UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

(Mark One)
x		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended September 29, 2006 or
o		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from            to
Commission file number: 000-30575

 

AVOCENT CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

 

256-430-4000
(Registrant’s Telephone Number, Including Area Code)

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, as amended, 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.

x Yes o No

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. (See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Securities Exchange Acto.)

Large Accelerated filer x

Accelerated Filer o

Non- Accelerated filer o

 

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

As of November 1, 2006, the number of outstanding shares of the Registrant’s Common Stock was 50,844,128.

AVOCENT CORPORATION
FORM 10-Q
September 29, 2006

INDEX

Part I	Financial Information
	Item 1.	Financial Statements (unaudited)
		Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 29, 2006 and September 30, 2005
		Condensed Consolidated Balance Sheets at September 29, 2006 and December 31, 2005
		Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 29, 2006 and September 30, 2005
		Notes to Condensed Consolidated Financial Statements
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk
	Item 4.	Controls and Procedures
Part II	Other Information
	Item 1.	Legal Proceedings
	Item 1A.	Risk Factors
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
	Item 6.	Exhibits
Signature

 

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PART I –FINANCIAL INFORMATION

AVOCENT CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited, in thousands except for per share amounts)

Item 1.  Financial Statements

		For the three months ended						For the nine months ended
		September 29,			September 30,			September 29,			September 30,
		2006			2005			2006			2005
Net sales:
Products and services		$	124,365		$	91,162		$	324,359		$	248,447
Licenses and royalties		17,349			5,546			29,972			14,604
Total net sales		141,814			96,708			354,331			263,051
Cost of sales:
Products and services		51,813			39,388			136,963			109,322
Licenses and royalties		1,010			—			1,010			—
Total cost of sales		52,823			39,388			137,973			109,322
Research and development expenses		16,004			14,640			43,535			43,495
Acquired in-process research and development expense		18,600			—			20,700			—
Selling, general and administrative expenses		38,314			20,764			94,414			67,069
Cyclades integration expenses		1,304			—			3,573			—
Amortization of intangible assets		6,589			2,731			13,841			15,976
Total operating expenses		80,811			38,135			176,063			126,540
Income from operations		8,180			19,185			40,295			27,189
Income from settlement of lawsuit		—			—			—			5,000
Net investment income		1,615			2,242			6,811			6,558
Net realized investment losses		(199		)	(100		)	(226		)	(483		)
Interest expense		(1,011		)	—			(1,157		)	—
Other expense, net		(133		)	(75		)	(361		)	(129		)
Income before income taxes		8,452			21,252			45,362			38,135
Provision for income taxes		5,902			4,887			16,297			8,838
Net income (1)		$	2,550		$	16,365		$	29,065		$	29,297
Earnings per share:
Basic		$	0.06		$	0.33		$	0.61		$	0.59
Diluted		$	0.05		$	0.33		$	0.60		$	0.58
Weighted average shares used in computing earnings per share:
Basic		46,289			48,966			47,770			49,550
Diluted		47,164			49,879			48,575			50,524

 

(1) Net income for the three and nine months ended September 29, 2006 includes stock-based compensation expense under SFAS 123R related to stock-based compensation of $3,510 and $5,842, respectively, net of tax. Net income for the three and nine months ended September 30, 2005 included stock-based compensation expense related to the amortization of deferred compensation recorded as a result of assumed options from the acquisition of OSA Technologies Inc of $510 and $1,529, respectively.  See Note 13 to the Condensed Consolidated Financial Statements for more information.

 

See notes accompanying these condensed consolidated financial statements.

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AVOCENT CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands)

		September 29,			December 31,
		2006			2005
ASSETS
Current assets
Cash and cash equivalents		$	81,733		$	66,425
Investments maturing within one year		39,643			227,478
Accounts receivable, net		119,188			68,712
Other receivables		12,562			8,328
Inventories, net		38,530			21,178
Other current assets		4,872			2,196
Deferred tax assets, net		9,073			4,054
Total current assets		305,601			398,371
Investments		9,631			51,939
Property and equipment, net		38,151			36,801
Goodwill		607,889			269,992
Other intangible assets, net		221,405			15,763
Other assets		3,436			885
Total assets		$	1,186,113		$	773,751
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	26,912		$	13,069
Accrued wages and commissions		20,792			10,500
Accrued liabilities		21,592			14,438
Income taxes payable		16,050			11,270
Deferred revenue, current		38,555			2,768
Accrued LANDesk acquisition costs		8,556			—
Other current liabilities		6,909			1,702
Total current liabilities		139,366			53,747
Note payable		162,005			—
Deferred tax liabilities, net		46,946			2,564
Deferred revenue, non-current		8,594			—
Other non-current liabilities		1,616			2,118
Total liabilities		358,527			58,429
Commitments and contingencies (see Note 12)
Stockholders’ equity:
Preferred stock, $0.001 par value; 5,000 shares authorized, no shares issued and outstanding as of September 29, 2006 and December 31, 2005, respectively		—			—
Common stock, $0.001 par value; 200,000 shares authorized, September 29, 2006 – 52,714 shares issued and 50,823 outstanding; December 31, 2005 – 51,612 shares issued and 48,837 outstanding		53			52
Additional paid-in capital		1,164,709			1,104,899
Accumulated other comprehensive loss		(20		)	(497		)
Accumulated deficit		(278,439		)	(307,503		)
Treasury stock, at cost; September 29, 2006 – 1,891 shares; December 31, 2005 – 2,775 shares		(58,717		)	(81,629		)
Total stockholders’ equity		827,586			715,322
Total liabilities and stockholders’ equity		$	1,186,113		$	773,751

 

See notes accompanying these condensed consolidated financial statements.

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AVOCENT CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)

		For the nine months ended
		September 29,			September 30,
		2006			2005
Cash flows from operating activities:
Net income		$	29,065		$	29,297
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		5,813			5,082
Amortization of intangible assets		14,735			15,976
Stock-based compensation		8,158			1,529
Acquired in-process research and development expenses		20,700			—
Amortization of premiums on investments		8			695
Net loss on sales of investments		226			483
Income tax benefit from exercise of stock options (see Note 13)		—			3,871
Excess tax benefit from stock-based compensation (see Note 13)		(4,130		)	—
Changes in operating assets and liabilities (net of effects of acquisitions):
Accounts receivable, net		(21,470		)	3,063
Inventories, net		(10,588		)	(263		)
Other assets		(1,687		)	(2,853		)
Accounts payable		(1,581		)	(469		)
Accrued wages and commissions		3,628			(3,786		)
Accrued liabilities (1) (2)		11,811			2,115
Income taxes, current and deferred		(1,957		)	(2,757		)
Net cash provided by operating activities		52,731			51,983
Cash flows from investing activities:
Purchase of Cyclades, net of cash received		(91,568		)	—
Purchase of LANDesk, net of cash received (2)		(198,145		)	—
Purchase of other intangibles		(3,750		)	—
Purchases of property and equipment		(2,079		)	(3,553		)
Purchases of investments		(147,422		)	(202,245		)
Maturities and proceeds from sales of investments		377,849			209,431
Net cash provided by (used in) investing activities		(65,115		)	3,633
Cash flows from financing activities:
Repayment of debt assumed in acquisition		(1,965		)	—
Borrowings under unsecured line of credit		160,000			—
Proceeds from employee stock option exercises		22,892			13,675
Excess tax benefit from stock-based compensation (see Note 13)		4,130			—
Proceeds from employee stock purchase plan		—			4,505
Purchases of treasury stock (see Note 3)		(157,617		)	(66,089		)
Net cash provided by (used in) financing activities		27,440			(47,909		)
Effect of exchange rate changes on cash and cash equivalents		252			(121		)
Net increase in cash and cash equivalents		15,308			7,586
Cash and cash equivalents at beginning of period		66,425			44,724
Cash and cash equivalents at end of period		$	81,733		$	52,310

 

(1)   As of September 29, 2006, $3,250 is included in accrued liabilities related to the purchase of certain tangible and intangible assets of an existing product line.

(2)   As of September 29, 2006, $5,572 is included in accrued liabilities related to LANDesk acquisition costs. See Note 8 regarding shares issued to fund the LANDesk acquisition.

See notes accompanying these condensed consolidated financial statements.

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AVOCENT CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited, in thousands, except per share data)

Note 1.          Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with generally accepted accounting principles and reflect all adjustments consisting of normal recurring adjustments which, in the opinion of management, are necessary for a fair presentation of the results for the periods shown.  The results of operations for these periods are not necessarily indicative of the results expected for the full fiscal year or for any future periods.  The preparation of financial statements in conformity with generally accepted accounting principles 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 revenues and expenses during the reporting period.  Actual results could differ from those estimates and assumptions.

The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the related notes contained in our Annual Report on
Form 10-K for the year ended December 31, 2005, which is on file with the Securities and Exchange Commission and is available at our website, www.avocent.com.  The consolidated balance sheet presented in the accompanying financial statements for December 31, 2005, was derived from the audited consolidated financial statements filed in our 10-K for the period ended December 31, 2005, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

We report our annual results based on years ending December 31.  We report our quarterly results for the first three interim periods based on 13 week periods ending on Fridays and for the fourth interim period ending on December 31.  Our financial statements are consolidated and include the accounts of Avocent Corporation and our wholly owned subsidiaries.  All significant inter-company transactions and balances have been eliminated in consolidation.  Certain prior period amounts were reclassified to conform with current period presentation.

Note 2.          Inventories

Inventories consisted of the following at:

		September 29, 2006			December 31, 2005
Raw materials		$	3,840		$	3,625
Work-in-process		782			173
Finished goods		33,908			17,380
Inventories, net		$	38,530		$	21,178

Inventories above have been reduced by reserves for excess and obsolete inventories of $7,915 and $4,558 as of September 29, 2006 and December 31, 2005, respectively.  The increase in inventories since December 31, 2005 includes inventories added through the Cyclades acquisition (see Note 8).

Note 3.          Stock Options and Treasury Stock

Stock option exercises — Shares of our common stock issued as a result of option exercises totaled 116 shares during the quarter ended September 29, 2006 and 396 shares during the quarter ended September 30, 2005.  Total proceeds received from these option exercises were $2,306 for the quarter ended September 29, 2006 and $7,235 for the quarter ended September 30, 2005.  Shares of our common stock issued as a result of option exercises totaled 1,103 shares during the nine months ended September 29, 2006 and 776 shares during the nine months ended September 30, 2005.  Total proceeds received from these option exercises were $22,892 for the nine months ended September 29, 2006 and $13,675 for the nine months ended September 30, 2005.  Additionally, common stock issued under our Employee Stock Purchase Plan totaled 181 shares during the nine months ended September 30, 2005.  Total proceeds received from the shares issued under the ESPP were $4,505 for the nine months ended September 30, 2005.  There were no shares issued under the ESPP for the quarter or

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nine months ended September 29, 2006 following the suspension of the ESPP by our Board of Directors in 2005.

Stock repurchases — We may repurchase a total of 10,000 shares under the share repurchase program approved by our Board of Directors.  We repurchased 1,400 shares of our common stock during the quarter ended September 29, 2006 at a cost totaling $35,362 for an average price of $25.26 per share.  We repurchased 6,189 shares of our common stock during the nine months ended September 29, 2006 at a cost totaling $157,617 for an average price of $25.47 per share.  We repurchased 500 shares of our common stock during the quarter ended September 30, 2005 at a cost totaling $15,818 for an average price of $31.64 per share.  We repurchased 2,275 shares of our common stock during the nine months ended September 30, 2005 at a cost totaling $66,089 for an average price of $29.05 per share.  These treasury shares were purchased on the open market through various brokers.  As of September 29, 2006, we have repurchased 8,964 shares under the plan since the initial approval of the plan in 2004.  In August 2006, we used 7,073 of these treasury shares to help fund the LANDesk acquisition (See Note 8).

Note 4.          Accumulated Other Comprehensive Loss

We record unrealized gains and losses on our foreign currency translation adjustments, unrealized gains and losses on derivatives which are cash flow hedges, and unrealized holding gains or losses on our available-for-sale securities, net of tax, as accumulated other comprehensive income (loss), which is included as a separate component of stockholders’ equity.  Comprehensive income in the first nine months of 2006 of $29,539 consists of $29,065 of net income, $381 of unrealized gains on investments and $433 of unrealized losses on the cash flow hedge (net of deferred income taxes) and $526 of foreign currency translation adjustments.  Comprehensive income for the first nine months of 2005 of $28,590 consists of $29,297 of net income, $301 of unrealized losses on investments (net of deferred income taxes) and $406 of foreign currency translation adjustments.  As of September 29, 2006 and December 31, 2005, total accumulated other comprehensive loss was $(20) and $(497), respectively.

Note 5.          Earnings Per Share

		Income			Shares		Per-Share Amount
		(Numerator)			(Denominator)
For the three months ended September 29, 2006
Basic EPS
Net income available to common stockholders		$	2,550		46,289		$	0.06
Effect of Dilutive Securities
Stock options and restricted stock awards		—			875		—
Diluted EPS
Net income available to common stockholders and assumed conversions		$	2,550		47,164		$	0.05
For the three months ended September 30, 2005
Basic EPS
Net income available to common stockholders		$	16,365		48,966		$	0.33
Effect of Dilutive Securities
Stock options		—			913		—
Diluted EPS
Net income available to common stockholders and assumed conversions		$	16,365		49,879		$	0.33
For the nine months ended September 29, 2006
Basic EPS
Net income available to common stockholders		$	29,065		47,770		$	0.61
Effect of Dilutive Securities
Stock options and restricted stock awards		—			805		—
Diluted EPS
Net income available to common stockholders and assumed conversions		$	29,065		48,575		$	0.60
For the nine months ended September 30, 2005
Basic EPS
Net income available to common stockholders		$	29,297		49,550		$	0.59
Effect of Dilutive Securities
Stock options		—			974		—
Diluted EPS
Net income available to common stockholders and assumed conversions		$	29,297		50,524		$	0.58

 

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Anti-dilutive options to purchase common stock outstanding were excluded from the calculations above.  Anti-dilutive options totaled 2,674 as of September 29, 2006.  Anti-dilutive options totaled 2,567 as of September 30, 2005.

Note 6.          Segment Reporting

In prior years, we reported our operations as a single reportable segment.  However, in the first quarter of 2006, we reorganized our business into five divisions and in the third quarter of 2006, we acquired our sixth division LANDesk (See Note 8).

·                       The Management Systems Division, which includes our branded and OEM KVM, serial console, power control and management appliance businesses;

·                       The Embedded Software and Solutions Division, which focuses on developing and marketing embedded systems and software including IPMI and embedded KVM technologies primarily for our OEM customers;

·                       The Connectivity and Control Division, which focuses on expanding the markets for Avocent’s serial and wireless broadcast, point-of-sale, and audio-visual products;

·                       The Desktop Solutions Division, which is developing new products to facilitate client blade deployments;

·                       The Mobile Technologies Division, which includes mobile device management and secure wireless systems administration; and

·                       The LANDesk Division, which includes software management solutions.

The reorganization included reconfiguring our systems and defining new cost centers and operating measures to track performance of the divisions and to use as a basis for our chief operating decision makers to manage and allocate resources.  As a result of this change in reportable segments, we have retroactively adjusted the segment information previously disclosed for the quarter and nine months ended September 30, 2005 to conform to the current segment disclosures.  In the fourth quarter of 2006, we plan to merge the Mobile Technologies Division into the LANDesk Division as their products consist primarily of software sold to similar customer groups.

We evaluate the performance of our segments based on revenue and operating profit, which excludes corporate and unallocated costs, amortization of intangibles, and acquired in-process research and development expense.  We do not track or use assets by segment as a measure of performance and, therefore, we have not presented assets by segment.

		For the three months ended						For the nine months ended
		September 29, 2006			September 30, 2005			September 29, 2006			September 30, 2005
Net revenue:
Management Systems		$	114,841		$	85,542		$	302,201		$	235,186
LANDesk		13,042			—			13,042			—
Embedded Software and Solutions		9,368			6,191			24,329			14,899
Other business units		3,690			3,844			11,962			10,804
Corporate and unallocated		873			1,131			2,797			2,162
Total net revenue		$	141,814		$	96,708		$	354,331		$	263,051

 

		For the three months ended						For the nine months ended
		September 29, 2006			September 30, 2005			September 29, 2006			September 30, 2005
Operating income (loss):
Management Systems		$	34,931		$	25,837		$	84,807		$	60,905
LANDesk		5,055			—			5,055			—
Embedded Software and Solutions		3,558			490			8,039			(609		)
Other business units		(4,266		)	(3,115		)	(10,918		)	(7,304		)
Corporate and unallocated costs		(4,864		)	(1,145		)	(10,801		)	(9,361		)
Amortization of intangibles and other expenses		(7,634		)	(2,882		)	(15,187		)	(16,442		)
Acquired in-process research and development expense		(18,600		)	—			(20,700		)	—
Total income from operations		$	8,180		$	19,185		$	40,295		$	27,189

 

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Revenue and operating income for our Management Systems Division includes the operating results of Cyclades from the date of the acquisition (See Note 8).

Sales by product line for our Management Systems Division and LANDesk Division for the three and nine months ended September 29, 2006 and September 30, 2005 are as follows:

		For the three months ended						For the nine months ended
		September 29, 2006			September 30, 2005			September 29, 2006			September 30, 2005
Management Systems Division (MSD) net revenue:
KVM		$	90,704		$	80,483		$	252,500		$	221,627
Serial Management		15,880			844			30,690			2,701
Other		8,257			4,215			19,011			10,858
Total MSD net revenue		$	114,841		$	85,542		$	302,201		$	235,186

 

		For the three months ended						For the nine months ended
		September 29, 2006			September 30, 2005			September 29, 2006			September 30, 2005
LANDesk Division net revenue:
Licenses and royalties		$	10,257		$	—		$	10,257		$	—
Maintenance and services		2,785			—			2,785			—
Total LANDesk net revenue		$	13,042		$	—		$	13,042		$	—

We defer revenue for service and maintenance contracts until earned.  As of September 29, 2006, deferred revenue was $47,149.  Approximately, $41,420 related to LANDesk and included a reduction of approximately 10%, as of the acquisition date in accordance with purchase accounting guidelines, to reflect the balance at its then estimated fair value.  As of September 30, 2005, deferred revenue was $2,768.

We sell our products internationally to customers in several countries; however no foreign country accounted for more than 10% of sales in the first nine months of 2006 or 2005.  Total foreign sales for the nine months ending September 29, 2006 and September 30, 2005 were each 43% of our total net sales.

As of September 29, 2006, long-lived assets totaled $867,445, which includes $563,793 held in the U.S. and $303,652 held outside of the U.S.  As of December 31, 2005, long-lived assets totaled $322,556, which includes $305,286 held in the U.S. and $17,270 held outside of the U.S.  The large increase in long lived assets held outside the U.S. primarily relates to intangible assets acquired through the LANDesk acquisition.

Note 7.          Forward Contracts

We occasionally use forward contracts to reduce a portion of our foreign currency exposure related to the net cash flows from our international operations.  The majority of these contracts are short-term contracts (three months or less) and are marked-to-market each quarter and included in trade payables, with the offsetting gain or loss included in other income (expense) in the accompanying consolidated statements of income.  As of September 29, 2006, and December 31, 2005, we had one open forward contract with an immaterial fair value.

Note 8.          Acquisitions

On March 30, 2006, we acquired Cyclades Corporation, a privately-held company based in Fremont, California, with additional operations in Sao Paulo, Brazil and Munich, Germany.  Cyclades employed approximately 325 people in 19 locations around the world.  The Cyclades product lines include serial, KVM and power management products.  The acquisition of Cyclades enhances our position in the Linux server and networking infrastructure management market, provides complementary products to our product lines, and allows us to provide our customers a more integrated platform for managing their IT infrastructure.  The results of Cyclades’ operations have been included in the consolidated financial statements since the date of acquisition.

The acquisition was recorded under the purchase method of accounting, and the purchase price was allocated based on the fair value of the assets acquired and liabilities assumed.  In accordance with generally accepted accounting principles, purchased research and development costs allocated to patented and patent-pending technology were capitalized and will be

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amortized over the respective estimated useful lives.  The remaining amounts of purchased research and development were expensed upon the closing of the transaction.  The goodwill recorded as a result of the acquisition will not be amortized but will be included in our annual review of goodwill for impairment.  Additionally, amortization of the other intangible assets acquired and the goodwill recorded is not tax deductible.  A summary of the total purchase consideration, excluding cash received, is as follows:

We funded the acquisition through available cash.  On the closing of the Cyclades transaction, we acquired $2,408 in cash held by Cyclades.

The purchase consideration was allocated, on a preliminary basis, to the estimated fair values of the assets acquired and liabilities assumed, as follows:

		Purchase
		Price			Amortization
		Allocation			Period
Tangible assets		$	22,973		—
In-process research and development		2,100			—
Developed technology		19,000			5 years
Customer base		12,100			5 years
Trademarks		3,100			5 years
Non-compete agreements		4,100			3 years
Goodwill		62,394			—
Deferred taxes		(14,860		)	—
Assumed liabilities		(16,931		)	—
		$	93,976

A $15,000 escrow account will be open for 21 months from the date of acquisition for indemnifiable events specified in the acquisition agreements.

The $2,100 in fair value of all of the in-process research and development (“IPR&D”) received in the acquisition was determined using a form of the discounted cash flow method known as the multi-period excess earnings method.  These amounts were for particular research and development projects that have no alternative future uses and were therefore expensed rather than capitalized at the time of purchase.

Cyclades’ in-process research and development activities consisted of the development of its KVM/net 3.0 product line and its PM 45 product lines.  KVM/Net 3.0 is the next generation KVM over IP technology that leverages DSP processing technology and software-based compression algorithms.  PM45 is an intelligent power distribution unit that provides high current on a 3-phase main power source.  It is anticipated that the products will be completed during late 2006.  These projects were still in process at the end of the third quarter of 2006.

The new generations of products under development are projected to sell through sales channels and to customers that are substantially the same as current and historical sales channels and customers.  Pricing and margins will not differ significantly from historical pricing and margins.  Revenue for the projects under development was projected through 2015.  Net income attributable to IPR&D was calculated by applying Cyclades’ projected gross, operating, and net profit margins to IPR&D revenue, while considering Avocent’s historical results and industry prospects.  These products have estimated economic lives of up to 10 years.  The discount rate used to value IPR&D was 28%.

On August 31, 2006, we acquired LANDesk Group Limited, a privately-held company based in Salt Lake City, Utah.  LANDesk employs approximately 600 people, located primarily in the United States, Europe, and Asia.  The LANDesk product lines include software for the centralized management and protection of information technology assets.  The acquisition agreement provides for total consideration of approximately $408 million, including $200 million in stock, $202 million in cash, and approximately $6 million in estimated fair value of assumed unvested employee stock options.  The transaction value may be

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increased by up to $60 million in cash if LANDesk meets certain 2006 revenue targets specified in the agreement.  The results of LANDesk’s operations have been included in the consolidated financial statements since the date of acquisition.

The acquisition was recorded under the purchase method of accounting, and the purchase price was allocated based on the fair value of the assets acquired and liabilities assumed.  In accordance with generally accepted accounting principles, purchased research and development costs allocated to patented and patent-pending technology were capitalized and will be amortized over the respective estimated useful lives.  The remaining amounts of purchased research and development were expensed upon the closing of the transaction.  The goodwill recorded as a result of the acquisition will not be amortized but will be included in our annual review of goodwill for impairment.  Additionally, amortization of the other intangible assets acquired and the goodwill recorded may be tax deductible if we make certain tax elections.  We are currently evaluating the impact of these elections which must be made within certain prescribed time periods following the date of acquisition.  Our preliminary allocation of the purchase consideration does not take into consideration the tax impacts should these elections be made within the required time period.  A summary of the total purchase consideration, excluding cash received, is as follows:

Cash paid for outstanding shares		$	202,010
Avocent common stock issued for outstanding shares		199,527
Estimated acquisition costs paid by Avocent		12,019
Estimated value of unvested options assumed related to prior service periods		5,788
Total estimated purchase consideration		$	419,344

 

The purchase consideration was allocated, on a preliminary basis, to the estimated fair values of the assets acquired and liabilities assumed, as follows:

		Purchase
		Price			Amortization
		Allocation			Period
Tangible assets		$	36,777		—
In-process research and development		18,600			—
Developed technology		35,400			5 years
Core technology		21,900			6 years
Customer base		78,400			7 years
Trademarks		23,600			7 years
Maintenance contracts		9,600			5 years
Non-compete agreements		6,100			3 years
Goodwill		275,322			—
Deferred taxes		(32,964		)	—
Assumed liabilities		(53,391		)	—
		$	419,344

 

We funded the acquisition through available cash, borrowings from our line of credit and the issuance of 7,073 shares of common stock.  On the closing of the LANDesk transaction, we acquired $10,312 in cash held by LANDesk.  An escrow account with $60 million of the stock consideration is held for indemnifiable claims for a period of 18 months after the acquisition.

The $18,600 in fair value of all of the in-process research and development (“IPR&D”) received in the acquisition was determined using a form of the discounted cash flow method known as the multi-period excess earnings method.  These amounts were deemed to be for particular research and development projects that have no alternative future uses and were therefore expensed rather than capitalized at the time of purchase.

LANDesk’s in-process research and development activities consisted of the development of the following products: Virtualization, Hostbase Intrusion Prevention Services (HIPS) and Configuration Management Database (CMDB) product lines.  Virtualization is a technology that presents a logical grouping of computing resources so that access can be provided in ways that enhance utilization over the original resource configuration.  HIPS technology is used to monitor computer and

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network activities to look for signs of intrusion into the computer system, which allows system administrators to identify potential system security threats and weaknesses.  CMBD is a repository for information about a company’s IT services and infrastructures and their relationships to each other, allowing IT professionals the ability to assess the current state of the IT infrastructure at any time.   It is anticipated that the products will be completed during 2007.

The new generations of products under development are projected to sell through sales channels and to customers that are substantially the same as current and historical sales channels and customers.  Pricing and margins will not differ significantly from historical pricing and margins.  Revenue for the projects under development was projected through 2015, with peak revenue for each being achieved in 2012.   Net income attributable to IPR&D was calculated by applying LANDesk’s projected gross, operating, and net profit margins to IPR&D revenue, while considering LANDesk’s  historical results and industry prospects.  These products have estimated economic lives of up to 10 years.  The discount rate used to value IPR&D was 25%.

Pro Forma Financial Information - The following unaudited pro forma summary combines the results of operations of Avocent, Cyclades and LANDesk as if the acquisitions had occurred prior to the beginning of each period presented.  Certain adjustments have been made to reflect the impact of the purchase transactions.  These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what would have occurred had the acquisitions been made at the beginning of 2005, or of results which may occur in the future.

		For the Three Months Ended						For the Nine Months Ended
		September 29, 2006			September 30, 2005			September 29, 2006			September 30, 2005
Net sales		$	154,559		$	132,578		$	428,679		$	362,293
Net income (loss)		$	6,908		$	7,885		$	18,825		$	(3,097	)
Income (loss) per basic share		$	0.14		$	0.14		$	0.35		$	(0.06	)
Income (loss) per diluted share		$	0.13		$	0.14		$	0.34		$	(0.05	)

 

The above amounts exclude acquired in-process research and development expense of $18,600 and $20,700 for the three months ended September 29, 2006 and the nine months ended September 26, 2006, respectively, related to the LANDesk and Cyclades acquisitions.

Note 9.          Goodwill and Other Intangible Assets

Other intangible assets subject to amortization were as follows:

		September 29, 2006						December 31, 2005
		Gross Carrying Amounts			Accumulated Amortization			Gross Carrying Amounts			Accumulated Amortization
Developed technology		$	91,120		$	14,679		$	14,820		$	8,293
Patents and trademarks		32,916			4,038			9,174			4,959
Customer base and certifications		100,060			5,426			4,870			1,719
Non-compete agreements		12,720			2,729			2,520			1,289
Maintenance Contracts		9,600			160			—			—
Licenses		4,228			2,207			1,814			1,175
		$	250,644		$	29,239		$	33,198		$	17,435

 

During March 2006, we acquired the remote systems management and diagnostics product line from Agilent Technologies, Inc. for approximately $6,250.  We recorded approximately $5,839 in other intangible assets related to this transaction, which is subject to future amortization.

For the three months ended September 29, 2006 and September 30, 2005, amortization expense for other intangible assets was $7,483 and $2,731, respectively.  For the nine months ended September 29, 2006 and September 30, 2005, amortization expense for other intangible assets was $14,735 and $15,976, respectively.  For the three and nine months ended September 29, 2006, we recorded $894 of amortization expense in cost of sales related to the amortization of certain software technology purchased in the LANDesk acquisition.  The approximate estimated annual amortization for other intangibles is as follows:

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For the nine months ended September 29, 2006, we recorded $275,322 of goodwill related to the LANDesk acquisition, $62,394 of goodwill related to the Cyclades acquisition and $181 of additional goodwill related to prior acquisitions.

Note 10.    Product Warranties

The activity within the liability for warranty returns for the nine months ended September 29, 2006 is:

Balance, January 1, 2006		$	2,536
Accruals for product warranties issued during the period		1,799
Assumed on acquisition of Cyclades		180
Settlements made during the period		(1,821		)
Balance,  September 29, 2006		$	2,694

Deferred revenue related to our extended warranty program was $2,143 as of September 29, 2006.  We recorded earned revenue from the amortization of deferred revenue related to extended warranties of $548 for the nine months ended September 29, 2006.  In addition, we recorded deferred revenue for new extended warranties of $769 during the nine months ended September 29, 2006.

Note 11.    Effective Tax Rate

The effective tax rate in the first nine months of 2006 was approximately 35.9%, compared to an effective tax rate of approximately 23.2% in the first nine months of 2005.  The provision for income taxes was approximately $16,297 for the first nine months of 2006, compared to $8,838 in the first nine months of 2005.  The increase in 2006 effective tax rate over that of 2005 is primarily due to $20.7 million of in-process research and development for the LANDesk and Cyclades acquisitions which were immediately expensed upon purchase.  Also, these items are not currently expected to be deductible for the tax purposes and therefore increased the effective tax.  The increase in provision for income taxes was partly the result of the change in mix of our pre-tax profit among our U.S. and international companies.  Additionally, the Irish statutory tax rate on manufactured goods increased from 10% to 12.5% on January 1, 2006.  The U.S. Research and Development credit also has expired, and as of September 29, 2006, this credit has not yet been reinstated by Congress.  The increases were partially offset by a deduction attributable to incentive stock options and the release of tax contingency reserves due to the favorable settlement of certain international tax examinations.

The amount of income taxes we pay is subject to audits by federal, state, and foreign authorities, and can result in proposed assessments.  We have reserves for taxes and associated interest that may become payable in future years as a result of audits by tax authorities.  Although we believe that the positions taken on previously filed tax returns are appropriate, we have nevertheless established tax and interest reserves in recognition that various tax authorities may challenge the positions taken by us resulting in additional liabilities and interest.  The tax reserves are reviewed as circumstances warrant and adjusted as events occur that affect our potential liability for additional taxes, such as lapsing of applicable statutes of limitations, conclusions of tax audits, additional exposure based on current calculations, identification of new issues, release of administrative guidance, or rendering of a court decision affecting a particular tax issue.

Additionally, in July 2006, the Financial Accounting Standards Board (FASB) released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (FIN 48).  FIN 48 clarifies the accounting and reporting for uncertainties in income tax law.  This Interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns.  We will adopt this Interpretation in the first quarter of 2007.  The cumulative effects, if any, of applying this Interpretation will be recorded as an adjustment to retained earnings as of the beginning of the period of adoption.  We have commenced the process of evaluating the expected effect of FIN 48 on our consolidated financial

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statements but are currently not yet in a position to determine such effects.

Note 12.    Legal Proceedings

In October 2003, Avocent filed a complaint for patent infringement in the United States District Court for the Northern District of Alabama against ClearCube Technology, Inc.  We settled our case with ClearCube in August 2006.  As part of the settlement, ClearCube agreed to license certain patents from us and potentially license other Avocent technologies.

On March 14, 2006, TFS Electronic Manufacturing Services, Inc. filed a Third-Party Complaint and an Objection to Claim of Avocent Corporation with the United States Bankruptcy Court, District of Arizona.  As a result of the complaint, an adversary proceeding has been commenced against Avocent in the TFS bankruptcy case in an effort to disallow Avocent’s claim in its entirety.  TFS also seeks damages in an undetermined amount for Avocent’s alleged breach of contract, negligence, negligent misrepresentations, breaches of warranty, unjust enrichment, disparagement of TFS’ business, and quantum merit.  TFS is seeking recovery of actual damages, punitive damages, attorneys’ fees, pre- and post-judgment interest, costs, and the imposition of joint and several liabilities as to Avocent and a named co-defendant, TopSearch Printed Circuits (HK), Ltd.  Avocent has moved to dismiss all claims, and discovery is under way.

Note 13.    Stock Based Compensation

On January 1, 2006, we adopted SFAS 123 (revised 2004), Share-Based Payment, (“SFAS 123R”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including grants of employee stock options, based on estimated fair values.  SFAS 123R supersedes SFAS No. 123 Accounting for Stock Based Compensation  and Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), which we previously applied, for periods beginning before fiscal 2006.  In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123R.  We have applied the provisions of SAB 107 in our adoption of SFAS 123R.

We adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our fiscal 2006 year.  Our consolidated statements of income for the three and nine months ended September 29, 2006 reflect the impact of SFAS 123R.  In accordance with the modified prospective transition method, our consolidated statements of income for prior periods have not been retroactively adjusted to reflect the impact of SFAS 123R.  New awards are valued and accounted for prospectively upon adoption.  Prior outstanding stock option awards that were not fully vested as of January 1, 2006 will be recognized as compensation expense in our consolidated statements of income over their remaining requisite service periods.

Stock Option Program Descriptions

We have stock option plans covering substantially all of our employees and directors.  Avocent also assumed the stock option plan and the related unvested stock options of LANDesk at the acquisition effective August 31, 2006.  Purchase prices for common stock subject to options issued under the assumed plans generally approximate the fair market value of the related shares at the date of grant.  Generally, options vest over three to four years and typically expire 10 years from the grant date.

We currently grant equity incentive awards under the 2005 Avocent Corporation Equity Incentive Plan (the 2005 Plan).  As originally approved by our stockholders, the 2005 Plan authorized a total of 2,500 shares of common stock for issuance, plus (i) any shares remaining available for issuance under previous stock option plans up to a maximum of 1,187 shares and (ii) any shares subject to any outstanding options under our stock option plans that subsequently expire unexercised.  New options may no longer be granted under any former plans.  The 2005 Plan allows for options, restricted stock, restricted stock units, stock appreciation rights, performance shares, performance units, deferred stock units, and dividend equivalents, and options granted under the 2005 Plan may be either incentive stock options or nonqualified stock options.  Nonqualified stock options, restricted stock, restricted stock units, performance shares, performance units, stock appreciation rights, deferred stock units, and dividend equivalents may be granted under the 2005 Plan to our directors, employees, or consultants, but  incentive stock options may be granted only to our employees.  Options may not be granted at less than the fair market value on date of grant and may not have a term of greater than 10 years.  We issue new shares to satisfy stock options exercised.  During the second quarter of 2006, our stockholders approved an additional 2,250 shares of common stock for issuance under the 2005 Plan.  In the first nine months of 2006, we granted both stock options and restricted stock units under the 2005 Plan.

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The following schedule summarizes the stock option activity in our stock-based compensation plans for the nine months ended September 29, 2006:

		Number of		Range of			Weighted Avg.			Vesting
		Options		Exercise Prices			Exercise Price			Provisions
Options outstanding, December 31, 2005		6,623		$	0.11– $70.94		$	32.00		Various
Options assumed (LANDesk)		572		$	3.34 - $33.86		13.03			Various
Options granted		62		$	22.77 – $34.64		$	31.02		Various
Options cancelled/forfeited		(322	)	$	1.31– $69.63		$	36.11		Various
Options exercised		(1,102	)	$	0.11– $31.00		$	20.79		Various
Options outstanding, September 29, 2006		5,833		$	1.31– $70.94		$	33.96		Various

 

The total pretax intrinsic value of options exercised during the nine months ended September 29, 2006 was $12,959.

The following table summarizes information about stock options outstanding at September 29, 2006:

Range of Exercise Prices		Number Outstanding		Weighted Avg. Remaining Contractual Life		Intrinsic Value			Weighted Avg. Exercise Price			Number Exercisable		Weighted Avg. Exercise Price			Intrinsic Value
$0.11 - $9.48		242		5.89		$	6,382		$	3.72		129		$	4.13		$	1,535
$10.46 - $20.00		511		6.82		7,782			14.88			258		14.86			2,733
$20.33 – $29.95		2,659		6.24		13,235			25.10			2,603		25.12			13,028
$30.02 - $44.25		790		7.49		—			38.15			678		39.11			—
$46.19 - $70.94		1,631		3.97		—			52.46			1,631		52.46			—
		5,833		5.82		$	27,399		$	34.69		5,299		$	34.22		$	17,296

 

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on our closing price of $30.12 as of September 29, 2006, which would have been received by option holders had all option holders exercised their options on that date.  The total number of in-the-money options exercisable as of September 29, 2006 was 2,990.  As of December 31, 2005, 6,248 options were exercisable and the weighted average exercise price was $32.33.

Restricted Stock Units

Our 2005 Plan permits the granting of restricted stock units to eligible employees and directors at the fair market value of our common stock at the date of grant.  Awards during the first nine months of 2006 typically become fully vested over two or three year periods.  Restricted stock units are payable in shares of our common stock upon vesting.

The following table presents a summary of the activity in our nonvested restricted stock units during the nine months ended September 29, 2006:

		Number of		Weighted-Average Grant-Date
Nonvested stock units		Stock Units		Fair Value
Nonvested stock units at December 31, 2005		—		—
Granted		977		$	28.63
Vested		—		—
Forfeited		(27	)	29.11
Nonvested stock units at September 29, 2006		950		$	28.61

 

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As of September 29, 2006, there was approximately $21,234 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the 2005 Plan.  That cost is expected to be recognized over an estimated weighted average amortization period of 2.4 years.

Performance – Based Restricted Stock Units

Certain restricted stock units contain both service and performance conditions that affect the quantity of awards that will vest.  Performance-based restricted stock units begin vesting upon the completion of a specified service period and the achievement of certain performance targets (which can include individual and company measures) and are converted into shares of our common stock upon vesting, typically over a three year period.  The fair value is based on the market price of our common stock on the grant date and assumes that the target payout level will be achieved.  Compensation cost is adjusted in future periods for subsequent changes in the expected outcome of the performance related conditions until the vesting date.  All performance-based restricted stock unit activity is included in the nonvested stock unit table of activity above.

Valuation and Expense Information

The following table summarizes stock-based compensation expense related to employee stock options and restricted stock units under SFAS 123R for the three and nine months ended September 29, 2006, which was allocated as follows:

		Three months ended			Nine months ended
		September 29, 2006			September 29, 2006
Cost of sales		$	289		$	502
Research and development		1,109			2,172
Selling, general and administrative		3,197			5,484
Stock-based compensation expense included in operating expenses		4,306			7,656
Total stock-based compensation expense		4,595			8,158
Tax benefit		(1,085		)	(2,316		)
Total stock-based compensation expense, net of tax		$	3,510		$	5,842

For the three and nine months ended September 30, 2005, we recorded stock compensation expense of $510 and $1,529, respectively, related to the amortization of deferred compensation recorded as a result of assumed options from the acquisition of OSA Technologies Inc.

The table below illustrates the effect on net income and earnings per share as if we had applied the fair-value recognition provisions of SFAS 123 to all of our stock-based compensation awards for periods prior to the adoption of SFAS 123R.

		Three months Ended			Nine months Ended
		September 30, 2005			September 30, 2005
Net income — as reported		$	16,365		$	29,297
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		510			1,529
Deduct: Total stock based employee compensation expense determined under fair value method for all awards, net of related tax effects		8,343			21,466
Net income — pro forma		$	8,532		$	9,360
Basic earnings per share — as reported		$	0.33		$	0.59
Basic earnings per share — pro forma		$	0.17		$	0. 19
Diluted earnings per share — as reported		$	0.33		$	0.58
Diluted earnings per share — pro forma		$	0.17		$	0.19

 

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