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

 

 

 

 

Form 10-Q

 

 

 

 

Commission file number: 001-31216

 

McAfee, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

 

Registrant’s telephone number, including area code:

(408) 988-3832

 

 

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

 

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

 

                                                                                                              (Do not check if a smaller reporting company)

 

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

 

As of July 31, 2008, 151,288,497 shares of the registrant’s common stock, $0.01 par value, were outstanding.

 

 

MCAFEE, INC.
FORM 10-Q

 

June 30, 2008

 

 

CONTENTS

 

 

 

MCAFEE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

 

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

MCAFEE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

 

 

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

MCAFEE, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

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

 

 

McAfee, Inc. and our wholly owned subsidiaries (“we”, “us” or “our”) are a leading dedicated security technology company that secures systems and networks from threats around the world. Our security solutions are offered primarily to large enterprises, government agencies, small and medium-sized businesses and consumers either directly or through a network of qualified partners. We operate our business in five geographic regions: North America; Europe, Middle East and Africa (“EMEA”); Japan; Asia-Pacific, excluding Japan; and Latin America.

 

 

The accompanying condensed consolidated financial statements include our accounts as of June 30, 2008 and December 31, 2007 and for the three and six months ended June 30, 2008 and June 30, 2007. All intercompany accounts and transactions have been eliminated in consolidation. These condensed consolidated financial statements have been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The December 31, 2007 condensed consolidated balance sheet was derived from audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. However, we believe that all disclosures are adequate to make the information presented not misleading. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto, included in our annual report on Form 10-K for the year ended December 31, 2007.

 

In the opinion of our management, all adjustments (which consist of normal recurring adjustments, except as disclosed herein) necessary to fairly present our financial position, results of operations and cash flows for the interim periods presented have been included. The results of operations for the three and six months ended June 30, 2008 are not necessarily indicative of the results to be expected for the full year or for any future periods.

 

Significant Accounting Policies

 

In the three months ended June 30, 2008, we added the disclosure of “Potential Impairment of Marketable Securities” to our critical accounting policies and, therefore, have included “Marketable Securities” in our significant accounting policies below. We have had no significant changes in our accounting policies during the six months ended June 30, 2008 as compared to our accounting policies for the year ended December 31, 2007.

 

Marketable Securities

 

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

 

We assess the value of our available-for-sale marketable securities on a regular basis to assess whether an other-than-temporary decline in the fair value has occurred. Factors which we use to assess whether an other than temporary decline has occurred include, but are not limited to, the period of time the fair value is below amortized cost, significant changes in the operating performance, financial condition or business model of the issuer or underlying assets, the difference between fair value and amortized cost, and changes in market conditions. Any “other than temporary decline” in value is reported in earnings and a new cost basis for the marketable security

established. In the three months and six months ended June 30, 2008, we recorded an impairment on a single marketable security of $2.6 million. We had no impairment of marketable securities in the three and six months ended June 30, 2007.

 

Inventory

 

Inventory, which consists primarily of finished goods held at fulfillment partner locations and inventory sold into our channel that has not been sold through to the end-user, is stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first in, first out basis. Inventory balances are included in other current assets in our condensed consolidated balance sheets and were $4.7 million as of June 30, 2008 and $3.0 million as of December 31, 2007.

 

Deferred Costs of Revenue

 

Deferred costs of revenue, which consist primarily of costs related to revenue-sharing arrangements and royalty arrangements, are included in prepaid expenses and other assets on our condensed consolidated balance sheets. We only defer direct and incremental costs related to revenue-sharing arrangements and recognize such deferred costs proportionate to the related revenue recognized. At June 30, 2008, our deferred costs were $149.0 million.

 

Investigation Costs

 

Investigation costs in 2008 include primarily ongoing legal expenses arising as a result of our recently completed investigation into our historical stock option granting practices and in 2007 include various expenses related to our recently completed investigation into our historical stock option granting practices.

 

Reclassifications

 

In the condensed consolidated statement of cash flows for the six months ended June 30, 2007, we have reclassified $103.7 million within investing activities to properly reflect partial pay downs received on asset-backed investments as “proceeds from maturities of marketable securities” rather than “proceeds from sales of marketable securities”.

 

Fair Value Measurements

 

On January 1, 2008, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value, and expands disclosure requirements regarding fair value measurement. We hold financial assets, such as available for

sale securities and foreign currency contracts, subject to valuation under SFAS 157. The following table details the fair value measurements within the fair value hierarchy of our financial assets (in thousands):

 

 

 

 

In February 2008, the Financial Accounting Standard Board (“FASB”) issued FASB Staff Position (“FSP”) No. 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”). FSP 157-2 delays the effective date of SFAS No. 157 for all non-financial assets and non-financial liabilities that are not remeasured at fair value on a recurring basis (at least annually) until fiscal years beginning after November 15, 2008. FSP 157-2 is effective for us beginning January 1, 2009 and will be applied prospectively. We continue to assess the impact that FSP 157-2 may have on our consolidated financial position and results of operations.

 

Fair Value Option

 

On January 1, 2008, we adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB Statement No. 1” (“SFAS 159”). SFAS 159 permits entities to choose to measure certain financial instruments and other items at fair value that are not currently required to be measured at fair value, with unrealized gains and losses related to these financial instruments reported in earnings at each subsequent reporting date. We did not elect the fair value measurement option for any of our financial assets or liabilities. Therefore, the adoption of SFAS 159 did not impact our consolidated financial position, results of operations or cash flows.

 

Recent Accounting Pronouncements

 

Maintenance Deposits Under Lease Arrangements

 

In June 2008, the FASB ratified Emerging Issues Task Force (“EITF”) Issue No. 08-3, “Accounting by Lessees for Maintenance Deposits” (EITF 08-3). EITF 08-3 provides guidance for accounting for nonrefundable

maintenance deposits. EITF 08-3 is effective for us beginning January 1, 2009. We are currently assessing the impact of EITF 08-3 on our consolidated financial position, results of operations and cash flows.

 

Hierarchy of Generally Accepted Accounting Principles

 

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements that are presented in conformity with generally accepted accounting principles in the United States. This Statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.” We do not expect SFAS 162 to have a material impact on our consolidated financial position, results of operations and cash flows.

 

Useful Life of Intangible Assets

 

In April 2008, the FASB issued FSP No. 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP 142-3”). FSP 142-3 amends the factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized intangible assets under FASB Statement No. 142, “Goodwill and Other Intangible Assets” and the period of expected cash flows used to measure the fair value under FASB Statement No. 141, “Business Combination”. FSP 142-3 is effective for us beginning January 1, 2009. We currently are assessing the impact that FSP 142-3 may have on our consolidated financial position, results of operations and cash flows.

 

Derivative Instruments and Hedging Activities

 

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133” (“SFAS 161”). SFAS 161 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), to expand disclosures about an entity’s derivative instruments and hedging activities, but does not change SFAS 133’s scope of accounting. SFAS 161 is effective for us beginning January 1, 2009.

 

Noncontrolling Interests

 

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

 

Business Combinations

 

In December 2007, the FASB revised SFAS No. 141, “Business Combinations” (“SFAS 141(R)”), to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. SFAS 141(R) establishes principles and requirements for recognizing and measuring identifiable assets and goodwill acquired, liabilities assumed, and any noncontrolling interest in an acquisition, at their fair value as of the acquisition date. SFAS 141(R) is effective for us beginning January 1, 2009. We will assess how the adoption of SFAS 141(R) will impact our consolidated financial position, results of operations and cash flows if we complete an acquisition after the date of adoption. The accounting treatment related to pre-acquisition uncertain tax positions will change when SFAS 141(R) becomes effective. At such time, any changes to the recognition or measurement of uncertain tax positions related to pre-acquisition periods will be recorded through income tax expense, whereas currently the accounting treatment would require any adjustment to be recognized through the purchase accounting.

 

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

 

The following table summarizes stock-based compensation expense (in thousands):

 

 

Amortization of fair value of options.  We recognize the fair value of stock options issued to employees and outside directors as stock-based compensation expense over the vesting period of the awards. As we adopted SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”) using the modified prospective method, these charges include compensation expense for stock options granted prior to January 1, 2006 but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123, and compensation expense for stock options granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R).

 

Extension of post-termination exercise period.  From July 2006, when we announced that we might have to restate our historical financial statements as a result of our ongoing stock option granting practices investigation, through December 21, 2007, the date we became current on our reporting obligations under the Securities Exchange Act of 1934, as amended, (“blackout period”), we imposed restrictions on our ability to issue any shares, including those pursuant to stock option exercises. In January 2007, we extended the post-termination exercise period for vested options held by 640 former employees and outside directors that would expire during the blackout period. As a result of this modification, we recognized $0.3 million of stock-based compensation expense in the three months ended June 30, 2007, and $11.1 million in the six months ended June 30, 2007, based on the fair value of the modified options. The expense was calculated in accordance with the guidance in SFAS 123(R). The options were deemed to have no value prior to the extension of the life beyond the blackout period.

 

Based on the guidance in SFAS 123(R) and related FSPs, after the January 2007 modification, stock options held by former employees and outside directors that terminated prior to such modification became subject to the provisions of EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,” (“EITF 00-19”). As a result, in January 2007, these options were reclassified as liability awards within current liabilities. Accordingly, at the end of each reporting period, we determined the fair value of these options utilizing the Black-Scholes valuation model and recognized any change in fair value of the options in our condensed consolidated statements of income and comprehensive income in the period of change.

 

In November 2007, due to a delay in our becoming current in our reporting obligations, we extended the post-termination exercise period for options held by 690 former employees and outside directors whose service to us terminated subsequent to the January 2007 modification and those previously modified in January 2007 as discussed above, until the earlier of (i) the ninetieth (90th) calendar day after December 21, 2007, the date we became current in our reporting obligations under the Securities Exchange Act of 1934, as amended, (ii) the

expiration of the contractual terms of the options, or (iii) December 31, 2008. Based on the guidance in SFAS 123(R) and related FSPs, after the November 2007 modification, stock options held by the former employees and outside directors that terminated subsequent to the January 2007 modification and prior to November 2007 became subject to the provisions of EITF 00-19. As a result, in November 2007, these options were reclassified as liability awards within current liabilities. Accordingly, at the end of each reporting period, we determined the fair value of these options utilizing the Black-Scholes valuation model and recognized any change in fair value of the options in our condensed consolidated statements of income and comprehensive income in the period of change.

 

As of March 31, 2008, the January 2007 and November 2007 modified options had been exercised or had expired. The fair values of the options that had been exercised during the first quarter of 2008 were remeasured on the respective date of exercise and recorded as an increase to additional paid-in capital. The options that expired were remeasured to have no fair value. We recognized no expense in the three months ended June 30, 2008 and a benefit of $5.5 million in the six months ended June 30, 2008 related to the change in fair value of these options. We recognized $1.9 million of expense related to the change in fair value of these options in the three and six months ended June 30, 2007. Such amounts are included in general and administrative expense in our condensed consolidated statements of income and comprehensive income, and are not reflected as stock-based compensation expense. We will not recognize any further expense related to these extensions of post-termination exercise period.

 

Cash settlement of options.  Certain stock options held by terminated employees expired during the blackout period as they could not be exercised during the 90-day period subsequent to termination. In January 2007, we determined that we would settle these options in cash. In the three and six months ended June 30, 2007, we recognized expense of approximately $2.0 million and $2.2 million, respectively, based on the change in the liability we recorded for the intrinsic value of these options. As of December 31, 2007, we recorded a liability of $5.7 million based on the intrinsic value of these options using our December 31, 2007 closing stock price. We paid $5.2 million in January 2008 to settle these options based on the average closing price of our common stock subsequent to December 21, 2007, the date we became current on our reporting obligations under the Securities Exchange Act of 1934, as amended. We recognized no expense in the three months ended June 30, 2008 and recognized a $0.4 million benefit for the difference between the December 31, 2007 liability and the amount paid in the six months ended June 30, 2008. All of these options were cash settled by March 31, 2008, and we will not recognize any further expense related to these options.

 

Restricted stock awards and units.  We recognize stock-based compensation expense for the fair value of RSAs and RSUs. Fair value is determined as the difference between the closing price of our common stock on the grant date and the purchase price of the RSAs and RSUs. The fair value of these awards is recognized to expense over the requisite service period of the awards.

 

Restricted stock units with performance-based vesting.  We recognize stock-based compensation expense for the fair value of PSUs. These awards vest as follows: 50% vest only if performance criteria are met (“performance component”) and 50% cliff vest four years from the date of grant, with accelerated vesting if performance criteria are met (“service component”). Certain executive grants have only the performance component. The performance component will vest one-third each year from the date of grant, provided that the performance criteria are met for each respective year. If the performance criteria are not met in any one year, then the options that would have vested in that year are forfeited. The performance component is being recognized as expense one-third each year provided we determine it is probable that the performance criteria will be met. For certain of the PSUs, we have not communicated the performance criteria to the employees. For these awards, the accounting grant date will not occur until it is known whether the performance criteria are met, and such achievement or non-achievement is communicated to the employees. These awards will be marked-to-market at the end of each reporting period through the accounting grant date, and recognized over the expected vesting period. For the awards for which the performance criteria have been communicated, stock-based compensation expense has been measured on the grant date, and is being recognized over the expected vesting period.

 

The service component will cliff vest four years from the grant date, with an acceleration provision based on the same performance criteria as the performance component. Each of the three tranches is being accounted for as a separate award. If the performance criteria are met for each respective year, the awards will vest one-third each year

from the grant date. The accounting grant date is deemed to have occurred and stock-based compensation has been measured on the grant date, and will be recognized over the expected vesting period.

 

Tender offer.  In January 2008, after we became current with our reporting obligations under the Securities Exchange Act of 1934, as amended, we filed a Tender Offer Statement on Schedule TO with the SEC. The tender offer extended an offer by us to holders of certain outstanding stock options to amend the exercise price on certain of their outstanding options. The purpose of the tender offer was to amend the exercise price on options to have the same price as the fair market value on the revised measurement dates that were identified during the investigation of our historical stock option grant practices. As part of this tender offer, we will pay a cash bonus of $1.7 million, of which $0.4 million was paid to Canadian employees in the six months ended June 30, 2008, and $1.3 million will be paid to U.S. employees in 2009, to reimburse optionees who elected to participate in the tender offer for any increase in the exercise price of their options resulting from the amendment. The impact of the cash bonus, as recorded during the six months ended June 30, 2008, resulted in stock-based compensation expense of $0.6 million and a decrease to additional paid-in capital of $1.1 million. We will not recognize any further expense related to the tender offer.

 

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

 

The following table summarizes pre-tax stock-based compensation expense recorded in our condensed consolidated statements of income and comprehensive income by line item in the three and six months ended June 30, 2008 and 2007 (in thousands):

 

 

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

 

At June 30, 2008, the estimated fair value of all unvested stock options, RSUs, PSUs, RSAs and ESPP grants that have not yet been recognized as compensation expense was $104.2 million, net of expected forfeitures. We expect to recognize this amount over a weighted-average period of 2.3 years. This amount does not reflect compensation expense relating to 0.7 million PSUs for which the performance criteria have not been set.

Under SFAS 123(R), we use the Black-Scholes model to estimate the fair value of our option awards and ESPP grants. The key assumptions used in the model during the three and six months ended June 30, 2008 and 2007, respectively, are provided below:

 

 

During the three and six months ended June 30, 2007, we did not have any ESPP grants.

 

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

 

Internal Revenue Code Section 409A

 

Adverse tax consequences resulted from our revision of accounting measurement dates during our restatement due to our investigation into our stock option granting practices for stock options that vested subsequent to December 31, 2004 (“409A affected options”). These adverse tax consequences included a penalty tax payable by the option holder under Internal Revenue Code (“IRC”) Section 409A (and, as applicable, similar penalty taxes under state tax laws). As virtually all holders of options with revised measurement dates were not involved in or aware of their incorrect option exercise prices, we took certain actions to deal with the adverse tax consequences that were incurred by the holders of such options.

 

Section 16(a) Officers and Directors

 

In December 2006, our board of directors approved the amendment of 409A affected options for those who were Section 16(a) officers at the time they received 409A affected options to increase the exercise price to the fair market value of our common stock on the revised measurement date. These amended options are not subject to taxation under IRC Section 409A. Under Internal Revenue Service (“IRS”) regulations, these option amendments had to be completed by December 31, 2006 for anyone subject to Section 16(a) requirements upon receipt of the 409A affected options. There were no costs associated with this action, as the modifications increased the exercise price, which resulted in no incremental expense.

 

In the three months ended March 31, 2008, for one executive officer, the exercise price on options were upward repriced to have the same price as the fair market value on the revised measurement dates that were identified during the investigation of our historical stock option grant practices. We will pay this executive officer a cash bonus of $0.1 million in 2009 as reimbursement for the increase in the exercise price of his options resulting from the amendment.

IRS Announcement 2007-18 Compliance

 

In February 2007, our board of directors approved our participation in a voluntary program under IRS Announcement 2007-18 and a similar state of California Announcement, whereby we paid additional 409A taxes on behalf of certain former U.S. employees who had already exercised 409A affected options for the additional taxes they incur under IRC Section 409A (and, as applicable, similar state of California tax law). Current and former Section 16(a) officers and directors were specifically excluded from the program. Through June 30, 2007, we recorded $1.3 million of expense associated with this program for Section 409A affected options exercised during this period. We had no expense associated with this program in the three and six months ended June 30, 2008.

 

Certain Former Employees Future Exercises of 409A Affected Options

 

In May 2007, our board of directors approved cash payments as necessary to certain former employees who exercised 409A affected options during 2006 or that may exercise 409A affected options in the future.

 

In November 2007, our board of directors approved the unilateral amendment of 409A affected options held by certain former employees who did not exercise 409A affected options during 2006 to increase the exercise price to the fair market value of our common stock on the revised measurement date, and to make cash payments as compensation for the increase in the exercise prices of amended options. These amended options would not be subject to taxation under IRC 409A.

 

In the three and six months ended June 30, 2008, we recorded no costs associated with former employees’ exercises of certain Section 409A affected options. The following table summarizes for the three and six months ended June 30, 2007 costs associated with actions taken by us with respect to IRC Section 409A (in thousands):

 

 

 

ScanAlert

 

In January 2008, we acquired 100% of the outstanding shares of ScanAlert, Inc. (“ScanAlert”), a provider of a vulnerability assessment and certification services for e-commerce sites, for $54.9 million. The purchase price consisted of the following (in thousands):

 

 

In the fourth quarter of 2007, we paid $4.5 million to a third party to settle prior alleged patent infringement claims against ScanAlert and for a fully paid future license for the use of the patent until its expiration. We have accounted for this entire amount as part of the ScanAlert purchase price as the arrangement with the third party was entered into as a result of the pending ScanAlert acquisition. Of the total $4.5 million payment, $0.9 million was allocated to the assumption of the patent infringement liability and $3.6 million was allocated to prepaid license fees to be amortized over five years. We have recorded a $1.3 million long-term liability on our consolidated balance sheet as of June 30, 2008 for a portion of the purchase price held-back for future indemnification claims.

The amount will be paid out, net of any claims, in July 2009. Excluding these two items from the total purchase price, cash paid for the acquisition in 2008 was $49.1 million.

 

The purchase agreement provides for two earn-out payments totaling $29.5 million contingent upon the achievement of ScanAlert net bookings targets during the three-year period subsequent to the close of the acquisition. The first earn-out payment is $12.5 million and the second earn-out payment is $17.0 million. We have not accrued any portion of the earn-out payments as purchase price as achievement of the earn-out targets is not determinable beyond a reasonable doubt. Approximately $1.3 million and $1.8 million of the first and second earn-out payments, respectively, are subject to certain employees providing future service. Therefore, these amounts will be accounted for as post-acquisition compensation expense to the extent the earn-out targets are probable of being met. We have assessed the first earn-out target as being probable and the second earn-out target as not being probable. We are recognizing the $1.3 million compensatory portion of the first earn-out as compensation expense from the close of the acquisition through the end of 2009, resulting in $0.2 million and $0.3 million of compensation expense being recognized in the three and six months ended June 30, 2008, respectively.

 

Our management determined the purchase price allocation based on estimates of the fair values of the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived at utilizing recognized valuation techniques. On the acquisition date, we recorded $42.7 million of goodwill, which is deductible for tax purposes due to a Section 338(h)(10) election under the IRC. Goodwill resulted primarily from our expectation that we will be able to provide ScanAlert’s service offerings to our customers and enhance our existing products with those of ScanAlert. We have incorporated ScanAlert’s technology into our existing SiteAdvisor web rating system. We recorded no in-process research and development related to this acquisition.

 

The intangible assets, other than goodwill, are being amortized over their useful lives of 1.0 to 6.0 years or a weighted-average period of 5.5 years. As part of the acquisition, we did not assume any outstanding stock options or warrants. A performance and retention plan, which covers two employees and provides for payment of up to $1.5 million through January 2011, was established at the close of the acquisition. At June 30, 2008, $0.2 million had been expensed and no amounts had been paid related to this performance plan.

 

The following is a summary of the assets acquired and liabilities assumed in the acquisition of ScanAlert, as adjusted for subsequent purchase price adjustments (in thousands):

 

 

The results of operations for ScanAlert have been included in our results of operations since the date of acquisition. Pro forma results of operations have not been presented because the effect of this acquisition was not material to our results of operations.

SafeBoot

 

In November 2007, we acquired 100% of the outstanding shares of SafeBoot Holding B.V. (“SafeBoot”) an enterprise security software vendor for data protection via encryption and access control, for $348.3 million. The purchase price consisted of the following (in thousands):

 

 

For convenience, we designated October 31, 2007 as the effective date for this acquisition, which resulted in $1.0 million of imputed interest being charged to results of operations.

 

Our management determined the purchase price allocation based on estimates of the fair values of the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived at utilizing recognized valuation techniques. On the acquisition date, we recorded $215.8 million of goodwill, which is deductible for tax purposes due to a Section 338(g) election under the IRC. Goodwill resulted primarily from our expectation that we will now be able to provide our customers with comprehensive data protection, including endpoint, network, web, email and data security, as well as risk and compliance solutions. We have integrated SafeBoot technology into our centralized management console for enterprise customers. We recorded no in-process research and development related to this acquisition.

 

The intangible assets, other than goodwill, are being amortized over their useful lives of 1.0 to 8.0 years or a weighted-average period of 4.5 years. As part of the acquisition, we assumed approximately 0.5 million outstanding stock options.

 

The following is a summary of the assets acquired and liabilities assumed in the acquisition of SafeBoot, as adjusted for subsequent purchase price adjustments (in thousands):

 

 

A performance and retention plan, which provides for payment of up to $0.3 million through 2008, was established at the closing of the acquisition. At June 30, 2008, $0.3 million had been expensed and $0.2 million had been paid related to this performance plan.

The following unaudited pro forma financial information presents our combined results with SafeBoot as if the acquisition had occurred at the beginning of 2007 (in thousands, except per share data):

 

 

 

We perform our annual impairment review as of October 1 of each year or earlier if indicators of impairment exist. In 2007, this analysis indicated that goodwill was not impaired. The fair value of the reporting units was estimated using the average of the expected present value of future cash flows and of the market multiple value. We will continue to test for impairment on an annual basis and on an interim basis if an event occurs or circumstances change that would more likely than not reduce the fair value of our reporting units below their carrying amounts.

 

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

 

 

The goodwill acquired during the six months ended June 30, 2008 is due to the acquisition of ScanAlert. The adjustments to goodwill are a result of purchase accounting adjustments for the ScanAlert and SafeBoot acquisitions.

 

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

 

The aggregate amortization expenses for the intangible assets listed above totaled $19.1 million and $12.1 million in the three months ended June 30, 2008 and 2007, respectively, and $38.0 million and $23.1 million in the six months ended June 30, 2008 and 2007, respectively.

 

Expected future intangible asset amortization expense as of June 30, 2008 is as follows (in thousands):

 

 

 

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

 

During 2008 (the “2008 Restructuring”), we took the following measures:

 

 

During 2006 (the “2006 Restructuring”), we took the following measures:

 

 

During 2004 and 2003 (the “2004 and 2003 Restructurings”), we took the following measures:

 

 

Restructuring benefits in the six months ended June 30, 2008 totaled $2.1 million, consisting of a $5.1 million benefit, net of accretion, related primarily to (i) changes in previous estimates of base rent and sublease income for the Santa Clara lease which was restructured in 2003 and 2004 and (ii) terminating sublease agreements for three floors in our Santa Clara facility which were previously included in our 2003 and 2004 restructuring activities, partially offset by a $2.9 million charge related to 2008 Restructuring. We intend to move back into these floors in 2008.

2008 Restructuring

 

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

 

 

In the six months ended June 30, 2008, we recorded a restructuring charge of $0.8 million related to the elimination of certain positions at SafeBoot that were redundant to positions at McAfee. This charge was recorded in our EMEA. We also recorded a $2.1 million restructuring charge related to the realignment of our sales force, of which $0.5 million and $1.6 million were recorded in North America and EMEA, respectively.

 

2006 Restructuring

 

Activity and liability balances related to our 2006 restructuring are as follows (in thousands):

 

 

During 2007, we completed the restructuring activities that we began in the fourth quarter of 2006 when we permanently vacated several leased facilities and recorded a $0.3 million accrual for estimated lease related costs associated with the permanently vacated facilities. We also recorded a restructuring charge of $2.6 million in 2007 related to a reduction in headcount of 33 marketing and sales employees, of which $0.2 million, $2.3 million and $0.1 million was recorded in North America, EMEA and Asia-Pacific, respectively.

 

Lease termination costs will be paid through 2009.

2004 and 2003 Restructurings

 

Activity and liability balances related to our 2004 and 2003 restructuring actions are as follows (in thousands):

 

 

Lease termination costs included vacating several leased facilities, net of estimated sublease income, costs associated with subleasing the vacated facilities, asset disposals and discontinued use of certain leasehold improvements and furniture and equipment primarily in North America. Other costs include legal expenses incurred in international locations in conjunction with headcount reductions. Lease termination costs will be paid through 2013.

 

The adjustment in 2008 primarily relates to (i) changes in previous estimates of base rent and sublease income for the Santa Clara lease and (ii) terminating sublease agreements for three floors in our Santa Clara facility which were previously included in our 2003 and 2004 restructuring activities. We intend to move back into these floors in 2008.

 

 

We have a 14.0 million Euro credit facility with a bank. The credit facility is available on an offering basis, meaning that transactions under the credit facility will be on such terms and conditions, including interest rate, maturity, representations, covenants and events of default, as mutually agreed between us and the bank at the time of each specific transaction. The credit facility is intended to be used for short-term credit requirements, with terms of one year or less. The credit facility can be cancelled at any time. No balances were outstanding as of June 30, 2008 and December 31, 2007.

 

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

 

 

 

 

 

For the three months ended June 30, 2008 and 2007 we had a tax provision of $17.0 million and $9.6 million, respectively, reflecting an effective tax rate of 26% and 17%, respectively. The effective tax rate for the three months ended June 30, 2008 differs from the U.S. federal statutory rate (“statutory rate”) primarily due to the benefit of lower tax rates in certain foreign jurisdictions. The effective tax rate for the three months ended June 30, 2007 differed from the statutory rate primarily due to the benefit of lower tax rates in certain jurisdictions as well as a decrease in our estimated annual effective tax rate and the resultant quarterly adjustment necessary to adjust year to date expense to the revised estimate of our annual effective rate.

 

For the six months ended June 30, 2008 and 2007 we had a tax provision of $55.6 million and $22.1 million, respectively, reflecting an effective tax rate of 42% and 19%, respectively. The effective tax rate for the six months ended June 30, 2008 differs from the U.S. statutory rate primarily due to the negative impact resulting from acquisition integration activities, which, on a year to date basis, accounts for 18 percentage points of the effective tax rate, offset by the benefit of lower tax rates in certain jurisdictions. We have filed for administrative relief from the negative tax consequences associated with the acquisition integration activities with the U.S. Internal Revenue Service. If the administrative relief is granted, we will reverse the previously recorded tax expense in the period in which the relief is granted. The effective tax rate for the six months ended June 30, 2007 differed from the statutory rate primarily due to the benefit of lower tax rates in certain foreign jurisdictions.

The earnings from our foreign operations in India are subject to a tax holiday. In May, 2008, the Indian government extended the period through which the holiday would be effective to March 31, 2010. The tax holiday provides for zero percent taxation on certain classes of income and requires certain conditions to be met. We were in compliance with these conditions as of June 30, 2008.

 

We account for uncertainty in income taxes in accordance with FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (“FIN 48”). As a result, we apply a more-likely-than-not recognition threshold for all income tax uncertainties. FIN 48 only allows the recognition of those tax benefits that have a greater than 50% likelihood of being sustained upon examination by the taxing authorities. We believe it is reasonably possible that, in the next 12 months, the amount of unrecognized tax benefits related to the resolution of federal, state and foreign matters could be reduced by $5.0 million to $20.0 million as audits close and statutes expire.

 

Subsequent to June 30, 2008, we concluded a limited scope examination of our U.S. federal income tax returns for the calendar years 2002, 2003, 2004 and 2005 with the Internal Revenue Service. There will be no material impact on the financial statements resulting from this examination.

 

 

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

 

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

 

Summarized financial information concerning our net revenue and income from operations by geographic region is as follows (in thousands):

 

The difference between income from operations and income before provision for income taxes is reflected on the face of our condensed consolidated statements of income and comprehensive income.

 

The corporate expenses, which are not considered attributable to any specific geographic region, are as follows (in thousands):

 

 

 

Settled Cases

 

On August 17, 2006, a patent infringement lawsuit — captioned Deep Nines, Inc. v. McAfee, Inc., No. 9:06CV174, (“Deep Nines litigation”) was filed in the United States District Court for the Eastern District of Texas. The lawsuit asserted that (i) several of our

 

Enterprise products infringe a Deep Nines’ patent and (ii) we falsely marked certain products with a McAfee patent that was abandoned after its issuance. On June 18, 2008, the District Court granted, in part, McAfee’s motion for summary judgment, thereby removing all accused products from the case except IntruShield, one of our network protection offerings. On July 15, 2008, a jury found that certain applications of IntruShield infringe upon Deep Nines’ patent and awarded a one-time, lump sum payment for past and future damages. On July 29, 2008 we resolved all patent litigation matters with Deep Nines, Inc. by entering into a $25.0 confidential settlement agreement. As part of the settlement, we acquired certain nonexclusive rights and entered into a mutual release of all related claims. In the three months ended June 30, 2008, we recorded $9.0 million of legal settlement costs. The remaining $16.0 million was recorded as an asset as of June 30, 2008, and will be amortized to cost of product revenues in our condensed consolidated statements of income and comprehensive income over the economic life, which is estimated to be the remaining life of the primary patent which expires in 2020. We expect dismissal of all litigation pending between us and Deep Nines, Inc. within 90 days.

 

In February 2007, we reached a confidential settlement of a breach of contract, fraud and bad faith lawsuit filed in June 2002 in the United States District Court, District of Massachusetts for $15.5 million. As part of the settlement, we acquired and recorded ownership of intangible assets which were valued at $9.3 million and we expensed $6.2 million for prior claims, of which $5.0 million was recognized as expense in the three months ended June 30, 2006, with the balance of $1.2 million being expensed in 2004 and prior periods. The case was dismissed in March 2007.

 

Open Cases

 

We have described below our material legal proceedings and investigations that are currently pending and are not in the ordinary course of business. If management believes that a loss arising from these matters is probable and can reasonably be estimated, we record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional information

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

 

Government Inquiries Relating to Historical Stock Option Practices

 

In May 2006, we announced that we had commenced an investigation of our historical stock option granting practices. As a result of that investigation, we concluded that certain stock options had been accounted for using incorrect measurement dates, which, in some instances, were chosen with the benefit of hindsight so as to intentionally give more favorable exercise prices. Consequently, certain of our historical financial statements needed to be restated to correct improper accounting for improperly priced stock options. In December 2007, we filed our Form 10-K for 2006, which included the effects of a restatement of our audited consolidated financial statements for 2004 and 2005, our selected financial data for 2002 through 2005, and our unaudited quarterly financial data for all quarters in 2005 and the first quarter of 2006.

 

On May 23, 2006, the SEC notified us that an investigation had begun regarding our historical stock option grants. On June 7, 2006, the SEC sent us a subpoena requesting certain documents related to stock option grants from January 1, 1995 through the date of the subpoena. At or around the same time, we received a notice of informal inquiry from the U.S. Department of Justice, the (“DOJ”), concerning our stock option granting practices. On August 15, 2006, we received a grand jury subpoena from the U.S. Attorney’s Office for the Northern District of California relating to the termination of our former general counsel, his stock option related activities and the investigation. On November 6, 2006, we received a document request from the SEC for option grant data for McAfee.com, previously one of our consolidated subsidiaries that was a publicly traded company from December 1999 through September 2002.

 

On November 2, 2006, the investigative team created by the Special Committee of our board of directors met with the Enforcement Staff of the SEC in Washington D.C. and presented the initial findings of the investigation. Pursuant to discussions between the investigative team and the SEC during that meeting, the scope of the investigation was expanded to include a review of the historical McAfee.com option grants along with our historical exercise activity with a view toward determining potential exercise date manipulation and post-employment arrangements with former executives.

 

We have provided documents requested, and we are cooperating with the SEC and DOJ. The SEC investigation is still in its preliminary stages thus we are unable to determine the ultimate outcome at this time. As such, no provision has been recorded in the financial statements for this matter.

 

Securities Cases

 

On May 31, 2006, a purported stockholder derivative lawsuit — styled Dossett v. McAfee, Inc., No. 5:06CV3484 (JF) — was filed in the United States District Court for the Northern District of California against certain of our current and former directors and officers (“Dossett”). On June 7, 2006, another purported stockholder’s derivative lawsuit — styled Heavy & General Laborers Locals 472 & 172 Pension & Annuity Funds v. McAfee, Inc., No. 5:06CV03620 (JF) — was filed in the United States District Court for the Northern District of California against certain of our current and former directors and officers (“Laborers”). The Dossett and Laborers actions generally allege that we improperly backdated stock option grants between 1997 and the present, and that certain of our current and former officers or directors either participated in this backdating or allowed it to happen. The Dossett and Laborers actions assert claims purportedly on behalf of us for, inter alia, breach of fiduciary duty, abuse of control, constructive fraud, corporate waste, unjust enrichment, gross mismanagement, and violations of the federal securities laws. On July 13, 2006, the United States District Court for the Northern District of California entered an order consolidating the Dossett and Laborers actions as In re McAfee, Inc. Derivative Litigation, Master File No. 5:06CV03484 (JF) (the “Consolidated Action”). On January 22, 2007, we moved to dismiss the complaint in the Consolidated Action on the grounds that plaintiffs lack standing to sue on our behalf because, inter alia, they did not make a pre-suit demand on our board of directors. At the parties’ request, the Court

continued on several occasions the due date for the plaintiffs’ opposition to our motion to dismiss and the date for the hearing of that motion. As a result of the settlement described below, there is no deadline by which plaintiffs must file an opposition to the motion to dismiss.

 

On August 7, 2007, a new stockholders’ derivative lawsuit — styled Webb v. McAfee, Inc., No. C 07 4048 (PVT) — was filed in the United States District Court for the Northern District of California against certain of our current and former directors and officers (“Webb”). The new lawsuit generally alleges the same facts and causes of action that plaintiffs have asserted in the Consolidated Action. The plaintiff in Webb requested that his action be consolidated with the Consolidated Action. On September 21, 2007, the Court consolidated the Webb action with the Consolidated Action.

 

On June 2, 2006, three identical lawsuits — styled Greenberg v. Samenuk, No. 106CV064854, Gordon v. Samenuk, No. 106CV064855, and Golden v. Samenuk, No. 106CV064856 — were filed in the Superior Court of the State of California, County of Santa Clara against certain of our current and former directors and officers (the “State Actions”). Like the Consolidated Action, the State Actions generally allege that we improperly backdated stock option grants between 2000 and the present, and that certain of our current and former officers or directors either participated in this backdating or allowed it to happen. Like the Consolidated Action, the State Actions assert claims purportedly on behalf of us for, inter alia, breach of fiduciary duty, abuse of control, corporate waste, unjust enrichment, and gross mismanagement. On June 23, 2006, we moved to dismiss these actions in favor of the first-filed Consolidated Action. On September 18, 2006, the Court consolidated the State Actions and denied our motions to dismiss, but stayed the State Actions due to the first-filed action in federal court. The stay, which was continued by the Court on several occasions, expired in December 2007.

 

In December 2007, we reached a tentative settlement with the plaintiffs in the Consolidated Action and the State Actions. The tentative agreement must be submitted to and approved by the Court. We accrued $13.8 million in the condensed consolidated financial statements as of June 30, 2006 due to our ongoing stock option investigation and restatement related to expected payments pursuant to the tentative settlement and expect to complete the documentation and the required approvals in the second half of 2008. While we cannot predict the ultimate outcome of the lawsuits in the event that the tentative settlement is not approved by the Court, the provision recorded in the financial statements represents our best estimate at this time.

 

Certain investment bank underwriters, our company, and certain of our directors and officers have been named in a putative class action for violation of the federal securities laws in the United States District Court for the Southern District of New York, captioned In re McAfee.com Corp. Initial Public Offering Securities Litigation, 01 Civ. 7034 (SAS). This is one of a number of cases challenging underwriting practices in the initial public offerings (“IPOs”) of more than 300 companies. These cases have been coordinated for pretrial proceedings as In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). Plaintiffs generally allege that certain underwriters engaged in undisclosed and improper underwriting activities, namely the receipt of excessive brokerage commissions and customer agreements regarding post-offering purchases of stock in exchange for allocations of IPO shares. Plaintiffs also allege that various investment bank securities analysts issued false and misleading analyst reports. The complaint against us claims that the purported improper underwriting activities were not disclosed in the registration statements for McAfee.com’s IPO and seeks unspecified damages on behalf of a purported class of persons who purchased our securities or sold put options during the time period from December 1, 1999 to December 6, 2000. On February 19, 2003 the Court issued an Opinion and Order dismissing certain of the claims against us with leave to amend. We accepted a settlement proposal on July 15, 2003.

 

We, together with the other issuer defendants and plaintiffs, entered into a stipulation of settlement and release of claims against the issuer defendants that was submitted to the Court for approval in June 2004. On August 31, 2005, the Court preliminarily approved the settlement which, among other things, was conditioned upon class certification. In December 2006, the appellate court overturned the certification of classes making it unlikely that the proposed settlement would receive final Court approval. As a result, on June 25, 2007, the Court entered an order terminating the proposed settlement. Plaintiffs have indicated that they will seek to amend their allegations and file amended complaints. It is uncertain whether there will be any revised or future settlement. Thus, the ultimate outcome, and any ultimate effect on us, cannot be precisely determined at this time.

Other

 

In February 2008, a former executive notified us of his intent to seek arbitration of claims associated with his employment. He alleges that McAfee breached his employment contract and committed certain additional wrongful acts related to the expiration of his stock options. The arbitration demand was filed on April 11, 2008 and we anticipate that arbitration will begin in December of 2008. We believe these claims are without merit, and intend to contest them vigorously. Additionally, we have filed counterclaims against the former executive. No provision has been recorded in the financial statements related to this matter.

 

On January 7, 2007, a former executive filed an arbitration demand with the American Arbitration Association, Dallas Texas, (the “Texas arbitration”) seeking the arbitration of claims associated with his employment. The Texas arbitration is scheduled to begin in November 2008. On September 5, 2007, a “Complaint for Damages and Other Relief” was also filed by the same former executive, in the Superior Court of the State of California, County of Santa Clara, No. 107CV-093592 (the “California litigation”). The California litigation generally contained the same claims as were filed in the Texas arbitration. A Motion to Compel Arbitration of the California litigation with the Texas arbitration was granted in December 2007. We have filed counterclaims against the former executive, who was terminated. The board determined this termination was for cause. We believe the claims associated with the Texas arbitration and the California litigation are without merit. We intend to vigorously contest these claims, and no provision has been recorded in the financial statements for either the Texas arbitration or the California litigation.

 

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

 

 

We offer a 90 day warranty on our hardware and software products and record a liability for the estimated future costs associated with warranty claims, which is based upon historical experience and our estimate of the level of future costs. A reconciliation of the change in our warranty obligation as of June 30, 2008 and December 31, 2007 follows (in thousands):