and enhancing infrastructure, systems and processes, addressing new markets and expanding international operations. A failure to manage our growth effectively could materially and adversely affect our ability to market and sell our products and services.
Our products incorporate components that are obtained in spot markets, and, as a result, our cost structure and our ability to respond in a timely manner to customer demand are sensitive to volatility in the market prices for these components.
A significant portion of our expenses is directly related to the pricing of commoditized components utilized in the manufacture of our products, such as memory chips, disk drives and CPUs. As part of our procurement model, we do not enter into long-term supply contracts for these components, but instead have our contract manufacturer purchase these components on our behalf. In some cases, our contract manufacturer does so in a competitive-bid purchase order environment with suppliers or on the open market at spot prices. As a result, our cost structure is affected by price volatility in the marketplace for these components, especially for disk drives. This volatility makes it difficult to predict expense levels and operating results and may cause them to fluctuate significantly. Furthermore, if we are successful in growing our business, we may not be able to continue to procure components on the spot market, which would require us to enter into contracts with component suppliers to obtain these components. This could increase our costs and decrease our gross margins.
We maintain relatively low inventory and acquire components only as needed; as a result, if shortages of these components arise, we may not be able to secure enough components to build new products to meet customer demand.
We maintain relatively low inventory and acquire components only as needed, and neither we nor our contract manufacturer enter into long-term supply contracts for these components. As a result, our ability to respond to customer orders efficiently may be constrained by the then-current availability or terms and pricing of these components. Our industry has experienced component shortages and delivery delays in the past, and we may experience shortages or delays of critical components in the future as a result of strong demand in the industry or other factors. For example, disk drives can represent a significant portion of our cost of revenue, and both the price and availability of various kinds of disk drives are subject to substantial volatility in the spot market. In the past, we have encountered situations where we paid higher prices than we had anticipated for disk drives or had to use a larger-size drive as a replacement. Likewise, in the past, the industry experienced a shortage of selected memory chips, which caused some of our motherboard suppliers to reduce or suspend shipments to us. This delayed our ability to ship selected configurations to some of our customers, and in some cases accelerated a transition by us to other components. In addition, new generations of disk drives are often in short supply and are subject to industry allocations that may limit our ability to procure these disk drives. Many of the other components required to build our systems are occasionally in short supply and subject to industry allocations. If shortages or delays arise, the prices of these components may increase or the components may not be available at all. We may not be able to secure enough components at reasonable prices or of acceptable quality to build new products to meet customer demand, which could adversely affect our business, operating results and financial condition.
If we lose key personnel, if key personnel are distracted or if we are unable to attract and retain highly-qualified personnel on a cost-effective basis, it would be more difficult for us to manage our existing business operations and to identify and pursue new growth opportunities.
Our future performance depends on the continued service of our key technical, sales, services, and management personnel. We rely on our executive officers and senior management to manage our existing business operations and to identify and pursue new growth opportunities. The loss of key employees could result in significant disruptions to our business, and the integration of replacement personnel could be time-consuming, cause additional disruptions to our business or be unsuccessful. The loss of the services of key executives for any reason could adversely affect our business, operating results and financial condition.
Our future success also depends on our continued ability to attract and retain highly-qualified technical, sales, services, and management personnel. In particular, our ability to enhance and maintain our technology requires talented software development engineers with specialized skills in areas such as distributed computing, file systems and operating systems. If we are not able to recruit and retain these engineers, the quality and speed with which our products are developed would likely be seriously compromised, and our reputation and business would suffer as a result. Competition for these and the other personnel we require, particularly in the Seattle metropolitan area, is intense, and we may fail to retain our key technical, sales, services and management employees or to attract or retain other highly-qualified technical, sales, services, and management personnel in the future.
Our ability to sell our products is highly dependent on the quality of our customer service offerings, and our failure to offer high-quality customer service offerings would have a material adverse effect on our ability to market and sell our products and services.
After our products are deployed within our customers’ networks, our customers depend on our services organization to resolve issues relating to our products. High-quality customer support services are 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 to resolve post-deployment issues quickly, and provide ongoing support, it would adversely affect our ability to sell our products to existing customers and could harm our prospects with potential customers. In addition, as we expand our operations internationally, our customer services organization will face additional challenges, including those associated with delivering services, training and documentation in languages other than English. As a result, our failure to maintain high-quality customer support services could have a material adverse effect on our business, operating results and financial condition.
Our products are highly technical and may contain undetected software or hardware defects, which could cause data unavailability, loss or corruption that might, in turn, result in liability to our customers and harm to our reputation and business.
Our storage products are highly technical and complex and are often used to store information critical to our customers’ business operations. Our products have contained and may contain undetected errors, defects or security vulnerabilities that could result in data unavailability, loss or corruption or other harm to our customers. Some errors in our products may only be discovered after they have been installed and used by customers. Any errors, defects or security vulnerabilities discovered in our products after commercial release, as well as any computer virus or human error on the part of our customer support or other personnel resulting in a customer’s data unavailability, loss or corruption could result in a loss of revenue or delay in revenue recognition, a loss of customers or increased service and warranty costs, any of which could adversely affect our business, operating results and financial condition. 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 be difficult to enforce. Defending a lawsuit, regardless of its merit, would be costly and might divert management’s attention and adversely affect the market’s perception of us and our products. In addition, if our business liability insurance coverage proves inadequate with respect to a claim or future coverage is unavailable on acceptable terms or at all, our business, operating results and financial condition could be adversely impacted.
Our international sales and operations subject us to additional risks that may adversely affect our international operations and reduce our international sales.
We derived approximately 33% and 31% of our total revenue from customers outside the United States during the three and nine months ended September 30, 2008, respectively. We have sales and technical support personnel in several countries worldwide. We expect to continue to add personnel in additional countries. Our various international operations subject us to a variety of risks, including:
| | · | the difficulty of managing and staffing international offices and the increased travel, infrastructure and legal compliance costs associated with multiple international locations; |
| | · | difficulties in enforcing contracts and collecting accounts receivable, and longer payment cycles, especially in emerging markets; |
| | · | the challenge of managing development teams in geographically disparate locations; |
| | · | tariffs and trade barriers and other regulatory or contractual limitations on our ability to sell or develop our products in various foreign markets; |
| | · | increased exposure to foreign currency exchange rate risk; |
| | · | reduced protection for intellectual property rights in some countries ; and |
| | · | political and economic instability, including a global recession. |
As we expand our business globally, our success will depend, in large part, on our ability to anticipate and effectively manage these risks. Our failure to manage any of these risks successfully could harm our international operations and reduce our international sales, adversely affecting our business, operating results and financial condition.
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.
Our success is dependent in part on obtaining, maintaining and enforcing our patent and other proprietary rights. 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. The steps we have taken to protect our proprietary rights may not be adequate to prevent misappropriation of our proprietary information or infringement of our intellectual property rights, and our ability to prevent this misappropriation or infringement is uncertain, particularly in countries outside of the United States. Further, with respect to patent rights, we do not know whether any of our pending patent applications will result in the issuance of a patent or whether the examination process will require us to narrow our claims. To date, we have obtained one issued United States patent and this patent, as well as any additional patents that may be issued to us may be contested, circumvented, found unenforceable or invalidated, and we may not be able to prevent third parties from infringing them. Moreover, the rights granted under any issued patents may not provide us with proprietary protection or competitive advantages, and, as a result, our competitors may be able to develop technologies similar or superior to ours.
Protecting against the unauthorized use of our products, trademarks and other proprietary rights is expensive and difficult. Litigation 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. Any such litigation could result in substantial costs and diversion of management resources, either of which could harm our business, operating results and financial condition. Further, many of our current and potential competitors have the ability to dedicate substantially greater resources to enforcing their intellectual property rights than we have. Accordingly, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property.
Our use of open source and third-party software could impose unanticipated conditions or restrictions on our ability to commercialize our products.
We incorporate open source software into our products. Although we monitor our use of open source software to avoid subjecting our products to conditions we do not intend, the terms of many open source licenses have not been interpreted by United States courts, and there is a risk that these licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to commercialize our products. In this event, we could be required to seek licenses from third parties in order to continue offering our products, to make generally available, in source code form, proprietary code that links to certain open source modules, to re-engineer our products, or to discontinue the sale of our products if re-engineering could not be accomplished on a timely basis, any of which could adversely affect our business, operating results and financial condition.
We may also find that we need to incorporate certain proprietary third-party technologies, including software programs, into our products in the future. However, licenses to relevant third-party technology may not 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.
Our products must interoperate with many software applications that are developed by others and if we are unable to devote the necessary resources to ensure that our products interoperate with those applications, we may fail to increase, or we may lose, market share and we may experience a weakening demand for our products.
Our products must interoperate with many software applications that are developed by others. When new or updated versions of these software applications are introduced, we must sometimes develop updated versions of our software so that they interoperate properly with these applications. We may not accomplish these development efforts quickly, cost-effectively or at all. These development efforts require substantial capital investment and the devotion of substantial employee resources. For example, our products currently interoperate with a number of data protection applications marketed by vendors such as Symantec Corporation and EMC. If we fail to maintain compatibility with these applications, our customers may not be able to protect adequately the data resident on our products and we may, among other consequences, fail to increase, or we may lose, market share and experience a weakening in demand for our products, which would adversely affect our business, operating results and financial condition.
Our products must interoperate with various data-access protocols and, if we are unable to ensure that our products interoperate with these protocols, our products might become less competitive.
Our products interoperate with servers and software applications predominantly through the use of protocols, many of which are created and maintained by independent standards organizations. However, some of these protocols that exist today or that may be created in the future are or could be proprietary technology and therefore require licensing the proprietary protocol’s specifications from a third party or implementing the protocol without specifications, which might entail significant effort on our part. If we fail to obtain a license to these specifications from third-party vendors on reasonable terms or at all, and we are not able to implement the protocol in the absence of these specifications, our products might become less competitive, which would harm our business. For example, Microsoft Corporation maintains and enhances the Common Internet File System, or CIFS, a proprietary protocol that our products use to communicate with the Windows operating system, the most popular computer operating system in the world. Although our products are currently compatible with CIFS, at present we do not license the specifications to this proprietary protocol. If we are not able to continue to maintain adequate compatibility with CIFS or if we are not able to license adequate specifications to this protocol on reasonable terms, our products would likely be less competitive in the marketplace, which would adversely affect our business, operating results and financial condition.
If our products do not interoperate with our customers’ networks, servers or software applications, installations would be delayed or cancelled.
Our products must interoperate with our customers’ existing infrastructure, specifically their networks, servers and software applications. This infrastructure often utilizes multiple protocol standards, products from multiple vendors and a wide range of storage features. If we find, as we have in the past, defects in the existing software or hardware used in our customers’ infrastructure or an incompatibility or deficiency in our software, we may have to modify our software so that our products will interoperate with our customers’ infrastructure. This could cause longer sales and implementation cycles for our products and could cause order cancellations, either of which would adversely affect our business, operating results and financial condition.
We may engage in future acquisitions that could disrupt our business, cause dilution to our stockholders, reduce our financial resources and result in increased expenses.
In the future, we may acquire other businesses, products or technologies. We have not made any acquisitions to date. Accordingly, our ability as an organization to make acquisitions is unproven. We may not be able to find suitable acquisition candidates, and we may not be able to complete acquisitions on favorable terms, if at all. If we do complete acquisitions, we may not strengthen our competitive position or achieve our goals, or these acquisitions may be viewed negatively by customers, financial markets or investors. In addition, any acquisitions that we make could lead to difficulties in integrating personnel, technologies and operations from the acquired businesses and in retaining and motivating key personnel from these businesses. Acquisitions may disrupt our ongoing operations, divert management from day-to-day responsibilities, increase our expenses and adversely impact our business, operating results and financial condition. Future 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.
Changes in financial accounting standards or practices may cause adverse, unexpected financial reporting fluctuations and affect our reported results of operations.
A change in accounting standards or practices can have a significant effect on our operating results and may affect our reporting of transactions completed before the change is effective. New accounting pronouncements and varying interpretations of existing accounting pronouncements have occurred and may occur in the future. Changes to existing rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business. For example, as a result of SFAS 123(R), our results of operations in 2006 and 2007 reflect expenses that are not reflected in prior periods, making it more difficult for investors to evaluate our 2006 and 2007 results of operations relative to prior periods.
Our business is subject to increasingly complex environmental legislation that has increased both our costs and the risk of noncompliance.
We face increasing complexity in our product design and procurement operations as we adjust to new and upcoming requirements relating to the materials composition of many of our products. The European Union, or EU, has adopted certain directives to facilitate the recycling of electrical and electronic equipment sold in the EU, including the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment, or RoHS, directive. The RoHS directive restricts the use of lead, mercury and certain other substances in electrical and electronic products placed on the market in the EU after July 1, 2006.
In connection with our compliance with these environmental laws and regulations, we could incur substantial costs, including reserves taken for excess component inventory, and be subject to disruptions to our operations and logistics. In addition, we will need to ensure that we can manufacture compliant products and that we can be assured a supply of compliant components from suppliers. Similar laws and regulations have been proposed or may be enacted in other regions, including in the United States, China and Japan. Other environmental regulations may require us to reengineer our products to utilize components that are compatible with these regulations, and this reengineering and component substitution may result in additional costs to us. We cannot assure you that existing laws or future laws will not have a material adverse effect on our business.
We are subject to governmental export and import controls that could impair our ability to compete in international markets.
Because we incorporate encryption technology into our products, our products are subject to United States export controls and may be exported outside the United States only with the required level of export license or through an export license exception. In addition, various countries regulate the importation 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 export and import regulations may 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 export or import regulations or related legislation, shift in approach to the enforcement or scope of existing regulations or change in the countries, persons or technologies targeted by these 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.
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 customer payments 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 and other natural catastrophic events, and to interruption by man-made problems such as computer viruses or terrorism.
Our corporate headquarters are located in Seattle, Washington, an area that is at heightened risk of earthquake and volcanic events. We may not have adequate business interruption insurance to compensate us for losses that may occur from any such significant events. A significant natural disaster, such as an earthquake or volcanic eruption, could have a material adverse impact on our business, operating results and financial condition. Also, our servers are vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems. In addition, acts of terrorism could cause disruptions in our or our customers’ business or the economy as a whole. To the extent that these 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 is likely to be volatile.
The trading prices of the securities of technology companies have been highly volatile. Further, our common stock has a limited trading history. Since our initial public offering in December 2006 through October 28, 2008, our stock price has fluctuated from a high of $28.50 to a low of $2.47. Factors affecting the trading price of our common stock, some of which are outside our control, include:
| | · | variations in our operating results or those of our competitors; |
| | · | announcements of technological innovations, new products or product enhancements, strategic alliances or significant agreements by us or by our competitors; |
| | · | the gain or loss of significant customers; |
| | · | the level of sales in a particular quarter; |
| | · | lawsuits threatened or filed against us; |
| | · | inquiries or investigations by the SEC, Nasdaq, law enforcement or other regulatory bodies; |
| | · | the recruitment or departure of key personnel; |
| | · | changes in the estimates of our operating results or changes in recommendations by any securities analysts who elect to follow our common stock; |
| | · | market conditions in our industry, the industries of our customers and the economy as a whole; and |
| | · | the adoption or modification of regulations, policies, procedures or programs applicable to our business. |
In addition, 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 events that affect other companies in our industry even if these events do not directly affect us. For example, in the past month, macroeconomic conditions have caused unprecedented volatility in the U.S. stock markets. Although such conditions have not been specific to our Company, our stock has experienced similar volatility. Some companies that have had volatile market prices for their securities have had securities class actions filed against them. If a suit were filed against us, regardless of its merits or outcome, it would likely result in substantial costs and divert management’s attention and resources. This could have a material adverse effect on our business, operating results and financial condition.
If securities or industry analysts cease publishing 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 depends in part on any research and reports that securities or industry analysts publish about us or our business. In the event one or more of these analysts downgrade our stock, cease publishing or publish inaccurate or unfavorable research about our business, our stock price would likely decline. If one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, demand for our stock could decrease, which could cause our stock price and trading volume to decline.
Future sales of shares by existing stockholders could cause our stock price to decline.
We completed our initial public offering in December 2006, and the contractual lock-up applicable to our equity holders at the time of our initial public offering expired in September 2007. As a result, additional shares of our common stock have become eligible for sale in the public market, including shares held by directors, executive officers and other affiliates. In addition, outstanding warrants and options to purchase shares of our common stock under our 2001 Stock Plan, 2006 Equity Incentive Plan or 2006 Employee Stock Purchase Plan, as well as additional shares reserved for issuance under our 2006 Equity Incentive Plan have become, and will continue to become, eligible for sale in the public market subject to certain legal and contractual limitations. If a significant portion of these shares are sold, or if it is perceived that they will continue to be sold, the trading price of our common stock could decline substantially.
Insiders continue to have substantial control over us and will be able to influence corporate matters.
As of September 30, 2008, our directors and executive officers and their affiliates beneficially own, in the aggregate, approximately 61% of our outstanding common stock. As a result, these stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, such as a merger or other sale of our company or its assets. This concentration of ownership could limit other stockholders’ ability to influence corporate matters and may have the effect of delaying or preventing a third party from acquiring control over us.
Provisions in our certificate of incorporation and bylaws and Delaware law might discourage, delay or prevent a change of control of our company or changes in our management and, therefore, depress the trading price of our common stock.
Our certificate of incorporation and bylaws contain provisions that could depress the trading price of our common stock by acting to discourage, delay or prevent a change in control of our company or changes in our management that the stockholders of our company may deem advantageous. These provisions:
| | · | establish a classified board of directors so that not all members of our board are elected at one time; |
| | · | provide that directors may only be removed “for cause;” |
| | · | authorize the issuance of “blank check” preferred stock that our board of directors could issue to increase the number of outstanding shares and to discourage a takeover attempt; |
| | · | eliminate the ability of our stockholders to call special meetings of stockholders; |
| | · | prohibit stockholder action by written consent, which has the effect of requiring all stockholder actions to be taken at a meeting of stockholders; |
| | · | provide that the board of directors is expressly authorized to make, alter or repeal our bylaws; and |
| | · | establish advance notice requirements for nominations for election to our board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings. |
In addition, Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control of our company by prohibiting stockholders owning in excess of 15% of our outstanding voting stock from merging or combining with us unless certain approvals are obtained.
None.
ITEM 3. Defaults Upon Senior Securities
None.
ITEM 4. Submission of Matters to a Vote of Security Holders
None.
ITEM 5. Other Information
Our insider trading policy allows directors, officers and other employees covered under the policy to establish, under limited circumstances contemplated by Rule 10b5-1 under the Securities Exchange Act of 1934, as amended, written programs that permit automatic trading of Isilon Systems stock or trading of Isilon systems stock by an independent person (such as a broker or an investment bank) who is not aware of material, nonpublic information at the time of the trade. In August 2008, a venture capital fund affiliated with one of our directors entered into Rule 10b5-1 trading plan pursuant to which shares of our common stock may be purchased for its respective account from time to time in accordance with the provisions of the plan.
The following exhibits are incorporated by reference or filed herewith.
| | | | |
| Exhibit | | | |
| Number | | Description | |
| | | | |
| 31.1* | | Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer. | |
| | | | |
| 31.2 * | | Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer. | |
| | | | |
| 32.1 ‡ | | Section 1350 Certification of Chief Executive Officer. | |
| | | | |
| 32.2 ‡ | | Section 1350 Certification of Chief Financial Officer. | |
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| | ISILON SYSTEMS, INC. |
| |
| Date: October 30, 2008 | By: | /s/ Sujal Patel | |
| | | Sujal Patel |
| | | President, Chief Executive Officer and Director (Principal Executive Officer) |
| |
| | |
| | By: | /s/ William Richter | |
| | | William Richter |
| | | Interim Chief Financial Officer and Vice President of Finance (Principal Accounting and Financial Officer) |
| | | |
| |
| | | | |
| Exhibit | | | |
| Number | | Description | |
| | | | |
| 31.1* | | Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer. | |
| | | | |
| 31.2 * | | Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer. | |
| | | | |
| 32.1 ‡ | | Section 1350 Certification of Chief Executive Officer. | |
| | | | |
| 32.2 ‡ | | Section 1350 Certification of Chief Financial Officer. | |
