UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

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

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

 

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 o     No þ

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

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

Large accelerated filer  þ     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 Exchange Act).  Yes o     No þ

 

The aggregate market value of the voting stock held by non-affiliates of the issuer as of the last business day of the Registrant’s most recently completed second fiscal quarter (June 30, 2006) was approximately $3.9 billion. The number of shares outstanding of the issuer’s common stock as of December 7, 2007 was 159,908,615.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

None.

 

 

MCAFEE INC.

 

FORM 10-K

For the fiscal year ended December 31, 2006

 

TABLE OF CONTENTS

 

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties. All forward-looking statements included in this Annual Report on Form 10-K are based on information available to us on the date hereof. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results to differ materially from those implied by the forward-looking statements. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Neither we nor any other person can assume responsibility for the accuracy and completeness of forward-looking statements. Important factors that may cause actual results to differ from expectations include, but are not limited to, those discussed in Item 1A, “Risk Factors” as well as in Item 1, “Business” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

 

These statements include, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future. Forward-looking statements in the Report include, but are not limited to, statements about the following matters:

 

 

In some cases, you can identify other forward-looking statements in the Report by terminology such as “may,” “should,” “could,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “targets,”

“goals,” “projects,” “continue,” or variations of such words, similar expressions, or the negative of these terms or other comparable terminology.

 

EXPLANATORY NOTE REGARDING RESTATEMENT

 

This annual report on Form 10-K for the year ended December 31, 2006 includes the effects of a restatement on the following previously issued consolidated financial statements, data and related disclosures: (i) our audited consolidated financial statements as of December 31, 2005 and for each of the two years in the period ended December 31, 2005; (ii) our selected financial data as of and for the years ended December 31, 2005, 2004, 2003 and 2002; and (iii) our unaudited quarterly financial data for the first quarter in the year ended December 31, 2006 and for all quarters in the year ended December 31, 2005.

 

Financial information included in our reports on Form 10-K and Form 10-Q filed prior to July 27, 2007, and the related opinions of our independent registered public accounting firms, and all earnings press releases and similar communications and all financial information included in our reports on Form 8-K issued by us prior to December 21, 2007, should not be relied upon and are superseded in their entirety by this annual report on Form 10-K and other reports on Form 10-Q and Form 8-K filed by us with the SEC on or after December 21, 2007.

 

We became aware of potential issues with respect to our historical stock option grants in May 2006 after the Center for Financial Research and Analysis (“CFRA”) released a report titled “Options Backdating — Which Companies are at Risk?” This report concluded there was a high probability that we backdated option grants from 1997 to 2002, based on stock price trends around certain grant dates. Upon becoming aware of the CFRA report, management immediately commenced a voluntary internal review involving the examination of certain stock option grants. In May 2006, management notified our board of directors that an internal review was in process in response to the analysis in the CFRA report.

 

During our initial review, management discovered irregularities in certain historical stock option grants and discussed these findings with the board of directors in late May 2006. We learned during the course of the initial review, and through subsequent discussions between our former general counsel and certain directors, of irregularities regarding the pricing of a grant to our former general counsel. Upon review of the findings of the internal review and subsequent to such discussions, the board of directors immediately terminated the employment of our former general counsel for cause.

 

The board of directors created a committee (the “special committee”) comprised of certain of its members who were independent of our company and management and who had not previously served as members of our board’s compensation committee to conduct an investigation to evaluate the conduct and performance of our officers, employees and directors who were involved in the option granting process and to evaluate the timing of option grants, the related approval documentation and accounting implications with respect to grants made during the period from January 1, 1995 through March 31, 2006. In May 2006, the special committee retained independent counsel and forensic accountants to assist in the investigation (collectively referred to as the “investigative team”). No limits were placed on the scope of the investigation. Independent counsel first met with the audit committee and with the special committee in June 2006.

 

The special committee held more than 50 meetings from June 10, 2006 through the date of this filing to discuss matters related to the investigation with its advisors. The investigation included interviews with over 80 individuals, which were conducted at the direction of the investigative team. More than 3.3 million emails and electronic documents were collected, of which approximately 830,000 were determined to be relevant to the investigation and reviewed. In addition, more than 900 boxes of documents were reviewed.

 

Findings and conclusions

 

The special committee presented its initial findings to the board of directors on October 10, 2006. As part of this presentation, the special committee communicated to our board of directors information concerning errors and irregularities with respect to our option granting practices, including, among others, the new hire option grant of our former president and one of the option grants to our former general counsel. Immediately following that

presentation, our chairman and chief executive officer retired and our president was terminated. The board determined this termination was a termination for cause.

 

The special committee investigation was completed in November 2007. The special committee concluded that there were both qualitative issues and accounting and administrative errors relating to our stock option granting process. In this regard, the special committee concluded that certain former members of management had acted inappropriately, giving rise to qualitative concerns. The qualitative concerns included the following:

 

 

In addition to the foregoing, the special committee concluded that certain stock option awards were previously accounted for using incorrect measurement dates because: (i) we had previously determined accounting measurement dates for certain stock option awards incorrectly, and, in some instances, such dates were chosen with the benefit of hindsight so as to intentionally, and not inadvertently or as a result of administrative error, give more favorable exercise prices, (ii) the key terms for a substantial portion of the grants in an annual merit grant had been determined with finality prior to the original measurement date, with a reduction in the exercise price on the original measurement date, which represented a repricing, (iii) original accounting measurement dates occurred prior to approval dates, (iv) original accounting measurement dates occurred prior to employment commencement dates, (v) approval and employment commencement date documentation was incorrect or inconsistent and (vi) certain director grants contained clerical errors.

 

As a result of these findings, we have restated our consolidated financial statements to properly reflect the correction of these errors. During this restatement, we also corrected other known errors.

 

To correct our past accounting for stock options under Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” (“APB 25”), we recorded additional pre-tax, non-cash, stock-based compensation expense totaling $137.4 million, including of $3.4 million ($2.5 million, net of tax) for the year ended December 31, 2005, $10.8 million ($7.2 million, net of tax) for the year ended December 31, 2004 and $123.1 million ($80.5 million, net of tax) for the periods 1995 through 2003. We also expect to amortize less than $0.1 million of such pre-tax charges under Statement of Financial Accounting Standards No. 123(R) “Share-Based Payment” (“SFAS 123(R)”), in periods from January 1, 2007 through 2009.

The following table presents stock-based compensation expense recorded in this restatement by type of error as discussed below (in thousands):

 

 

Option grants previously accounted for using incorrect measurement dates

 

The special committee identified instances of the following:

 

 

In light of the significant judgment used in establishing revised measurement dates, alternate approaches to those used by us could have resulted in different stock-based compensation expense than recorded by us in the restatement. While we considered various alternative approaches, we believe that the approaches we used were the most appropriate under the circumstances. We conducted a sensitivity analysis to assess how the restatement adjustments described in this annual report on Form 10-K could have changed under alternative methodologies for determining measurement dates for stock option grants from 1995 through 2005. See “Critical Accounting Policies and Estimates” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of the annual report on Form 10-K for information regarding the incremental stock-based compensation charges that would result from using alternate measurement dates.

 

Approximately 98% of the total intrinsic value (the stock price on the revised measurement date minus the exercise price) recognized as a result of the investigation results from option grants made during the period 1995 through 2003. With the exception of a few individuals who are no longer associated with McAfee, we believe all holders of incorrectly priced options issued by us were not involved in or aware of the improper dating of options or other errors. Accordingly, we plan to continue to honor the options that violated the terms of our stock option plans, except in certain isolated cases described in the section “Modifications in 2006 to Certain Stock Options Granted to Former Executive Officers and Current Directors” in Note 16, “Employee Stock Benefit Plans” to our consolidated financial statements.

 

The special committee and management determined that the measurement dates for grants made after April 2005 complied with the prevailing accounting pronouncements and are not subject to restatement. The special committee proposed a number of remedial measures arising out of its investigation intended to enhance existing internal controls, policies and procedures relating to our stock option granting processes. Since November 2006, all

grants have been approved at regularly scheduled compensation committee meetings which have been documented in compensation committee minutes.

 

Repriced Annual Merit Grant

 

The 1999 annual merit grant consisted of 2.1 million options which had an original measurement date of April 20, 1999. We determined that the key terms were determined with finality for approximately 1.6 million of these options in March 1999, and that the exercise price was reduced to $11.06 on April 20, 1999. The reduction in the exercise price was considered a repricing, therefore, we have accounted for these options as variable awards in accordance with Financial Accounting Standards Board Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25” (“FIN 44”).

 

Post-employment option modifications previously not recorded

 

During the course of the investigation, we identified modifications to the key terms of certain stock option awards which had not been accounted for previously. These modifications occurred upon the termination of an employee and, in some cases, provided for the extension of the post-termination time period in which options could be exercised and allowed for the continued vesting of options subsequent to the former employee’s termination date. To the extent the terminated employee was not expected to perform substantive services on our behalf after termination, we should have recorded stock-based compensation expense based on the intrinsic value of the options on the date of the modification. To the extent the terminated employee was expected to continue to perform services on our behalf after termination or the modification occurred after the employee terminated, we should have recognized stock-based compensation expense based upon the fair value of the options received by the non-employee during the period in which services were provided. We did not properly account for the stock-based compensation expenses associated with certain option modifications in our previously issued financial statements. To correct our past accounting for stock option modifications, we recorded additional pre-tax, non-cash, stock-based compensation expense in the amount of $0.2 million and $22.9 million in 2004 and periods prior to 2004, respectively. We had no adjustments related to post-employment modifications in 2005.

 

Certain of the post-employment modifications also resulted in cash payments to former employees subsequent to their termination date. We should have recorded cash-based compensation expense on the termination date for the amount of the cash payments made subsequent to the termination date. In our previously issued financial statements, we incorrectly accounted for post-termination cash payments in the periods in which the payments were made. To correct our past accounting for these post-termination payments, we recorded adjustments to cash compensation expense which effectively shifted previously recorded compensation expense into the proper periods. These adjustments did not affect 2005. We recorded additional cash-based compensation benefit totaling $0.1 million during 2004 and additional cash-based compensation expense totaling $0.1 million in periods prior to 2004.

 

Correction of errors, primarily options historically accounted for as variable awards

 

Additionally, we discovered certain errors in our accounting for stock options that were repriced and historically accounted for as variable awards. These errors consisted primarily of an error in applying the transition guidance provided in FIN 44. To correct these errors in accounting for variable awards, we recorded additional pre-tax, non-cash, stock-based compensation expense in the amount of $0.3 million, $2.2 million and $6.5 million in 2005, in 2004 and periods prior to 2004, respectively. We recorded additional pre-tax, non-cash, stock-based compensation expense in the amount of $0.9 million in periods prior to 2004 related to other corrections of errors.

 

Income tax implications exist as a result of the revision of stock option measurement dates

 

As a result of our determination that certain of our measurement dates were not determined appropriately, we also reviewed our stock option grants to assess any related tax implications. Section 162(m) of the Internal Revenue Code (“Section 162(m)”) prohibits tax deductions for non-performance based compensation paid to the chief executive officer and the four highest compensated officers in excess of $1.0 million in a taxable year. Compensation attributable to stock options issued under our employee stock option plan meets the requirements for treatment as qualified performance-based compensation and is an exception from the deduction limit of

Section 162(m) provided the exercise price is greater than or equal to the fair market value of our common stock on the date of grant. During our internal review of historical stock option granting practices, we determined that certain tax deductions related to stock options exercised by certain employees are not allowed under Section 162(m) because the exercise price of the stock option was less than the fair market value of our common stock on the date of grant. Accordingly, we reduced the additional paid-in-capital balances by $4.5 million, $0.7 million and $9.1 million from amounts previously reported in 2005, 2004 and periods prior to 2004, respectively, with corresponding adjustments to certain deferred tax assets and income taxes payable.

 

In addition, we recorded $0.2 million, less than $0.1 million and $0.5 million of expense in 2005, 2004 and periods prior to 2004, respectively, related to international tax implications as a result of revising stock option measurement dates.

 

Other prior-period errors

 

This restatement of prior-period financial statements also includes corrections of other errors. We have corrected these errors in the appropriate accounting period with the restatement of our financial statements for the non-cash stock-based compensation expense discussed above. The aggregate effect on net income was a decrease in income of $18.1 million in 2005 an increase of $2.1 million in 2004 and an increase of $4.0 million in periods prior to 2004.

 

Other issues

 

In addition to the charges resulting from the correction of the errors determined pursuant to the investigation, we expect additional expenses in future periods associated with our strategy to mitigate employee income tax implications for those individuals with options affected by revised measurement dates and we have taken certain actions and are considering other actions to modify certain option agreements to compensate those former employees who were unable to exercise options during the blackout period, the 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 investigation, through the date we become current on our reporting obligations under the Securities Exchange Act of 1934, as amended.

 

Section 409A

 

We also reviewed the consequences of issuing in-the-money grants under Section 409A of the Internal Revenue Code. We are considering offering active employees who are option holders the opportunity to amend or exchange their options to avoid the adverse tax consequences of Section 409A.

 

Blackout 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 investigation, through the date we become current on our reporting obligations under the Securities Exchange Act of 1934, as amended, we have not been able to issue any shares, including those pursuant to stock option exercises. In January 2007, we extended the post-termination exercise period for all vested options held by certain former employees and outside directors that would expire during the blackout period until the earlier of i) the ninetieth calendar day after we become current on 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, 2007. As a result of the modifications, we recognized $4.3 million of stock-based compensation expense in the fourth quarter of 2006 based on the fair value of these modified options.

 

Based on the guidance in SFAS 123(R) and related FASB Staff Positions, 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 will determine the fair value of these options utilizing the Black-Scholes valuation model and recognize any change in fair value of the options in our consolidated statements of income in the period of change until the options are

exercised, expire or are otherwise settled. The expense or benefit associated with these options will be included in general and administrative expense in our consolidated statements of income, and will not be reflected as stock-based compensation expense. We will record expense or benefit in future periods based on the closing price of our common stock.

 

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 former employees and outside directors who terminated subsequent to the January 2007 modification and those previously modified in January 2007 as discussed above, until the earlier of i) the ninetieth calendar day after we become 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 FASB Staff Positions, 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, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.” As a result, in November 2007, these options will be reclassified as liability awards within current liabilities. Accordingly, at the end of each reporting period, we will determine the fair value of these options utilizing the Black-Scholes valuation model and recognize any change in fair value of the options in our consolidated statements of income in the period of change until the options are exercised, expire or are otherwise settled. The expense or benefit associated with these options will be included in general and administrative expense in our consolidated statements of income, and will not be reflected as stock-based compensation expense. We will record expense or benefit in future periods based on the closing price of our common stock.

 

PART I.

 

 

OVERVIEW

 

We are a leading dedicated security technology company that secures systems and networks from known and unknown threats around the world. We empower home users, businesses, government agencies, service providers and our partners with the ability to block attacks, prevent disruptions, and continuously track and improve their security. We were incorporated in 1992. In June 2004, we changed our name to McAfee, Inc. from Networks Associates, Inc. and began trading on the New York Stock Exchange under the symbol MFE. We previously changed our name from McAfee Associates, Inc. to Networks Associates, Inc. in conjunction with our December 1997 merger with Network General Corporation. We are headquartered at 3965 Freedom Circle, Santa Clara, California, 95054, and the telephone number at that location is (408) 988-3832. Our internet address is www.mcafee.com.

 

This report includes registered trademarks and trade names of McAfee and other corporations. Trademarks or trade names owned by McAfee and/or its affiliates include: “McAfee,” “Network Associates,” “ePolicy Orchestrator,” “VirusScan,” “IntruShield,” “Entercept,” “Foundstone,” “McAfee SiteAdvisor,” “Avert,” “Preventsys,” “Hercules,” “Citadel,” “Policy Enforcer,” “Total Protection,” “AntiSpyware” and “SecurityAlliance.”

 

OUR APPROACH AND OFFERINGS

 

We apply business discipline and a pragmatic approach to security that is based on four principles of security risk management, (i) identify and prioritize assets, (ii) determine acceptable risk, (iii) protect against threats and (iv) enforce and measure compliance. We incorporate some or all of these principles into our solutions. Our solutions protect systems and networks, blocking immediate threats while proactively providing protection from future threats. We also provide software to manage and enforce security policies for organizations of any size. Finally, we incorporate McAfee Expert Services, Foundstone services and technical support to ensure a solution is actively meeting our customers’ needs. These integrated solutions help our customers solve problems, enhance security and reduce costs.

 

Threat Protection Offerings

 

Our threat protection offerings enable management of risks to systems, networks, and data with comprehensive, layered threat protection. Our portfolio includes system security, network protection, and messaging and web security. Each of our threat protection offerings is backed by McAfee Avert Labs, a leading global threat research organization. A substantial majority of our net revenue has historically been derived from our McAfee threat protection solutions, in particular the system security products now represented in McAfee Total Protection Solutions.

 

Our flagship business offering for system security is McAfee Total Protection Solutions, which was introduced in April 2006. A single solution with a single management console, McAfee Total Protection reduces the complexity of managing enterprise security and offers comprehensive protection against spyware, viruses, worms, spam, and intrusions, and incorporates centralized management and scalable network access control. This integrated approach enables organizations to proactively block known and unknown attacks and supports business continuity by controlling non-compliant endpoints. McAfee Total Protection Solutions comes as a licensed offering or in a software-as-a-service model. With our SiteAdvisor acquisition in the second quarter of 2006, we now offer unique web security with our McAfee Total Protection Solutions.

 

Our consumer products are also based on McAfee global protection technology and use McAfee Avert Labs research to provide our customers with online threat updates and up-to-date protection within our products.

 

Our network protection offerings help enterprises, small businesses, government agencies, educational organizations and service providers maximize the availability, performance and security of their network infrastructure. McAfee’s network protection solutions defend against network worms, intrusions, denial-of-service and other network-borne threats.

Our messaging and web security offerings provide gateway defense at an organization’s perimeter for systems such as web servers and email servers.

 

Compliance Management Offerings

 

Our compliance solutions can identify and resolve policy issues in a measurable and sustainable manner. McAfee’s compliance management portfolio offerings can help ensure compliance objectives are met across an organization — from the identification of security risks to the enforcement of security policies and audit against increasing regulations. McAfee’s network access control solution, McAfee NAC, supports internal security policies by preventing non-compliant personal computers (“PC’s”) from connecting to the internal network. Our McAfee Foundstone offerings assess and prioritize risks from vulnerabilities and threats and can be integrated with our McAfee Preventsys Risk Analyzer, McAfee Preventsys Compliance Auditor, the McAfee Policy Auditor and McAfee Remediation Manager to provide advanced risk mitigation, further assisting regulatory compliance. The latter offering joined the McAfee Compliance product line via acquisition of Preventsys in 2006. Onigma, a 2006 acquisition, adds data loss prevention capabilities to the compliance management portfolio. Data Loss Prevention (“DLP”) represents an exciting new technology addressing an increasingly visible problem shared by many companies. Citadel, another 2006 acquisition, adds security policy compliance plus automated vulnerability remediation (e.g. patch management) capabilities.

 

Unified Management Offerings

 

Our offering, McAfee ePolicy Orchestrator, is the unified management platform that links our protection and compliance capabilities and provides our customers with centralized policy management, common agent, efficient deployment and administration processes. Generally, our protection and compliance capabilities contained in the McAfee Total Protection Solutions are integrated with our McAfee ePolicy Orchestrator.

 

Mobile Security Offerings

 

Our mobile security offerings proactively protect mobile operators and their users by safeguarding mobile networks, terminals, applications and content. Our mobile security offerings limit the spread of mobile malware, inappropriate content, and unsolicited messaging. In addition, these offerings lessen negative brand impact, recovery costs, customer service issues and revenue disruption while enabling future operator strategies such as mobile payments, location-based services and mobile advertising. Our approach enables mobile network operators to assess global and local risks, protect their network and devices, and recover from attacks to their environment.

 

SiteAdvisor

 

We acquired SiteAdvisor Inc. in April 2006. SiteAdvisor’s innovative technology helps protect internet users from a broad range of security threats including spyware, spam and identity theft scams. Using a proprietary database of automated safety tests covering a substantial portion of the internet, SiteAdvisor’s software adds easy-to-understand safety annotations to websites, search engine results and links in e-mail and instant messages.

 

The basic version of SiteAdvisor is currently free. SiteAdvisor is included as a feature in each of our suite products worldwide. SiteAdvisor was introduced into certain of our enterprise security solutions in 2007. SiteAdvisor Plus is a paid version of SiteAdvisor that contains additional premium features.

 

Expert Services and Technical Support

 

Our McAfee Professional Services and McAfee Technical Support provide professional assistance in the design, installation, configuration and support of our customers’ products. We offer a range of consulting and educational services under both the McAfee and Foundstone banners.

 

Our McAfee Professional Services provide product design and deployment support with an array of standardized and custom offerings. This business is organized around our major product groupings and also offers a range of classroom education courses designed to assist customers and partners in their deployment and operation

of McAfee’s products. Services are also available to help our customers plan for upgrades or enhancements of security infrastructure, and to respond to serious security outbreaks.

 

Our Foundstone Consulting Services include (i) threat modeling to identify potential software security problems, (ii) security assessments and (iii) education. Foundstone Consulting Services assist clients in the early assessment, design, and enhancement of their security and risk architectures. Through research and innovation, the Foundstone Security Practice is able to advise government and commercial organizations on the most effective countermeasures required to meet business and legislative policies for security and privacy. Foundstone Consulting Services are augmented by a range of classroom-based training and education courses.

 

McAfee Technical Support provides our customers online, telephone-based, and on-site technical support in an effort to ensure that our products are installed and working properly. Our support offerings include Tier I, Tier II, Tier III and Platinum support, providing varying levels of support for single consumers up through the largest organizations. All Technical Support programs include regular software updates and upgrades, and are available to customers worldwide from various regional support centers.

 

We have enhanced our support capabilities through our McAfee Virtual Technician (“MVT”), which provides automated online troubleshooting and assistance. MVT enables a growing percentage of customers to obtain the necessary assistance and resolution quickly, directly, and exclusively online — solving their problems and increasing satisfaction, while lowering costs.

 

Research and Development, Investments and Acquisitions

 

The market for computer software has low barriers to entry, is subject to rapid technological change, and is highly competitive with respect to timely product introductions. We believe that our ability to maintain our competitiveness depends in large part upon our ability to develop, acquire, integrate, and launch new products and solutions, and to enhance existing offerings.

 

Our research and development efforts support all of our offerings. They refine our security risk management processes, improve our product design and usability, and keep us on the forefront of threat research. Most importantly, our research helps ensure that our customers are protected.

 

In addition to developing new offerings and solutions, our development staff also focuses on upgrades and updates to existing products and on enhancement and integration of acquired technology. Future upgrades and updates may include additional functionality to respond to market needs, while also assuring compatibility with new systems and technologies.

 

We are committed to researching malicious code and vulnerability through our McAfee Avert Labs organization. McAfee Avert Labs conducts research in the areas of host intrusion prevention, network intrusion prevention, wireless intrusion prevention, malicious code defense, security policy and management, high-performance assurance and forensics and threats, attacks, vulnerabilities and architectures.

 

For 2006, 2005 and 2004, we expensed $193.4 million, $176.4 million and $174.9 million, respectively, on research and development as incurred.

 

As part of our growth strategy, we have also made and expect to continue to make acquisitions of, or investments in, complementary businesses, products and technologies.

 

OUR CUSTOMERS AND MARKETS

 

We develop, market, distribute and support computer security solutions for large enterprises, governments, small and medium-sized business and individual consumers through a network of qualified partners and other distribution models. We do business in five geographic regions: North America; Europe, Middle East and Africa, collectively referred to as EMEA; Japan; Asia-Pacific, excluding Japan; and Latin America. For financial information about foreign and domestic operations, see Note 19 to our consolidated financial statements included elsewhere in this report.

Business to Business Solutions

 

We market our business solutions and offerings to commercial and government customers through resellers and distributors. Our two largest distributors, Ingram Micro Inc. and Tech Data Corp., together accounted for approximately 28% of our net revenue in 2006.

 

Consumer Solutions

 

We market our consumer solutions and offerings to individual consumers directly through online distribution methods, and indirectly through traditional distribution channels, such as retail and original equipment manufacturers (“OEMs”). Our McAfee consumer business is responsible for online distribution of our products sold to individual consumers over the internet, including products distributed by our online partners, and for licensing of technology to strategic distribution partners for sale to individual consumers, with certain exceptions.

 

LICENSING MODELS

 

Our customers can obtain our offerings through either perpetual or term licensing, or software-as-a-service models (“SaaS”).

 

Product Licensing Model

 

We typically license our software products to corporate and government customers using our perpetual-plus licensing arrangements, which provide a perpetual license coupled with an initial support period of one year. We also sell perpetual licenses in connection with sales of our hardware-based products in which software is bundled with the hardware platform. Most of our licenses are sold with renewable annual maintenance contracts.

 

Online Subscriptions and Managed Applications

 

For our online subscription services, customers “rent” or subscribe to the use of our security services for a defined period of time. Because our online subscription services are versionless, or self-updating, customers subscribing to these services are always using the most recent version of the software without having to purchase product updates or upgrades. Our online subscription consumer products and services are found at our website (www.mcafee.com) where customers download our applications. These enable detection and elimination of viruses on their PCs, repair of their PCs from damage caused by some viruses, and optimization of their hard drives. Our website offers McAfee SiteAdvisor for free download and offers McAfee SiteAdvisor Plus, McAfee Virus Scan Plus, McAfee Internet Security Suites and McAfee Total Protection for customers to purchase.

 

Our online subscription services are also available to customers and small business through various channel relationships with internet service providers (“ISPs”), such as AOL and Comcast, and available through PC suppliers, such as Dell and Gateway. ISPs offer McAfee subscription services as either a standard feature included in their service, or as a premium service.

 

Similarly, McAfee Total Protection provides our customers our most up-to-date protection software. This offering provides protection for both desktop/laptop PCs and file servers. In addition, McAfee Managed Mail Protection screens emails to detect spam and to quarantine viruses and infected attachments. Our McAfee Desktop Firewall blocks unauthorized network access and stops known network threats.

 

We also make our online subscription products and services available over the internet as a managed environment. Unlike our online subscription service solutions, these managed service provider (“MSP”) solutions are customized, monitored and updated by networking professionals for a specific customer.

 

MCAFEE MARKETING AND SALES

 

Our marketing and sales activities are directed at larger corporate and government customers, small and medium-sized companies and consumers. We engage resellers, distributors, system integrators, internet service providers and OEMs worldwide, through multiple channels.

Resellers and Distributors

 

In all of our geographic regions, most McAfee products are sold through partners, including corporate resellers, distributors, retailers, service providers and OEMs. In addition, our channel efforts include strategic alliances with complementary manufacturers to expand our reach and scale. We currently utilize corporate resellers, including ASAP Software, Inc., CDW Corporation, Computacenter PLC, Dell Inc., Dimension Data, Gateway, Inc., Insight Enterprises, Inc., Softmart, Inc., Software House International, Softchoice Corporation, Telefonica S.A., Terra Networks S.A. and others, as well as network and systems integrators who offer our solutions to corporate, small and medium-business and government customers.

 

Independent software distributors who currently supply our products include Avnet, Inc., Ingram Micro Inc., MOCA and Tech Data Corporation. These distributors supply our products primarily to large retailers, value-added resellers (“VARs”), mail order and telemarketing companies. We also sell our retail packaged products through several of the larger computer and software retailers, including Best Buy, Costco, Dixons, Fry’s, Office Depot, Office Max, Staples, Wal-Mart and Yamada. McAfee marketing and sales work closely with our major reseller and distributor accounts to manage demand generating activities, training, order flow and affiliate relationship management.

 

Our top ten distributors typically account for 45% to 65% of our net revenue quarterly. Our agreements with our distributors are not exclusive and may be terminated by either party without cause. Terminated distributors may not continue to sell our products. If one of our significant distributors terminated its relationship with us, we could experience a significant disruption in the distribution of our products.

 

We utilize a sell-through business model for distributors under which we recognize revenue at the time our distributors sell the products to their customers. Under this business model, our distributors are permitted to purchase software licenses at the same time they fill customer orders and to pay for hardware and retail products only when these products are sold by our distributors to their customers. In addition, prior to the sale of our products to the distributors’ customers, our distributors are permitted rights of return subject to varying limitations. After a sale by a distributor to its customer, there is generally no right of return from the distributor to us with respect to such product, unless we approve the return from the final customer to the distributor.

 

Original Equipment Manufacturers

 

OEMs license our products for resale to end users or inclusion with their products. For example, we are a security services provider for PC hardware manufacturers such as Dell, Inc., Gateway, Inc. (recently acquired by Acer), Samsung and Toshiba Corporation. Depending on the arrangement, OEMs may sell our software bundled with the PC or related services, pre-install our software and allow us to complete the sale, or sublicense a single version of our products to end users who must register the product with us in order to receive updates.

 

Strategic Alliances

 

From time to time, we enter into strategic alliances with third parties to support our future growth plans. These relationships may include joint technology development and integration, research cooperation, co-marketing activities and/or sell-through arrangements. Strategic alliance partners include AOL, AT&T, Cable and Wireless PLC, Comcast Corporation, Dell, Inc., Gateway, Inc. (recently acquired by Acer), Telecom Italia S.p.A. and Telefonica S.A., among others. Also, in 2007 EMC Corporation/RSA became a new partner. As part of our NTT DoCoMo alliance in Japan, we have jointly developed technology to provide integrated malware protection against mobile threats to owners of 3G FOMA handsets.

 

Sales in North America

 

Our North American sales force is organized by product offerings and customer type. Most of our commercial customers are served through reseller partners. A subset of our sales representatives focus on renewing the McAfee systems security installed base, while a larger group focuses on our full offering of Security Risk Management products and upgrades. Small business customers are served primarily through our reseller partners with a channel

marketing organization assisting with lead generation, and a channel support team responsible for partner training and support.

 

Sales outside of North America

 

Outside of North America, we have sales and support operations in EMEA, Japan, Asia-Pacific, and Latin America. In 2006, 2005, and 2004, net revenue outside of North America accounted for approximately 45%, 43% and 39% of our net revenue, respectively.

 

Within our global geographies, our sales resources are organized by country, and the larger markets may further segment their sales resources by McAfee product line and/or customer segments.

 

Other Marketing Activities

 

We use channel marketing to market, promote, train and provide incentives to our resellers and distributors, and to promote our offerings to their end-user customers. We offer our resellers and distributors technical and sales training classes, online training resources, and marketing and sales demand generation assistance kits. We also provide specific cooperative marketing programs for end-user seminars, catalogs, demand creation programs, sales events, and other items.

 

One of the principal means of marketing our products and services is online via the internet. Our website, www.mcafee.com, supports marketing activities to our key customer and prospect segments, including home and home office users, small and medium-sized businesses, large enterprises and our partner community. Our website contains various marketing materials and information about our products. Our customers can download and purchase some products directly online. We also promote our products and services through advertising activities in trade publications, direct mail campaigns, television and strategic arrangements, as well as online through key word and search-based advertising. In addition, we attend trade shows, industry conferences, and publish periodic channel and customer newsletters.

 

We also market our products through the use of rebate programs and marketing funds. Within most countries, we typically offer volume incentive rebates to strategic channel partners and promotional rebates to end users. Our strategic channel partners may earn a volume incentive rebate primarily based upon their sale of our products to end users.

 

COMPETITION

 

The markets for our products are intensely competitive and are subject to rapid changes in technology. We also expect competition to continue to increase in the near-term. We believe that the principal competitive factors affecting the markets for our products include, but are not limited to:

 

 

 

We believe that we compete favorably against our competitors in many of these areas. However, some of our competitors have longer operating histories, greater brand recognition, stronger relationships with strategic channel partners, larger technical staffs, established relationships with hardware vendors and/or greater financial, technical and marketing resources, and other advantages. These factors may provide our competitors with an advantage in penetrating markets with their security and management products.

 

System Protection Market.  Our principal competitors in the anti-virus market are Symantec Corp., CA, Inc., and Microsoft Corporation. Trend Micro Inc. remains the strongest competitor in the Asian anti-virus market and has entered the U.S. and EMEA markets. Kaspersky Lab, Inc., Panda Software, Sophos, F-Secure Corporation and Dr. Ahn’s Anti-Virus Lab are also competitors in their respective markets.

 

Network Protection Market.  Our principal competitors in the network protection market are Cisco Systems Inc., CA, Inc., IBM (which acquired Internet Security Systems in October 2006), Juniper Networks, Inc., Symantec Corp., Check Point Software Technologies Ltd. and 3Com Corporation. IBM, Qualys and nCircle are the strongest competitors for our Foundstone products and solutions.

 

Web Security Market.  Our principal competitors in the web security market, which includes our SiteAdvisor products, include Microsoft Corporation, Trend Micro, Inc. and various search engine providers, namely Google, Inc. and Yahoo!, Inc. In addition, we anticipate that Symantec Corporation may enter this market in the near future.

 

Other Competitors.  In addition to competition from large technology companies such as Hewlett-Packard Co., IBM, Novell Inc. and Microsoft Corporation, we also face competition from smaller companies and shareware authors that may develop competing products.

 

OUR PROPRIETARY TECHNOLOGY

 

Our success depends significantly upon proprietary software technology. We rely on a combination of patents, trademarks, trade secrets and copyrights to establish and protect proprietary rights to our software. However, these protections may be inadequate or competitors may independently develop technologies or products that are substantially equivalent or superior to our products. Often, we do not obtain signed license agreements from customers who license products from us. In these cases, we include an electronic version of an end-user license in all of our electronically distributed software and a printed license in the box for our products. Since none of these licenses are signed by the licensee, many legal authorities believe that such licenses may not be enforceable under the laws of many states and foreign jurisdictions. In addition, the laws of some foreign countries either do not protect these rights at all or offer only limited protection for these rights. The steps taken by us to protect our proprietary software technology may be inadequate to deter misuse or theft of this technology. For example, we are aware that a substantial number of users of our anti-virus products have not paid any license or support fees to us.

 

OUR EMPLOYEES

 

As of December 31, 2006, we employed approximately 3,700 individuals worldwide. Less than 2% of our employees are represented by a labor union. Competition for qualified management and technical personnel is intense in the software industry. Our continued success depends in part upon our ability to attract, assimilate and retain qualified personnel. To date, we believe that we have been successful in recruiting qualified employees, but there is no assurance that we will continue to be successful in the future.

ADDITIONAL INFORMATION

 

We file registration statements, periodic and current reports, proxy statements, and other materials with the Securities and Exchange Commission (“SEC”). You may read and copy any materials we file with the SEC at the SEC’s Office of Public Reference at 100 F Street, NE, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains a web site at www.sec.gov that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC, including our filings. Other than the information expressly set forth in this annual report, on Form 10-K, the information contained or referred to on our website is not part of this annual report. We make available, free of charge, through the investor relations section of our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and any amendments to those reports filed pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after they are electronically filed with or furnished to the SEC. The contents of our website are not incorporated into, or otherwise to be regarded as part of this Annual Report on Form 10-K.

 

 

Investing in our common stock involves a high degree of risk. The risks described below are not the only ones facing our company. Additional risks not presently known to us or that we deem immaterial may also impair our business operations. Any of the following risks could materially adversely affect our business, operating results and financial condition and could result in a complete loss of your investment.

 

We Are Subject to Intense Competition and We Expect to Face Increased Competition in the Future.

 

The markets for our products are intensely competitive and we expect both product and pricing competition to increase. If our competitors gain market share in the markets for our products, our business and operating results could be adversely affected.

 

As competition increases, we expect increases in our product-related expenses, including increased product rebates, funds provided to our partners for marketing and strategic channel partner revenue-sharing agreements. Some of our competitors have longer operating histories, have more extensive international operations, greater name recognition, larger technical staffs, established relationships with hardware vendors and/or greater financial, technical and marketing resources. Our principal competitors in specific product markets include, but are not limited to:

 

 

Other competitors for our various products could include large technology companies. We also face competition from numerous smaller companies, shareware and freeware authors and open source projects that may develop competing products, as well as from future competitors, currently unknown to us, who may develop competing products or enter into our product markets.

 

A significant portion of our revenue comes from our consumer business. We focus on growth in this segment both directly and through relationships with ISPs such as AOL and Comcast, and PC OEMs, such as Dell, Acer/

Gateway and Toshiba. As competition in this market increases, we have experienced and expect continued pricing pressures from both our competitors and partners that have had and may continue to have a negative effect on our ability to sustain our revenue and market share growth. In addition, as our consumer business becomes more dependent upon the partner model, our direct online revenue may suffer and our retail business may also continue to decline. Further, as penetration of the consumer anti-virus market through the ISP model increases, we expect that pricing and competitive pressures in this market will become even more acute.

 

Increasingly, our competitors are large vendors of hardware or operating system software. These competitors are continuously developing or incorporating system and network protection functionality into their products. For example, in the second quarter of 2006 Microsoft released its consumer security solution and continues to execute on its announced plans to boost the security functionality of its Windows platform through its acquisition of managed service provider FrontBridge Technologies, anti-virus provider Sybari Software, Inc. and anti-spyware provider GIANT Company Software. Through its acquisitions of Okena, Inc., Riverhead Networks and NetSolv, Cisco Systems Inc. may incorporate into its firewall and router products functionality which competes with our content filtering and anti-virus products. In addition, Juniper Networks, Inc. acquired Netscreen Technologies, which allows them to incorporate intrusion prevention solutions into their firewalls and routers.

 

The widespread inclusion of products that perform the same or similar functions as our products within computer hardware or other companies’ software products could reduce the perceived need for our products or render our products obsolete and unmarketable. Even if these competitors’ incorporated products are inferior or more limited than our products, customers may elect to accept the incorporated products rather than purchase our products. For example, Microsoft over time has sought to add security features to its operating systems that would provide functionality similar to what our products offer. We believe that Microsoft has in the past and may in the future increase such security features while at the same time making it more difficult for us to integrate our products with its operating systems. We could be adversely affected if our customers generally believe that Microsoft’s integrated offerings reduce the need for our products or if they prefer products that Microsoft chooses to bundle with its operating systems, as these products and the use of bundling could impair our ability to generate sales of our products to and through PC OEMs.

 

In addition, the software industry is currently undergoing consolidation as firms seek to offer more extensive suites and broader arrays of software products, as well as integrated software and hardware solutions. This consolidation may negatively impact our competitive position. Additionally, if our competitors’ products are offered at significant discounts to our prices or are bundled for free, we may be unable to respond competitively, or may have to significantly reduce our prices, which could negatively impact our revenue and gross margins.

 

Software-as-a-service (SaaS) is becoming an increasingly important method and business models for the delivery of applications. SaaS models enable software owners to offer extensible software applications to customers for their use over the Internet, allowing customers to purchase and use applications and modules on a subscription basis, without the need for individual client installations or high maintenance costs. Because of the advantages that SaaS models offer over traditional software sales and licensing, competitors using SaaS models could enjoy growth in their businesses and, as a result, we could lose business to such competitors.

 

We Face Product Development Risks Associated with Rapid Technological Changes in Our Market.

 

The markets for our products are highly fragmented and characterized by ongoing technological developments, evolving industry standards and rapid changes in customer requirements. Our success depends on our ability to timely and effectively:

 

 

 

We may experience delays in product development as we have at times in the past. Complex products like ours may contain undetected errors or version compatibility problems, particularly when first released, which could delay or harm market acceptance. In addition, we may choose not to deliver a previously announced product. The widespread inclusion of products that perform the same or similar functions as our products within the Windows platform could reduce the perceived need for our products. For example, in the second quarter of 2006 Microsoft executed on its announced plans to boost the security functionality of its Windows platform. Even if these incorporated products are inferior or more limited than our products, customers may elect to accept the incorporated products rather than purchase our products. The occurrence of these events could negatively impact our business.

 

In addition, we must continuously work to ensure that our products meet industry certifications and standards. Failure to meet industry standards and obtain product certifications could cause us to lose customers and sales and could impact our business. Also, if we fail to recognize and adapt to industry trends which challenge traditional software licensing models, including virtualization technologies that impact how software is purchased and deployed, we may experience lower revenues as a result.

 

The Discovery That We Had Retroactively Priced Stock Options and Had Not Accounted for Them Correctly May Result in Continued or Additional Litigation, Regulatory Proceedings and Government Enforcement Actions.

 

In May 2006, we announced that we had commenced an investigation of our historical stock option granting practices. In June 2006, we received a document subpoena from the Securities and Exchange Commission, or SEC, related to our historical stock option granting practices. Also, around the same time, we received a notice of informal inquiry from the United States Department of Justice, or DOJ, concerning our stock option granting practices. In this Form 10-K, we are filing restated consolidated financial statements for the years ended December 31, 2005 and 2004 to make certain non-cash, and other, adjustments as a result of our review of our historical stock option granting practices. In addition, we are also restating our condensed consolidated financial statements for the quarters ended June 30, 2005, September 30, 2005, and March 31, 2006 in our Form 10-Qs for the quarters ended June 30, 2006, September 30, 2006 and March 31, 2007, filed simultaneously with this annual report on Form 10-K. In connection with the restatement, we recorded additional pre-tax, non-cash, stock-based compensation expense totaling $137.4 million, consisting of $3.4 million ($2.5 million, net of tax) for the year ended December 31, 2005, $10.8 million ($7.2 million, net of tax) for the year ended December 31, 2004 and $123.1 million ($80.5 million, net of tax) for the periods 1995 through 2003.

 

The filing of our restated consolidated financial statements does not resolve the pending SEC inquiry into our historical stock option granting practices. We are engaged in ongoing discussions with, and continue to provide information to, the SEC regarding certain of our prior period consolidated financial statements. The resolution of the SEC inquiry into our historical stock option granting practices could require the filing of additional restatements of our prior consolidated financial statements or require that we take other actions not presently contemplated.

 

As part of the remedial actions we have taken in connection with the investigation and restatement, we have terminated for cause the employment of some employees, including former executive officers. We are the subject of litigation and similar proceedings in connection with such terminations, and we expect that we may be subject to similar actions in the future. In addition, terminations and related actions, litigations and proceedings may require

us to make severance, settlement or other related payments in the future, which could adversely impact our operating results.

 

We cannot predict the outcome of the pending government inquiries or stockholder or other lawsuits, and we may face additional government inquiries, stockholder lawsuits and other legal proceedings related to our historical stock option granting practices and the remedial actions we have taken. We cannot predict what, if any, enforcement action the SEC or DOJ will take with respect to our failure to be current in our periodic reports or our historical stock option granting practices. All of these events have required us, and we expect will continue to require us, to expend significant management time and incur significant accounting, legal, and other expenses and ultimately adversely affect our financial condition and results of operations.

 

Our International Operations Involve Risks Which Could Increase our Expenses Adversely, Impact Our Operating Results and Divert the Time and Attention of Management.

 

During 2006, net revenue in our operating regions outside of North America represented approximately 45% of our total net revenue. We expect international revenue to remain a significant percentage of our net revenue and our continued focus on international growth exposes us to numerous risks, the impact of any of which could adversely affect our operating results.

 

Risks related to our international operations and strategy and specific to our company include:

 

 

The impact of any one or more of these risks could negatively affect our business and operating results. Generally, we are subject to a lower blended corporate tax rate on our international sales. Changes in domestic or

international tax regulations could adversely affect this arrangement in the future and impact our ability to realize similar tax benefits.

 

We Face a Number of Risks Related to Our Product Sales Through Intermediaries.

 

We sell a significant amount of our products through intermediaries such as distributors, PC OEMs, ISPs and other strategic channel partners, referred to collectively as distributors. Our top ten distributors typically represent approximately 45% to 65% of our net sales in any quarter. We expect that this percentage will increase as we continue to focus our sales efforts through our channel partners and other partners. Our two largest distributors, Ingram Micro Inc. and Tech Data Corporation, together accounted for approximately 28% of our net revenue during 2006.

 

Uncertain Timing and Delivery of Products

 

We may be unable to determine and unable to control the timing of the delivery of our products to end users by our distributors, which may make it difficult for us to forecast our revenue with respect to product sales through these intermediaries. Our reseller and OEM partners are not subject to any minimum sales volumes with respect to our products and, as such, the revenue attributable to sales from these distributors is uncertain and may vary significantly from period to period, affecting our operating results. Volume of product shipped by our OEM partners depends on volumes of the OEM partners’ products shipped, which is generally outside of our control.

 

Sale of Competing Products

 

Our distributors and resellers may sell other vendors’ products that are complementary to, or compete with, our products. While we have instituted programs designed to motivate our distributors and resellers to focus on our products, these distributors may give greater priority to products of other suppliers, including competitors. Our ability to meaningfully increase the amount of our products sold through our distributors and resellers depends on our ability to adequately and efficiently support these partners with, among other things, appropriate financial incentives to encourage pre-sales investment and sales tools, such as online sales and technical training and product collateral needed to support their customers and prospects. Any failure to properly and efficiently support our partners in this manner may result in them focusing more on our competitors’ products rather than our products and lost sales opportunities.

 

Loss of a Distributor

 

The agreements we have with our distributors, including those we have with Ingram Micro Inc. and Tech Data Corporation, are generally terminable by either party without cause with no or minimal notice or penalties. We may expend significant time, money and resources to further relationships with our distributors that are thereafter terminated. If one of our significant distributors terminated its agreement with us, we could experience a significant interruption in the distribution of our products. In addition, our business interests and those of our distributors may diverge over time, which could result in conflict, and termination of, or a reduction in, collaboration. In the past, our acquisition activity has resulted in the termination of distributor relationships. Future acquisition activity could cause similar termination of, or disruption in, our distributor relationships, which could adversely impact our revenues.

 

Payment Difficulties

 

Some of our distributors may experience financial difficulties, which could adversely impact our collection of accounts receivable. Our allowance for doubtful accounts was approximately $2.0 million as of December 31, 2006. We regularly review the collectability and credit-worthiness of our distributors to determine an appropriate allowance for doubtful accounts. Our uncollectible accounts could exceed our current or future allowances.

 

Pricing Competition

 

Increased competition in the markets in which we operate, particularly in connection with bids for PC OEM business, has led to increased pricing pressures. In the event that any of our PC OEM partners or other distributors

terminates their relationship with us, our revenues could decline and our business may be harmed. Further, to the extent that any of our PC OEM partners or other distributors renegotiates its arrangement with us on less favorable terms, our operating results could be harmed.

 

We Face Risks Associated with Past and Future Acquisitions.

 

We may buy or make investments in complementary companies, products and technologies. For example, in October 2004 we acquired Foundstone to bolster our risk assessment and vulnerability management capabilities and in June 2005 we acquired Wireless Security Corporation to continue to develop their patent-pending technology to introduce a new consumer wireless security offering, and to integrate the technology into our small business managed solution. In addition, we acquired SiteAdvisor in April 2006, Preventsys in June 2006, Onigma Ltd. in October 2006 and substantially all of the assets of Citadel Security Software Inc. in December 2006. In November 2007 we acquired SafeBoot, and we expect to close our acquisition of ScanAlert in January 2008. We may not realize the anticipated benefits from these acquisitions. Future acquisitions could result in significant acquisition-related charges and dilution to our stockholders.

 

We face a number of risks relating to our acquisitions, including the following, any of which could harm our ability to achieve the anticipated benefits of our past or future acquisitions.

 

Integration

 

Integration of an acquired company or technology is a complex, time consuming and expensive process. The successful integration of an acquisition requires, among other things, that we:

 

 

The geographic distance between the companies, the complexity of the technologies and operations being integrated and the disparate corporate cultures being combined may increase the difficulties of integrating an acquired company or technology. Management’s focus on the integration of operations may distract attention from our day-to-day business and may disrupt key research and development, marketing or sales efforts. In addition, it is common in the technology industry for aggressive competitors to attract customers and recruit key employees away from companies during the integration phase of an acquisition. If integration of our acquired businesses or assets is not successful, we may experience adverse financial or competitive effects which we currently do not anticipate.

 

Internal Controls, Policies and Procedures

 

Acquired companies or businesses are likely to have different standards, controls, contracts, procedures and policies, making it more difficult to implement and harmonize company-wide financial, accounting, billing, information and other systems. This risk is amplified by the increased costs and efforts in connection with compliance with the Sarbanes-Oxley Act.

 

“Open Source” Software

 

Despite having conducted the appropriate due diligence prior to the consummation of an acquisition, products or technologies acquired by us may nonetheless include so-called “open source” software which was not identified during the initial due diligence. Open source software is typically licensed for use at no initial charge, but imposes on the user of the open source software certain requirements to license to others both the open source software as well as the software that relates to, or interacts with, the open source software. Our ability to commercialize

products or technologies incorporating open source software or otherwise fully realize the anticipated benefits of any such acquisition may be restricted because, among other reasons open source license terms may be ambiguous and may result in unanticipated or uncertain obligations regarding our products; and it may be difficult for us to accurately determine the developers of the open source code and whether the acquired software infringes third-party intellectual property rights.

 

Use of Cash and Securities

 

Our available cash and securities may be used to acquire or invest in companies or products. For example, in November 2007, we used approximately $350 million to acquire SafeBoot, B.V., and in January 2008, we expect to close the acquisition of ScanAlert, Inc., in which we will use approximately $51 million. In December 2006, we used approximately $61.2 million to acquire substantially all of the assets of Citadel Security Software Inc. and in October 2006, we used approximately $19.1 million to acquire Onigma, Ltd. In June 2006, we used approximately $4.8 million to acquire Preventsys, Inc., in April 2006 we used approximately $61.0 million to acquire SiteAdvisor, Inc. and in June 2005, we used approximately $20.3 million to acquire Wireless Security Corporation. Moreover, if we acquire a company, we may have to incur or assume that company’s liabilities, including liabilities that may not be fully known at the time of acquisition.

 

Accounting Charges

 

Acquisitions may result in substantial accounting charges for restructuring and other expenses, write-off of in-process research and development, future impairment of goodwill, amortization of intangible assets and stock-based compensation expense, any of which could materially adversely affect our operating results.

 

Critical Personnel May Be Difficult to Attract, Assimilate and Retain.

 

Our success depends in large part on our ability to attract and retain senior management personnel, as well as technically qualified and highly-skilled sales, consulting, technical, finance and marketing personnel. Other than executive management who have “at will” employment agreements, our employees are not typically subject to an employment agreement or non-competition agreement. In the recent past we have experienced significant turnover in our senior management team and in our worldwide sales and finance organization and replacing this personnel remains difficult.

 

Once we become current in our reporting obligations and our registration statements on Form S-8 are declared effective with respect to shares of common stock underlying our stock option plans and outstanding stock option awards, we expect some increase in short-term attrition rates as employees are able exercise stock options which they have been unable to exercise as a result of our aforementioned blackout period on stock option exercises.

 

It could be difficult, time consuming and expensive to replace any key management member or other critical personnel. Integrating new management and other key personnel also may be difficult and costly. Changes in management or other critical personnel may be disruptive to our business and might also result in our loss of unique skills and the departure of existing employees and/or customers. It may take significant time to locate, retain and integrate qualified management personnel.

 

Other personnel related issues that we may encounter include:

 

Competition for Personnel; Need for Competitive Pay Packages

 

Competition for qualified individuals in our industry is intense. To attract and retain critical personnel, we believe that we must maintain an open and collaborative work environment. We also believe we need to provide a competitive compensation package, including stock options and restricted stock. Increases in shares available for issuance under our stock option plans require stockholder approval. Institutional stockholders, or our other stockholders, may not approve future requests for increases in shares available under our equity incentive plans. For example, at our 2003 annual meeting held in December 2003, our stockholders did not approve a proposed increase in shares available for grant under our employee stock option plans. Additionally, as of January 1, 2006, we are required to include compensation expense in our consolidated statement of income and comprehensive income

relating to the issuance of employee stock options. We are currently evaluating our compensation programs and in particular our equity compensation philosophy. In the future, we may decide to issue fewer stock options, possibly impairing our ability to attract and retain necessary personnel. Conversely, issuing a comparable number of stock options could adversely impact our results of operations when compared with periods prior to the effective date of these new rules.

 

Reduced Productivity of New Hires; Senior Management Changes

 

We continue to hire in key areas and have added a number of new employees in connection with our acquisitions. We have also increased our hiring in Bangalore, India in connection with the relocation of a significant portion of our research and development operations to India.

 

During 2006 and 2007, we experienced significant change in our senior management team and we may continue to experience such changes. Our former general counsel was terminated for cause in May 2006, our former president was terminated in October 2006, our former chief executive officer, George Samenuk, retired in October 2006, and for a significant period during 2006 and 2007 several other key senior management positions were vacant. The board determined the termination of our former president was for cause. In March 2007, we announced the appointment of David DeWalt as our chief executive officer and president, effective April 2007, who replaced Dale Fuller, who served as our interim chief executive officer and president from October 2006 to April 2007. Most recently, in September 2007, we announced the appointment of Mark Cochran as our general counsel, and in October 2007, we announced the appointment of Michael DeCesare as our executive vice president of worldwide sales operations.

 

For new employees or changes in senior management, there may be reduced levels of productivity as recent additions or hires are trained or otherwise assimilate and adapt to our organization and culture. The significant turnover in our senior management team during 2006 and 2007 may make it difficult to attract new employees and retain existing employees. Further, this turnover may also make it difficult to execute on our business plan and achieve our planned financial results.

 

Our Financial Results Will Likely Fluctuate, Making It Difficult for Us to Accurately Estimate Operating Results.

 

Our revenues, gross margins and operating results have varied significantly in the past, and we expect fluctuations in our operating results to continue in the future due at least in part to a number of factors, many of which are outside of our control and which could adversely affect our operations and operating results. Our expenses are based in part on our expectations regarding future revenues, making expenses in the short term relatively fixed. We may be unable to adjust our expenses in time to compensate for any unexpected revenue shortfall. If our quarterly financial results or our predictions of future financial results fail to meet the expectations of securities analysts and investors, our stock price could be negatively affected. Any volatility in our quarterly financial results may make it more difficult for us to raise capital in the future or pursue acquisitions that involve issuances of our stock. Our operating results for prior periods may not be effective predictors of our future performance.

 

Factors that may cause our revenues, gross margins and operating results to fluctuate significantly from period to period, include, but are not limited to the following:

 

 

 

Although a significant portion of our revenue in any quarter comes from previously deferred revenue, a meaningful part of our revenue in any quarter depends on contracts entered into or orders booked and shipped in that quarter. Historically, we have experienced more product orders, and hence, a higher percentage of revenue shipments, in the last month of our fiscal quarters. Some customers believe they can enhance their bargaining power by waiting until the end of our quarter to place their order. Any failure or delay in the closing of significant new orders in a given quarter could have a material adverse effect on our quarterly operating results. In addition, a significant portion of our revenue is derived from product sales through our distributors. We recognize revenue on products sold by our distributors when distributors sell our products to their customers. To determine our business performance at any point in time or for any given period, we must accurately gather sales information on a timely basis from our distributors’ information systems at an increased cost to us. Our distributors’ information systems may be less accurate or reliable than our internal systems. We may be required to expend time and money to ensure that interfaces between our systems and our distributors’ systems are up to date and effective. As our reliance upon interdependent automated computer systems continues to increase, a disruption in any one of these systems could interrupt the distribution of our products and impact our ability to accurately and timely recognize and report revenue. Further, as we increasingly rely upon third-party manufacturers to manufacture our hardware-based products, our reliance on their ability to provide us with timely and accurate product cost information exposes us to risk. A failure of our third-party manufacturers to provide us with timely and accurate product cost information may impact our costs of goods sold and negatively impact our ability to accurately and timely report revenue.

 

Because we expect continued uncertainty relating to these factors, it may be difficult for us to accurately estimate operating results prior to the end of a quarter.

 

We Face Risks in Connection With the Material Weaknesses Identified by Our Management and Any Related Remedial Measures That We Undertake.

 

In conjunction with (i) our ongoing reporting obligations as a public company and (ii) the requirements of Section 404 of the Sarbanes-Oxley Act that management report as of December 31, 2006 on the effectiveness of our

internal control over financial reporting and identify any material weaknesses in our internal control over financial reporting, we engaged in a process to document, evaluate and test our internal controls and procedures, including corrections to existing controls and additional controls and procedures that we may implement. As a result of this evaluation and testing process, our management identified material weaknesses in our internal control over financial reporting relating to (i) our accounting for stock-based compensation expenses related to Company stock options and (ii) our accounting for income taxes.

 

In response to the material weakness in our internal control over financial reporting with respect to our accounting for stock-based compensation expenses, we have implemented additional controls and procedures, including standardizing grant evidence and approval and standardizing grant timing. To ensure the completeness and accuracy of all stock-based compensation expense resulting from the independent investigation, we have implemented controls for accumulation and tracking of stock-based compensation expense, processing and reconciliation of stock-based compensation expense and independent approval and recording of stock-based compensation expense.

 

In response to the material weakness in our internal control over financial reporting with respect to our accounting for income taxes, we have implemented and will continue to implement, additional controls and procedures, including enhancing the training and education of our tax accounting personnel, automating key elements of the calculation for the provision for income taxes and the account reconciliation processes by implementing a new tax accounting system and improving our interim and annual review processes for various calculations, including the tax provision computation process. We also intend to help address material weakness in our internal control over financial reporting with respect to our accounting for income taxes by hiring more tax accounting personnel, with an emphasis on hiring personnel having international tax expertise.

 

These efforts have resulted, and could further result, in increased cost and could divert management attention away from operating our business. As a result of the identified material weaknesses, even though our management believes that our efforts to remediate and re-test our internal control deficiencies have resulted in the improved operation of our internal control over financial reporting, we cannot be certain that the measures we have taken or we are planning to take will sufficiently and satisfactorily remediate the identified material weaknesses.

 

In future periods, if the process required by Section 404 of the Sarbanes-Oxley Act reveals further material weaknesses or significant deficiencies, the correction of any such material weaknesses or significant deficiency could require additional remedial measures which could be costly and time-consuming. In addition, the discovery of further material weaknesses could also require the restatement of prior period operating results. If a material weakness is identified as of a future period year-end (including a material weakness identified prior to year-end for which there is an insufficient period of time to evaluate and confirm the effectiveness of the corrections or related new procedures) or if our previously identified material weaknesses are not remediated, our independent auditors would continue to be unable to express an opinion on the effectiveness of our internal controls. This in turn, could cause us to fail to regain investor confidence in the accuracy and completeness of our financial reports, which could continue to adversely affect our stock price and potentially subject us to litigation.

 

We May Incur Additional Expenses in Order To Assist Our Employees With Potential Income Tax Liabilities Which May Arise Under Section 409A of the Internal Revenue Code.

 

As a result of our investigation into our historical stock option granting practices, we have determined that a number of our outstanding stock option awards were granted at exercise prices below the fair market value of our stock on the appropriate accounting measurement date. The primary adverse tax consequence is that the re-measured options vesting after December 31, 2004 are potentially subject to option holder excise tax under Section 409A of the Internal Revenue Code (and, as applicable, similar excise taxes under state law or foreign law). Our employees who hold options which are determined to have been granted with exercise prices below the fair market value of the underlying shares of common stock on the appropriate measurement date may be subject to taxes, penalties and interest under Section 409A if no action is taken to cure the options from exposure under Section 409A before December 31, 2008.

 

Regarding potential future liabilities associated with Section 409A, we are in the process of determining whether we will implement a plan to assist affected employees and former employees, adjust the terms of the

original option grants, or adjust the terms of the original option grant and pay the affected employees an amount to compensate such employees for this lost benefit. Once we have determined a final course of action in these respects, if we undertake any such plan or process, we anticipate that we will record additional expenses in periods when such actions are taken.

 

We Rely Heavily on Our Intellectual Property Rights, Which Offer Only Limited Protection Against Potential Infringers; Intellectual Property Litigation in the Network and System Security Market is Common and Can Be Expensive.

 

We rely on a combination of contractual rights, trademarks, trade secrets, patents and copyrights to establish and protect proprietary rights in our software. However, the steps taken by us to protect our proprietary software may not deter its misuse, theft or misappropriation. Competitors may independently develop technologies or products that are substantially equivalent or superior to our products or that inappropriately incorporate our proprietary technology. We are aware that a number of users of our security products have not paid registration, license or subscription fees to us. Certain jurisdictions may not provide adequate legal infrastructure for effective protection of our intellectual property rights. Changing legal interpretations of liability for unauthorized use of our software or lessened sensitivity by corporate, government or institutional users to avoiding infringement of intellectual property could also harm our business.

 

Litigation may be necessary to enforce and protect trade secrets, patents and other intellectual property rights that we own. Similarly, we may be required to defend against claimed infringement by others. For example, as discussed in Note 20 to the notes to consolidated financial statements, we are currently defending a patent infringement case seeking preliminary and permanent injunctions against the sale of certain of our products.

 

In addition to the expense and distractions associated with litigation, adverse determinations could:

 

 

The litigation process is subject to inherent uncertainties. We may not prevail in these matters, or we may be unable to obtain licenses with respect to any patents or other intellectual property rights that may be held valid or infringed upon by our products or us.

 

If we acquire a portion of technology included in our products from third parties, our exposure to infringement actions may increase because we must rely upon these third parties as to the origin and ownership of any software being acquired. Similarly, notwithstanding measures taken by our competitors or us to protect our competitors’ intellectual property, exposure to infringement claims increases if we employ or hire software engineers previously employed by competitors. Further, to the extent we utilize “open source” software we face risks. For example, the scope and requirements of the most common open source software license, the GNU General Public License, or GPL, have not been interpreted in a court of law. Use of GPL software could subject certain portions of our proprietary software to the GPL requirements, which may have adverse effects on our sale of the products incorporating any such software. Other forms of “open source” software licensing present license compliance risks, which could result in litigation or loss of the right to use this software.

 

We Face Risks Related to The Strategic Alliances We Use to Distribute Our Products.

 

Through our strategic alliances, we may from time to time license technology from third parties to integrate or bundle with our products or we may license our technology for others to integrate or bundle with their products. We

may not realize the desired benefits from our strategic alliances on a timely basis or at all. We face a number of risks relating to our strategic alliances, including the following:

 

 

Increased Customer Demands on Our Technical Support Services May Adversely Affect Our Relationships with Our Customers and Negatively Impact Our Financial Results.

 

We offer technical support services with many of our products. We may be unable to respond quickly enough to accommodate short-term increases in customer demand for support services. We also may be unable to modify the format of our support services to compete with changes in support services provided by competitors or successfully integrate support for our customers. Further customer demand for these services, without corresponding revenues, could increase costs and adversely affect our operating results.

 

We have outsourced a substantial portion of our worldwide consumer support functions to third-party service providers. If these companies experience financial difficulties, do not maintain sufficiently skilled workers and resources to satisfy our contracts, or otherwise fail to perform at a sufficient level under these contracts, the level of support services to our customers may be significantly disrupted, which could materially harm our relationships with these customers.

 

Failure of Our Products to Work Properly Or Misuse of Our Products Could Impact Sales, Increase Costs, and Create Risks of Potential Negative Publicity and Legal Liability.

 

Our products are complex and are deployed in a wide variety of complex network environments. Our products may have errors or defects that users identify after deployment, which could harm our reputation and our business. In addition, products as complex as ours frequently contain undetected errors when first introduced or when new versions or enhancements are released. We have from time to time found errors in versions of our products, and we may find such errors in the future. Because customers rely on our products to manage employee behavior to protect against security risks and prevent the loss of sensitive data, any significant defects or errors in our products may result in negative publicity or legal claims. The occurrence of errors could adversely affect sales of our products, divert the attention of engineering personnel from our product development efforts and cause significant customer relations or legal problems.

 

Our products may also be misused or abused by customers or non-customer third parties who obtain access and use of our products. These situations may arise where an organization uses our products in a manner that impacts their end users’ or employees’ privacy or where our products are misappropriated to censor private access to the Internet. Any of these situations could result in negative press coverage and negatively affect our reputation.

We Face Manufacturing, Supply, Inventory, Licensing and Obsolescence Risks Relating to Our Products.

 

Third-Party Manufacturing

 

We rely on a small number of third parties to manufacture some of our hardware-based network protection and system protection products. We expect the number of our hardware-based products and our reliance on third-party manufacturers to increase as we continue to expand our portfolio of hardware-based network protection and system protection products. Reliance on third-party manufacturers, including software replicators, involves a number of risks, including the lack of control over the manufacturing process and the potential absence or unavailability of adequate capacity. If any of our third-party manufacturers cannot or will not manufacture our products in required volumes on a cost-effective basis, in a timely manner, at a sufficient level of quality, or at all, we will have to secure additional manufacturing capacity. Even if this additional capacity is available at commercially acceptable terms, the qualification process could be lengthy and could cause interruptions in product shipments. The unexpected loss of any of our manufacturers would be disruptive to our business. Furthermore, supply disruptions or cost increases could increase our costs of goods sold and negatively impact our financial performance. For example, if the price to us of our hardware-based products increased and we were unable to offset the price increase, then the increased cost to us of selling the product could reduce our overall profitability.

 

Sourcing

 

Some of our hardware products contain critical components supplied by a single or a limited number of third parties. Any significant shortage of components or the failure of the third-party supplier to maintain or enhance these products could lead to cancellations of customer orders or delays in placement of orders.

 

Third-Party Licenses

 

Some of our products incorporate software licensed from third parties. We must be able to obtain reasonably priced licenses and successfully integrate this software with our hardware and other software. In addition, some of our products may include “open source” software. Our ability to commercialize products or technologies incorporating open source software may be restricted because, among other reasons, open source license terms may be ambiguous and may result in unanticipated obligations regarding our products.

 

Obsolescence

 

Hardware-based products may face greater obsolescence risks than software products. We could incur losses or other charges in disposing of obsolete inventory. In addition, to the extent that our third-party manufacturers upgrade or otherwise alter their manufacturing processes, our hardware-based products could face supply constraints or risks associated with the transition of hardware-based products to new platforms, which could increase the risk of losses or other charges associated with obsolete inventory.

 

Product Fulfillment

 

We typically fulfill delivery of our hardware-based products from centralized distribution centers. We have in the past and may in the future make changes in our product delivery network. Changes in our product delivery network may disrupt our ability to timely and efficiently meet our product delivery commitments, particularly at the end of a quarter. As a result, we may experience increased costs in the short term as temporary delivery solutions are implemented to address unanticipated delays in product delivery. In addition, product delivery delays may negatively impact our ability to recognize revenue if shipments are delayed at the end of a quarter.

 

We Face Risks Related to Customer Outsourcing to System Integrators.

 

Some of our customers have outsourced the management of their information technology departments to large system integrators. If this trend continues, our established customer relationships could be disrupted and our products could be displaced by alternative system and network protection solutions offered by system integrators that do not bundle our solutions. Significant product displacements could negatively impact our revenue and have a material adverse effect on our business.

Product Liability and Related Claims May Be Asserted Against Us.

 

Our products are used to protect and manage computer systems and networks that may be critical to organizations. Because of the complexity of the environments in which our products operate, an error, or a false positive, failure or defect in our products, including a security vulnerability, could disrupt or cause damage to the networks of our customers, including disruption of legitimate network traffic by our products. For example, in March 2006, we released a data file update that contained a defect causing certain of our products to generate false positives. Failure of our products to perform to specifications (including the failure of our products to identify or block a virus), disruption of our customers’ network traffic or damages to our customers’ networks caused by our products could result in product liability damage claims by our customers. Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. It is possible, however, that the limitation of liability provisions may not be effective under the laws of certain jurisdictions, particularly in circumstances involving unsigned licenses.

 

Cryptography Contained in Our Technology is Subject to Export Restrictions.

 

Some of our computer security solutions, particularly those incorporating encryption functionality, may be subject to export restrictions. As a result, some products may not be exported to international customers without prior U.S. government approval. The list of products and end users for which export approval is required, and the related regulatory policies, are subject to revision by the U.S. government at any time. The cost of compliance with U.S. and international export laws and changes in existing laws could affect our ability to sell certain products in certain markets and could have a material adverse effect on our international revenues. If we fail to comply with applicable law and regulations, we may become subject to penalties and fines or restrictions that may adversely affect our business.

 

If We Fail to Effectively Upgrade Our Information Technology System, We May Not Be Able to Accurately Report Our Financial Results or Prevent Fraud.

 

As part of our efforts to continue improving our internal control over financial reporting, we upgraded our existing SAP information technology system during 2006 in order to automate certain controls that are currently performed manually. We may experience difficulties in transitioning to new or upgraded systems and in applying maintenance patches to existing systems, including loss of data and decreases in productivity as personnel become familiar with new, upgraded or modified systems. Our management information systems will require modification and refinement as we grow and as our business needs change, which could prolong difficulties we experience with systems transitions, and we may not always employ the most effective systems for our purposes. If we experience difficulties in implementing new or upgraded information systems or experience significant system failures, or if we are unable to successfully modify our management information systems and respond to changes in our business needs, our operating results could be harmed or we may fail to meet our reporting obligations. We may also experience similar results if we have difficulty applying routine maintenance patches to existing systems.

 

Pending or Future Litigation Could Have a Material Adverse Impact on Our Results of Operation and Financial Condition.

 

In addition to intellectual property litigation, from time to time, we have been, and may be in the future, subject to other litigation including stockholder derivative actions or actions brought by current or former employees. Where we can make a reasonable estimate of the liability relating to pending litigation and determine that an adverse liability resulting from such litigation is probable, we record a related liability. As additional information becomes available, we assess the potential liability and revise estimates as appropriate. However, because of the inherent uncertainties relating to litigation, the amount of our estimates could be wrong. In addition to the related cost and use of cash, pending or future litigation could cause the diversion of management’s attention. In this regard, we and a number of our current and former officers and directors are involved in or the subject of various legal actions. Managing, defending and indemnity obligations related to these actions have caused significant diversion of management’s and the board of director’s time and resulted in material expense to us. See Note 20 to the notes to consolidated financial statements for additional information with respect to currently pending legal matters.

We Face Risks Related to Our 2006 Settlement Agreement with the Securities and Exchange Commission.

 

On February 9, 2006, the United States District Court for the Northern District of California entered a final judgment permanently enjoining us and our officers and agents from future violations of the securities laws. This final judgment resolved the charges filed against us in connection with the SEC’s investigation of our accounting practices that commenced in March 2002. As a result of the judgment, we will forfeit for three years the ability to invoke the “safe harbor” for forward-looking statements provision of the Private Securities Litigation Reform Act, or the Reform Act. This safe harbor provided us enhanced protection from liability related to forward-looking statements if the forward-looking statements were either accompanied by meaningful cautionary statements or were made without actual knowledge that they were false or misleading. While we may still rely on the “bespeaks caution” doctrine that existed prior to the Reform Act for defenses against securities lawsuits, without the statutory safe harbor, it may be more difficult for us to defend against any such claims. In addition, due to the permanent restraint and injunction against violating applicable securities laws, any future violation of the securities laws would be a violation of a federal court order and potentially subject us to a contempt order. For instance, if, at some point in the future, we were to discover a fact that caused us to restate our financial statements similar to the restatements that were the subject of the SEC action, we could be found to have violated the final judgment. We cannot predict whether the SEC might assert that our failure to remain current in our periodic reporting obligations or our historical stock option practices violated the final judgment or what, if any, enforcement action the SEC might take upon such a determination. Further, any collateral criminal or civil investigation, proceeding or litigation related to any future violation of the judgment, such as the compliance actions mandated by the judgment, could result in the distraction of management from our day-to-day business and may materially and adversely affect our reputation and results of operations.

 

False Detection of Viruses and Actual or Perceived Security Breaches Could Adversely Affect Our Business.

 

Our system protection software products have in the past, and these products and our intrusion protection products may at times in the future, falsely detect viruses or computer threats that do not actually exist. These false alarms, while typical in the industry, may impair the perceived reliability of our products and may therefore adversely impact market acceptance of our products. In addition, we have in the past been subject to litigation claiming damages related to a false alarm, and similar claims may be made in the future. An actual or perceived breach of network or computer security at one of our customers, regardless of whether the breach is attributable to our products, could adversely affect the market’s perception of our security products.

 

Computer “Hackers” May Damage Our Products, Services and Systems.

 

Due to our high profile in the network and system protection market, we have been a target of computer hackers who have, among other things, created viruses to sabotage or otherwise attack our products and services, including our various websites. For example, we have seen the spread of viruses, or worms, that intentionally delete anti-virus and firewall software. Similarly, hackers may attempt to penetrate our network security and misappropriate proprietary information or cause interruptions of our internal systems and services. Also, a number of websites have been subject to denial of service attacks, where a website is bombarded with information requests eventually causing the website to overload, resulting in a delay or disruption of service. If successful, any of these events could damage users’ or our computer systems. In addition, since we do not control disk duplication by distributors or our independent agents, disks containing our software may be infected with viruses.

 

We Face Risks Related to Our Anti-Spam, Anti-Spyware and Safe Search Software Products.

 

Our anti-spam, anti-spyware and safe search products may falsely identify emails, programs or websites as unwanted “spam”, “potentially unwanted programs” or “unsafe,” fail to properly identify unwanted emails, programs or unsafe websites, particularly because “spam” emails, spyware or malware are often designed to circumvent anti-spam or spyware products, or, in the case of our anti-spam products, incorrectly identify legitimate businesses as users of “phishing” technology that seeks to gain access to personal user information. Parties whose emails or programs are blocked by our products, or whose websites are incorrectly identified as unsafe or as

utilizing phishing techniques, may seek redress against us for labeling them as “spammers”, spyware or unsafe, or for interfering with their business. In addition, false identification of emails or programs as unwanted “spam” or “potentially unwanted programs” may reduce the adoption of these products.

 

“Open Source” Software and Failure to Comply with Open Source Licenses and Obligations Could Negatively Affect our Business.

 

To the extent we utilize “open source” software we face risks. For example, the scope and requirements of the most common open source software license, the GNU General Public License, or GPL, have not been interpreted in a court of law. Use of GPL or other open source software could subject certain portions of our proprietary software to the GPL requirements or other similar requirements, as applicable, which may have adverse effects on our sale of the products incorporating any such software. Other forms of open source software licensing present license compliance risks, which could result in litigation or loss of the right to use this software, our ability to commercialize products or technologies incorporating open source software or otherwise fully realize the anticipated benefits of any such acquisition may be restricted because, among other reasons, open source license terms may be ambiguous and may result in unanticipated or uncertain obligations regarding our products. It may be difficult for us to accurately determine the developers of the open source code and whether the acquired software infringes third-party intellectual property rights. We have in place processes and controls designed to address these risks and concerns, including a review process for screening requests from our development organizations for the use of open source, but we cannot be sure that all open source is submitted for approval prior to use in our products.

 

Compliance Or the Failure to Comply with Current and Future Environmental Regulations Could Cause Us Significant Expense.

 

We are subject to a variety of federal, state, local and foreign environmental regulations. If we fail to comply with any present and future regulations, we could be subject to future liabilities, the suspension of production or a prohibition on the sale of our products. In addition, such regulations could require us to incur other significant expenses to comply with environmental regulations, including expenses associated with the redesign of any non-compliant product. From time to time new regulations are enacted, and it is difficult to anticipate how such regulations will be implemented and enforced. For example, the European Union recently effected the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment Directive (RoHS) and the Waste Electrical and Electronic Equipment Directive (WEEE). Similar legislation is currently in force or is being considered in the United States, as well as other countries, such as Japan and China. The failure to comply with any of such regulatory requirements or contractual obligations could result in us being liable for costs, fines, penalties and third-party claims, and could jeopardize our ability to conduct business in the jurisdictions where these regulations apply.

 

Our Tax Strategy May Expose Us to Risk.

 

We are generally required to account for taxes in each jurisdiction in which we operate. This process may require us to make assumptions, interpretations and judgments with respect to the meaning and application of promulgated tax laws and related administrative and judicial interpretations thereof of the jurisdictions in which we operate. The positions that we take and our interpretations of the tax laws may differ from the positions and interpretations of the tax authorities in the jurisdictions in which we operate. An audit by a tax authority that results in a contrary decision could have a significant negative impact on our cash position and net income.

 

Business Interruptions May Impede Our Operations and the Operations of Our Customers.

 

We are continually updating or modifying our accounting and other internal and external facing business systems. Modifications of these types of systems are often disruptive to business and may cause us to incur higher costs than we anticipate. Failure to properly manage this process could materially harm our business operations.

 

In addition, we and our customers face a number of potential business interruption risks that are beyond our respective control. Natural disasters or other events could interrupt our business or the business of our customers, and each of us is reliant on external infrastructure that may be antiquated. Our corporate headquarters are located

near a major earthquake fault. The potential impact of a major earthquake on our facilities, infrastructure and overall operations is not known, but could be quite severe. Despite safety precautions that have been implemented, an earthquake could seriously disrupt our entire business process. We are largely uninsured for losses and business disruptions caused by an earthquake and other natural disasters.

 

Our Stock Price Has Been Volatile and Is Likely to Remain Volatile.

 

During 2007 and up to the date of this filing, our stock price was highly volatile ranging from a per share high of $41.66 to a low of $27.74. On December 7, 2007, our stock’s closing price per share price was $38.94. Announcements, business developments, such as a material acquisition or disposition, litigation developments and our ability to meet the expectations of investors with respect to our operating and financial results, may contribute to current and future stock price volatility. In addition, third-party announcements such as those made by our partners and competitors may contribute to current and future stock price volatility. For example, future announcements by Microsoft Corporation related to its consumer security solution may contribute to future volatility in our stock price. Certain types of investors may choose not to invest in stocks with this level of stock price volatility.

 

We Face the Risk of a Decrease in Our Cash Balances and Losses in Our Investment Portfolio.

 

Our cash balances are held in numerous locations throughout the world. A portion of our cash is invested in marketable securities as part of our investment portfolio. We rely on third-party money managers to manage our investment portfolio. Among other factors, changes in interest rates, foreign currency fluctuations and macro economic conditions could cause our cash balances to fluctuate and losses in our investment portfolio. Most amounts held outside the United States could be repatriated to the United States, but, under current law, would be subject to U.S. federal income tax, less applicable foreign tax credits.

 

Our Charter Documents and Delaware Law and Our Rights Plan May Impede or Discourage a Takeover, Which Could Lower Our Stock Price.

 

Our Charter Documents and Delaware Law

 

Under to our certificate of incorporation, our board of directors has the authority to issue up to 5.0 million shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by our stockholders. The issuance of preferred stock could have the effect of making it more difficult for a third-party to acquire a majority of our outstanding voting stock and could have the effect of discouraging a change of control of the company or changes in management.

 

Our classified board and other provisions of Delaware law and our certificate of incorporation and bylaws, could also delay or make a merger, tender offer or proxy contest involving us or changes in our board of directors and management more difficult. For example, any stockholder wishing to make a stockholder proposal (including director nominations) at our 2008 annual meeting, must meet the qualifications and follow the procedures specified under both the Securities Exchange Act of 1934 and our bylaws.

 

Our Rights Plan

 

Our board of directors has adopted a stockholders’ rights plan. The rights would become exercisable on the tenth day after a person or group announces the acquisition of 15% or more of our common stock or announces the commencement of a tender or exchange offer the consummation of which would result in ownership by the person or group of 15% or more of our common stock. If the rights become exercisable, the holders of the rights (other than the person acquiring 15% or more of our common stock) will be entitled to acquire in exchange for the rights’ exercise price, shares of our common stock or shares of any company in which we are merged with a value equal to twice the rights’ exercise price. The rights plan makes it more difficult for a third-party to acquire a majority of our outstanding voting stock and discourages a change of control of the company not approved by our board of directors.

 

 

None.

 

 

Our worldwide headquarters currently occupies approximately 95,000 square feet in facilities located in Santa Clara, California under leases expiring through 2013 which excludes approximately 113,000 square feet of leased space that we sublease to third parties. Worldwide, we lease facilities with approximately 766,000 total square feet, with leases that expire at various times. Total square footage excludes approximately 131,000 square feet of leased space in North America and EMEA that we sublease to third parties. Our primary international facilities are located in India, Ireland, Japan, the Netherlands, the United Kingdom and Singapore. Significant domestic sites include California, Oregon and Texas. We believe that our existing facilities are adequate for the present and that additional space will be available as needed.

 

We own our regional office located in Plano, Texas. The approximately 170,000 square feet facility opened in January 2003 and is located on 21.0 acres of owned land. This facility supports approximately 800 employees working in our customer support, engineering, accounting and finance, information technology, internal audit, human resources, legal and sales groups.

 

 

Special Committee Investigation of Historical Stock Option Granting Practices

 

We became aware of potential issues with respect to our historical stock option grants in May 2006 after the Center for Financial Research and Analysis (“CFRA”) released a report titled “Options Backdating — Which Companies are at Risk?” This report concluded there was a high probability that we backdated option grants from 1997 to 2002, based on stock price trends around certain grant dates. Upon becoming aware of the CFRA report, management immediately commenced a voluntary internal review involving the examination of certain stock option grants. In May 2006, management notified our board of directors that an internal review was in process in response to the findings in the CFRA report.

 

During our initial review, management discovered irregularities in certain historical stock option grants and discussed these findings with the board of directors in late May 2006. We learned during the course of the initial review, and through subsequent discussions between our former general counsel and certain directors, of irregularities regarding the pricing of a grant to our former general counsel. Upon review of the findings of the internal review, the board of directors immediately terminated the employment of our former general counsel for cause.

 

The board of directors created a committee (the “special committee”) comprised of certain of its members who were independent of our company and management and who had not previously served as members of our board’s compensation committee to conduct an investigation to evaluate the conduct and performance of our officers, employees and directors who were involved in the option granting process and to evaluate the timing of option grants, the related approval documentation and accounting implications with respect to grants made during the period from January 1, 1995 through March 31, 2006. In May 2006, the special committee retained independent counsel and forensic accountants to assist in the investigation (collectively referred to as the “investigative team”). No limits were placed on the scope of the investigation. Independent counsel first met with the audit committee and with the special committee in June 2006.

 

Findings and Conclusions

 

The special committee presented its initial findings to the board of directors on October 10, 2006. As part of this presentation, the special committee communicated to our board of directors information concerning errors and irregularities with respect to our option granting practices, including, among others, the new hire option grant of our former president and one of the option grants to our former general counsel. Immediately following that presentation, our chairman and chief executive officer retired and our president was terminated. The board determined this termination was a termination for cause.

The special committee investigation was completed in November 2007. The special committee concluded that there were both qualitative issues and accounting and administrative errors relating to our stock option granting process. In this regard, the special committee concluded that certain former members of management had acted inappropriately, giving rise to qualitative concerns. The qualitative concerns included the following:

 

 

In addition to the foregoing, the special committee concluded that certain stock option awards were previously accounted for using incorrect measurement dates because: (i) we had previously determined accounting measurement dates for certain stock option awards incorrectly, and, in some instances, such dates were chosen with the benefit of hindsight so as to intentionally, and not inadvertently or as a result of administrative error, give more favorable exercise prices, (ii) the key terms for a substantial portion of the grants in an annual merit grant had been determined with finality prior to the original measurement date, with a reduction in the exercise price on the original measurement date, which represented a repricing, (iii) original accounting measurement dates occurred prior to approval dates, (iv) original accounting measurement dates occurred prior to employment commencement dates, (v) approval and employment commencement date documentation was incorrect or inconsistent and (vi) certain director grants contained clerical errors.

 

Government Inquiries Relating to Historical Stock Option Practices

 

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 options granted between January 1, 1995 and the date of the subpoena. At or around the same time we received a notice of informal inquiry from the United States 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 2, 2006, certain members of the investigative team met with the staff of the SEC’s Division of Enforcement and presented the initial findings of the investigation. As a result of that meeting, the scope of the investigation was expanded to include: (i) a review of the historical option grants made by McAfee.com, (ii) historical exercise activity with respect to our option grants to consider potential exercise date manipulation and (iii) post-employment arrangements with former executives.

 

On November 6, 2006, we received a document request from the SEC for option grant data for McAfee.com, one of our former consolidated subsidiaries that had been a publicly traded company from December 1999 through September 2002.

 

The investigative team has had meetings and continuous discussions with the SEC from May 2006 through the end of the investigation in November 2007. We have provided documents requested by the SEC to date, and we are cooperating with the SEC’s investigation.

We cannot predict how long it will take or how much more time and resources we will have to expend to resolve these government inquiries, nor can we predict the outcome of the inquiries. There can be no assurance that other inquiries, investigations or actions will not be commenced by other United States federal or state regulatory agencies or authorities or by foreign governmental agencies or authorities and that such actions will not result in significant fines and/or penalties.

 

Late SEC Filings

 

Due to the time necessary to conclude the special committee investigation and to restate our consolidated financial statements, we were not a timely filer of this annual report on Form 10-K and of our quarterly reports on Form 10-Q for the quarters ended June 30, 2006, September 30, 2006, March 31, 2007, June 30, 2007, and September 30, 2007. As a result, we received a letter, dated March 19, 2007, from The New York Stock Exchange (the “NYSE”), which requested that we contact the NYSE to discuss the status of this filing of our annual report on Form 10-K and that we issue a press release disclosing the status of the filing, noting the delay, the reason for the delay and the anticipated filing date. Our press release already issued on February 8, 2007 satisfied these requirements. On August 28, 2007, we requested the NYSE to grant an extension of our continued listing and trading until December 31, 2007 in order to provide adequate time to conclude our investigation and become current in our late filings with the SEC, including the filing of this annual report on Form 10-K. The NYSE granted this request on September 17, 2007, subject to reassessment on an ongoing basis, and on September 18, 2007, we issued a press release disclosing this extension. We have periodically met with the NYSE to discuss the status of the investigation and the timing of filing of this annual report on Form 10-K.

 

With the filing of this annual report on Form 10-K and our quarterly reports on Form 10-Q for the quarters ended June 30, 2006, September 30, 2006, March 31, 2007, June 30, 2007, and September 30, 2007, we believe we have returned to full compliance with SEC reporting requirements.

 

Stockholder Derivative Litigation Relating to Historical Stock Option Practices

 

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 has 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. Currently, there is no deadline by which plaintiffs must file an opposition to the pending 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 has 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 Court has continued the stay on several occasions.

 

In December 2007, we reached a tentative settlement with the plaintiffs in the Consolidated Action and the State Actions. We have accrued $13.8 million in the condensed consolidated financial statements as of June 30, 2006 related to expected payments pursuant to the tentative settlement and expect to complete the documentation and the required approvals in late December 2007 or early in the first quarter of 2008. While we cannot predict the ultimate outcome of the lawsuits, the provision recorded in the financial statements represents our best estimate at this time.

 

SEC Settlement Related to Prior Restatement

 

On March 22, 2002, the SEC notified us that it had commenced a “Formal Order of Private Investigation” into our accounting practices. In October 2003, we completed a restatement of our consolidated financial statements for 1998 through 2000. On September 29, 2005, we announced we had reserved $50.0 million in connection with the proposed settlement with the SEC and we had deposited $50.0 million in an escrow account with the SEC as the designated beneficiary. On February 9, 2006, the SEC entered the final judgment for the settlement with us. We also agreed to release $50.0 million to the SEC for the civil penalty on February 13, 2006 and certain other conditions, such as engaging independent consultants to examine and recommend improvements to our internal controls to ensure compliance with federal securities laws.

 

Indemnification Obligations

 

As permitted under Delaware law, we have indemnification agreements in effect whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is not limited; however, we have director and officer insurance coverage that reduces our expense exposure and may enable us to recover a portion of future amounts paid.

 

Other Legal Matters

 

We are named from time to time as a party to lawsuits in the normal course of our business. Litigation in general and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of legal proceedings are difficult to predict. See Note 20 to the notes to consolidated financial statements for additional information with respect to legal matters.

 

 

No matters were submitted to a vote of stockholders during the quarter ended December 31, 2006.

 

PART II

 

 

Price Range of Common Stock

 

Our common stock is traded on the New York Stock Exchange (“NYSE”), under the symbol MFE. Prior to December 1, 1997, our common stock traded on the NASDAQ National Market under the symbol MCAF. From December 1, 1997 until February 12, 2002, our common stock traded under the symbol NETA. Our common stock

began trading on the NYSE effective February 12, 2002, and traded under the symbol NET from February 12, 2002 until June 2004, when we changed our name to McAfee, Inc. and we began trading under the symbol MFE.

 

The following table sets forth, for the period indicated, the high and low sales prices for our common stock for the last eight quarters, all as reported by NYSE. The prices appearing in the table below do not reflect retail mark-up, mark-down or commission.

 

 

The annual certification to the NYSE attesting to our compliance with the NYSE’s corporate governance listing standards was submitted by our chief executive officer to the NYSE in June 2006.

 

Dividend Policy

 

We have not paid any cash dividends since our reorganization into a corporate form in October 1992. We intend to retain future earnings for use in our business and do not anticipate paying cash dividends in the foreseeable future.

Stock Performance

 

The following Performance Graph and related information shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that we specifically incorporate it by reference into such filing.

 

The following graph shows a five-year comparison of cumulative total returns for our common stock, the CRSP Total Return Index for the NASDAQ Stock Market and the CRSP Total Return Industry Index for NASDAQ Computer and Data Processing Services Stocks, each of which assumes an initial value of $100 and reinvestment of dividends. The information presented in the graph and table is as of the end of each fiscal year ended December 31.

 

Comparison of Five-Year Cumulative Total Returns

 

 

 

Performance for 2006 reflects a December 29, 2006 closing market price on the New York Stock Exchange of $28.38.

 

Holders of Common Stock

 

As of December 7, 2007, there were 663 record owners of our common stock.

 

Common Stock Repurchases

 

Our board of directors had previously authorized the repurchase of our common stock in the open market from time to time until October 2007, depending upon market conditions, share price and other factors. Beginning in May 2006, we suspended repurchases of our common stock in the open market due to the announced investigation into our historical stock option granting practices. Therefore, we had no repurchases of our common stock during the fourth quarter of 2006 that were pursuant to a publicly announced plan or program. At December 31, 2006, we had remaining authorization to repurchase $246.2 million of our common stock in the open market; however, this

authorization expired in October 2007. We expect that our executive management will recommend to our board of directors that a new common stock repurchase program be authorized.

 

Retirements of Common Stock

 

In 2004, we retired the approximately 13.0 million treasury shares we had repurchased on the open market in 2003 and 2004.

 

In 1998, we deposited approximately 1.7 million shares of our common stock with a trustee for the benefit of the employees of our Dr. Solomon’s acquisition to cover the stock options assumed in our acquisition of this company. These shares, which have been included in our outstanding share balance, were to be issued upon the exercise of stock options by Dr. Solomon’s employees. We determined in June 2004 that Dr. Solomon’s employees had exercised approximately 1.6 million options, and that we had issued new shares in connection with these exercises rather than using the trust shares to satisfy the option exercises. The trustee returned the 1.6 million shares to us in June 2004, at which time we retired them and they were no longer included in our outstanding share balance. In December 2004, the trustee sold the remaining 133,288 shares in the trust for proceeds of $3.8 million, and remitted the funds to us. The terms of the trust prohibited the trustee from returning the shares to us and stipulated that only employees could benefit from the shares. We distributed these funds to all employees below the level of vice president through a bonus which was recognized as expense in 2004.

 

 

You should read the following selected financial data as of December 31, 2006 and 2005 and for each of the three years ended December 31, 2006 with our consolidated financial statements and related notes, specifically Note 3 “Restatement of Consolidated Financial Statements,” and “Management’s Discussion and Analysis of Financial Conditions and Results of Operations.” The following selected financial data as of December 31, 2004, 2003 and 2002 and for each of the two years ended December 31, 2003 is derived from our consolidated financial statements and notes not included in this filing. Historical results may not be indicative of future results.

 

 

 

 

 

 

 

 

 

Forward-Looking Statements and Factors That May Affect Future Results

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. Please see “Special Note Regarding Forward-Looking Statements.”

 

Overview and Executive Summary

 

We are a leading dedicated security technology company that secures systems and networks from known and unknown threats around the world. We empower home users, businesses, government agencies, service providers and our partners with the latest technology available in order to block attacks, prevent disruptions, and continuously track and improve their security.

 

We apply business discipline and a pragmatic approach to security that is based on four principles of security risk management (identify and prioritize assets; determine acceptable risk; protect against threats; enforce and measure compliance). We incorporate some or all of these principles into our solutions. Our solutions protect systems and networks, blocking immediate threats while proactively providing protection from future threats. We also provide software to manage and enforce security policies for organizations of any size. Finally, we incorporate expert services and technical support to ensure a solution is actively meeting our customers’ needs. These integrated solutions help our customers solve problems, enhance security and reduce costs.

 

We have one business and operate in one industry, developing, marketing, distributing and supporting computer security solutions for large enterprises, governments, small and medium-sized business and consumers either directly or through a network of qualified partners. We derive our revenue and generate cash from customers primarily from three sources: (i) services and support revenue, which includes maintenance, training and consulting revenue, (ii) subscription revenue, which includes revenue from subscription-based offerings and (iii) product revenue, which includes hardware and perpetual license revenue. We continue to focus our efforts on building a full line of complementary network and system protection solutions. During 2006, we acquired three companies, SiteAdvisor, Preventsys and Onigma, and substantially all of the assets of a fourth, Citadel Security Software, to enhance and complement our current offerings. The acquisition of SiteAdvisor in April 2006 significantly enhances our internet security solutions. Our system security management and vulnerability management capabilities were further advanced with the acquisition of Preventsys in June. Onigma, acquired in October, complements our enterprise offerings by providing businesses with data loss prevention. The acquisition of Citadel Security Software’s assets in December broadens our capabilities for security policy compliance enforcement and vulnerability remediation.

 

The majority of our net revenue has historically been derived from our McAfee Security anti-virus products and, until the sale of the Sniffer product line in July 2004, our Sniffer Technologies network fault identification and application performance management products. We have also focused our efforts on building a full line of complementary network and system protection solutions. On the system protection side, we strengthened our anti-virus lineup by adding complementary products in the anti-spam and host intrusion prevention categories, and through our June 2005 Wireless Security Corporation acquisition, we have strengthened our solution portfolio in our consumer segment. On the network protection side, we have added products in the network intrusion prevention and detection category, and through our October 2004 Foundstone acquisition, vulnerability management products and services.

 

We evaluate our consolidated financial performance utilizing a variety of indicators. Two of the primary indicators that we utilize are total net revenue and net income. As discussed more fully below, our net revenue in 2006 grew by 17% to $1,145.2 million from $981.6 million in 2005. We believe net revenue is a key indicator of the growth and health of our business. Our net revenue is directly impacted by corporate information technology, government and consumer spending levels. We believe net income is a key indicator of the profitability of our business. Our net income for 2006 and 2005 was $137.5 million and $118.2 million, respectively. Net income in

2006 includes stock option related charges of $57.8 million due to the adoption of SFAS 123(R) and increased legal and professional fees compared to 2005 totaling approximately $17.8 million due to the investigation into our past stock option granting practices, fees incurred for engaging independent consultants to examine and recommend improvements to our internal controls pursuant to our SEC settlement, which was unrelated to the investigation of our stock option granting practices. Net income in 2005 was negatively impacted by a $50.0 million SEC settlement charge. On February 9, 2006, the SEC entered the final judgment for the settlement with us and the $50.0 million escrow was released to the SEC on February 13, 2006.

 

For 2004 our net revenue was $907.6 million and our net income was $220.0 million. Net income in 2004 was favorably impacted by a $46.1 million pre-tax gain from the sale of our Magic product line in January 2004, a $197.4 million pre-tax gain from the sale of our Sniffer product line in July 2004 and insurance reimbursements of approximately $25.0 million relating to our previously settled class action lawsuit. In addition to total net revenue and net income, in evaluating our business, management considers, among many other factors, the following:

 

Net revenue by Geography

 

We operate our business in five geographic segments: North America; Europe, Middle East and Africa, collectively referred to as EMEA; Japan; Asia-Pacific, excluding Japan; and Latin America. During 2006, 45% of our total net revenue was generated outside of North America. North America and EMEA collectively accounted for approximately 86% of our total net revenue in 2006. During 2005, 43% of our total net revenue was generated outside of North America, with North America and EMEA collectively accounting for approximately 86% of our total net revenue. North America and EMEA have benefited from increased corporate IT spending related to security in both 2006 and 2005. Revenue generated in Japan was negatively impacted during 2006 as the Japanese Yen weakened against the U.S. Dollar compared to 2005. See Note 19 to our consolidated financial statements for a description of revenue and income from operations by geographic region.

 

Net revenue by Product Groups and Customer Category

 

 

Our corporate products include (i) our small and medium-sized business (“SMB”) products and (ii) our enterprise products. These products focus on threat prevention and protection and compliance management and include our current year acquisitions and include IntruShield intrusion protection products, our Entercept host-based intrusion protection products and Foundstone Risk Management products that were acquired in connection with the Foundstone acquisition in October 2004. Revenue from our corporate products increased $102.2 million, or 18%, to $668.6 million during 2006 from $566.4 million in 2005. The year over year increase in revenue is due to increased corporate spending on McAfee security products, increased activity of our Total Protection Solutions and Foundstone product lines and increased maintenance renewals.

 

Our consumer market is comprised of our McAfee consumer online subscription service and retail boxed-product sales. Net revenue from our consumer security market increased $61.3 million, or 15%, to $476.6 million in 2006 from $415.3 million in 2005. The main driver of the increase in revenue from our consumer market is our strengthening relationships with strategic channel partners, such as AOL, Comcast, Dell and Gateway.

 

 

 

Deferred Revenue

 

Our deferred revenue balance at December 31, 2006 was $897.5 million compared to $751.8 million at December 31, 2005, which is an increase of 19%. The increase is attributable to sales of maintenance renewals from our growing customer base and increased sales of subscription-based offerings. Approximately 82% of our total net revenue during 2006 came from prior-period deferred revenue. As with revenue, we believe that deferred revenue is a key indicator of the growth and health of our business.

 

Cash, Cash Equivalents and Marketable Securities

 

The balance of cash, cash equivalents and marketable securities at December 31, 2006 was $1,240.2 million compared to $1,257.0 million at December 31, 2005. The decrease was primarily attributable to (i) the repurchase of 9.8 million shares of common stock for approximately $234.7 million, including commissions and our obligation to withhold the number of shares required to satisfy the tax liabilities in connection with the vesting of the restricted stock of four holders for approximately $0.5 million, (ii) acquisition-related purchases totaling $146.1 million including SiteAdvisor, Inc. for approximately $61.0 million, Preventsys, Inc. for approximately $4.8 million, Citadel Security Software, Inc. for approximately $61.2 million, and Onigma Ltd. for approximately $19.1 million, net of cash acquired, and (iii) the purchase of property and equipment for approximately $43.8 million. These decreases were largely offset by (i) net cash provided by operating activities of $290.5 million (ii) cash received from the exercise of stock options and stock purchases under the stock purchase plans of $32.0 million (iii) a reduction in our restricted cash of $50.0 million for the settlement with the SEC and (iv) an increase in net cash of $20.6 million due to foreign exchange rate fluctuations. See the Liquidity and Capital Resources section below.

 

The following discussion and analysis reflects the restatement of our financial results, which is more fully described in the “Explanatory Note Regarding Restatement” immediately preceding Part I, Item 1, in “Legal Proceedings” in Item 3, and in Note 3, “Restatement of Consolidated Financial Statements” to the consolidated financial statements included in this annual report on Form 10-K.

 

Special Committee Investigation of Historical Stock Option Practices

 

We became aware of potential issues with respect to our historical stock option grants in May 2006 after the Center for Financial Research and Analysis (“CFRA”) released a report titled “Options Backdating — Which Companies are at Risk?” This report concluded there was a high probability that we backdated option grants from 1997 to 2002, based on stock price trends around certain grant dates. Upon becoming aware of the CFRA report, management immediately commenced a voluntary internal review involving the examination of certain stock option grants. In May 2006, management notified our board of directors that an internal review was in process in response to the analysis in the CFRA report.

 

On May 25, 2006, we announced we had voluntarily initiated a review of our stock option grant practices during the late 1990s and early 2000s timeframe. During our initial review, management discovered irregularities in certain historical stock option grants and discussed these findings with the board of directors in late May 2006. We learned during the course of the initial review, and through subsequent discussions between our former general counsel and certain directors, of irregularities regarding the pricing of a grant to our former general counsel. Upon review of the findings of the internal review, the board of directors immediately terminated the employment of our former general counsel for cause.

 

Our board of directors established a special committee of independent directors to review our stock option granting practices and related accounting. The special committee was assisted by independent counsel and forensic accountants (collectively referred to as “the investigative team”). The investigation primarily focused on the

processes used to establish option exercise prices and obtain approvals of stock option grants and post-employment option modifications. The investigation, which covered the time period from January 1, 1995 through March 31, 2006, included a review of our historical stock option practices, accounting policies, accounting records, supporting documentation, email communications and other documentation, as well as interviews with a number of current and former directors, officers and employees.

 

On October 10, 2006, the special committee presented its initial findings to the board of directors. As part of this presentation, the special committee communicated to our board of directors information concerning errors and irregularities with respect to the new hire option grant of our former president. Following that presentation, our chairman and chief executive officer retired and our president was terminated. The board determined this termination was for cause. In November 2006, certain members of the investigative team met with the staff of the SEC’s Division of Enforcement and presented the initial findings of the investigation. As a result of that meeting, the scope of the investigation was expanded to include a review of the: (i) historical option grants by McAfee.com, (ii) historical exercise activity with respect to our option grants to consider potential exercise date manipulation and (iii) post-employment arrangements with former executives. The special committee investigation was completed in November 2007. The special committee concluded that there were both qualitative issues and accounting and administrative errors relating to our stock option granting process. In this regard, the special committee concluded that certain former members of management had acted inappropriately, giving rise to qualitative concerns. The qualitative concerns included the following:

 

 

In addition to the foregoing, the special committee concluded that certain stock option awards were previously accounted for using incorrect measurement dates because: (i) such dates were chosen with the benefit of hindsight so as to intentionally, and not inadvertently or as a result of administrative error, give more favorable exercise prices, (ii) the key terms for a substantial portion of the grants in an annual merit grant had been determined with finality prior to the original measurement date, with a reduction in the exercise price on the original measurement date, which represented a repricing, (iii) original accounting measurement dates occurred prior to approval dates, (iv) original accounting measurement dates occurred prior to employment commencement dates, (v) approval and employment commencement date documentation was incorrect or inconsistent and (vi) certain director grants contained clerical errors.

 

In each instance, we revised the accounting measurement date after considering all available relevant evidence. Approximately 98% of the total intrinsic value (stock price on the revised measurement date minus exercise price) of all of our options and restricted stock awards remeasured as a result of this investigation were attributable to options remeasured during the period from 1995 through 2003. The special committee concluded that there were procedures in place after April 2005 to provide reasonable assurance that stock options were granted at the fair market value of the stock price on the grant date.

 

The special committee determined that we did not previously record appropriate charges associated with certain option modifications. These modifications occurred upon the termination of an employee and, in some

cases, provided for the extension of the post-termination time period in which options could be exercised and allowed for the continued vesting of options subsequent to the former employee’s termination date. These option modifications occurred from 1998 to 2004.

 

The investigation also identified an error in our accounting for options historically accounted for as variable awards. This error was comprised of our application of transition guidance provided by FIN 44, which required us to account for repriced options as variable awards beginning July 1, 2000.

 

To correct our past accounting for stock options under APB 25 we recorded additional pre-tax, non-cash, stock-based compensation expense of $3.4 million ($2.5 million net of tax) for the year ended December 31, 2005, $10.8 million ($7.2 million net of tax) for the year ended December 31, 2004 and $123.1 million ($80.5 million net of tax) for the periods 1995 through 2003. We also expect to amortize less than $0.1 million of such pre-tax charges under Statement of Financial Accounting Standards No. 123(R) “Share-Based Payment” (“SFAS 123(R)”), in periods from January 1, 2007 through 2009.

 

We have incurred material expenses in 2007 and 2006 as a direct result of the investigation into our stock option grant practices and related accounting. These costs primarily related to professional services for the investigation, legal, accounting and tax guidance. In addition, we have incurred costs related to litigation, the investigation by the SEC, the grand jury subpoena from the U.S. Attorney’s Office for the Northern District of California and the preparation and review of our restated consolidated financial statements. We expect that we will continue to incur costs associated with these matters and that we may be subject to certain fines and/or penalties resulting from the findings of the investigation. We cannot reasonably estimate the range of fines and/or penalties, if any, that might be incurred as a result of the investigation.

 

Critical Accounting Policies and Estimates

 

In preparing our consolidated financial statements, we make estimates, assumptions and judgments that can have a significant impact on our net revenue, income from operations and net income, as well as the value of certain assets and liabilities on our consolidated balance sheet. The application of our critical accounting policies requires an evaluation of a number of complex criteria and significant accounting judgments by us. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We evaluate our estimates on a regular basis and make changes accordingly. Senior management has discussed the development, selection and disclosure of these estimates with the audit committee of our board of directors. Actual results may materially differ from these estimates under different assumptions or conditions. If actual results were to differ from these estimates materially, the resulting changes could have a material adverse effect on the consolidated financial statements.

 

An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about complex matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the consolidated financial statements. Management believes the following critical accounting policies reflect our more significant estimates and assumptions used in the preparation of the consolidated financial statements.

 

Our critical accounting policies are as follows:

 

 

 

Restatement of Stock-Based Compensation

 

We previously applied Accounting Principles Bulletin No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and its related interpretations including Financial Accounting Standards Board Interpretations No. 44, “Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Option No. 25” (FIN 44), and provided the required pro forma disclosure under Statement of Accounting Financial Standards No. 123 “Accounting for Stock-Based Compensation” (“SFAS 123”) through the fiscal year ended December 31, 2005. Under APB 25, a non-cash, stock-based compensation expense should have been recognized for any option with intrinsic value on the accounting measurement date. An option is deemed to have intrinsic value when the exercise price is below the market price of the underlying stock on the accounting measurement date. Certain of our stock options were incorrectly measured prior to the completion of required approvals and granting actions. After revising the measurement date for these options, certain options were deemed to have intrinsic value and, as a result, there should have been stock-based compensation expense for each of these options under APB 25 equal to the number of options multiplied by their intrinsic value on the revised measurement date. That expense should have been amortized over the vesting period of the option. Starting in our fiscal year ended December 31, 2006, we adopted SFAS 123(R). As a result, for 2006, the additional stock-based compensation required to be recorded for each of these stock options was equal to the fair value of these options on the revised measurement date for options vesting in 2006 or later. We did not record the additional stock-based compensation expenses under APB 25 or SFAS 123(R) related to these stock options in our previously issued financial statements.

 

As a result of the investigation, we determined that the original measurement dates we used for accounting purposes for certain option and restricted stock grants to employees from April 1995 through April 2005 were not appropriate and, in some cases, were chosen with the benefit of hindsight so as to give a more favorable exercise price. Other than director grants with clerical errors, we had no revised measurement dates from May 2005 through March 2006.

 

We revised measurement dates and recorded stock-based compensation charges due to the following errors, certain of which are the result of incorrect measurement dates from the use of hindsight to select more favorable exercise prices:

 

 

After reviewing available relevant documentation, a general hierarchy of documentation was considered when establishing the revised measurement date for accounting purposes. The hierarchy was considered in evaluating

each grant on an individual basis based on the particular facts and circumstances. The documentation considered, when available, was:

 

 

DB dates are not appropriate for determining system entry dates for our grants entered into the stock administration database prior to June 17, 1998 due to the implementation of a new stock administration system on that date. All grants entered into the stock administration database prior to the system conversion have a default DB date of June 17, 1998.

 

DB dates were applied on a grant by grant basis, resulting in multiple measurement dates for annual merit grants for which there were multiple DB dates.

 

 

APB 25 defines the measurement date as the first date upon which the number of options and exercise price are known. Our determination of the revised measurement date was based on our assessment that a grant was determined with finality and was no longer subject to change. Such determinations involved judgment and careful

evaluation of all relevant facts and circumstances for each grant. The following are the judgments involved in determining revised measurement dates.

 

In light of the significant judgment used in establishing revised measurement dates, alternate approaches to those used by us could have resulted in different stock-based compensation expense than recorded by us in the restatement. While we considered various alternative approaches, we believe that the approaches we used were the most appropriate under the circumstances. We conducted a sensitivity analysis to assess how the restatement adjustments described in this annual report on Form 10-K could have changed under alternative methodologies for determining measurement dates for stock option grants from 1995 through 2005. See “Critical Accounting Policies and Estimates” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of this annual report on Form 10-K for information regarding the incremental stock-based compensation charges that would result from using alternate measurement dates.

 

Date of Execution of UWC

 

For certain grants, we were unable to locate contemporaneous documentation confirming that a compensation committee meeting, or a meeting by a delegated level of authority, occurred on the effective date of the UWC. For compensation committee UWCs with effective dates in 2004 and 2005, which cover 0.4 million options, we discovered instances in which documented approval actually occurred subsequent to the UWC effective date. The revised measurement date in these instances is the documented approval date. There were no options granted in compensation committee UWCs from 2001 through 2003. For UWCs prior to 2001, which cover 9.4 million options, and all delegated committee UWCs, the compensation or delegated committee resolved to grant options, and later documented such resolutions in UWCs, with an effective date which was the date of the granting actions. With the exception of one UWC, no evidence was located that contradicted a UWC effective date as the approval date for any compensation committee grants prior to 2001. For UWCs prior to 2001, we did not locate any evidence that caused us to question the reliability of UWCs, outside the one instance discussed above. We have therefore placed reliance on the compensation committee UWCs prior to 2001.

 

There were also instances where UWCs were not signed during the period prior to 2001. These unsigned UWCs were located in our minute books. We did not locate any evidence that contradicted the effective dates of unsigned UWCs as the approval date, therefore, we have placed reliance on unsigned UWCs in this period.

 

Had we used DB dates where available, we would have recognized an additional $4.8 million in stock-based compensation expense from 1999 through 2004. Had we used the highest closing stock price during the one-month period subsequent to the UWC effective date for grants for which DB dates are not available, we would have recognized an additional $26.6 million in stock-based compensation expense from 1995 through 2004.

 

Annual Merit Grants

 

For annual merit grants, a pool of options was allocated among non-executive employees, and in certain years for executives as well, in conjunction with their annual performance review. We located evidence that allocations were completed and grants determined with finality on a business unit/geographic region basis, resulting in multiple measurement dates for annual merit grants. For grants not included in complete allocations, we have selected the DB date as the revised measurement date as the terms of grants were determined with finality on or prior to the database entry dates.

 

The 1999 annual merit grant consisted of 2.1 million options which had an original measurement date of April 20, 1999. We determined that the key terms were determined with finality for approximately 1.6 million of these options in March 1999, and that the exercise price was reduced to $11.06 on April 20, 1999, which represents a repricing. As the stock price on the revised measurement date in March 1999 exceeded the exercise price, there was grant date intrinsic value, which is being recognized over the requisite service period. Additionally, the options are accounted for as variable awards in accordance with FIN 44 due to the repricing on April 20, 1999.

 

We were not able to determine allocation completion dates for the annual merit grants with an original measurement date in January 1998. We would have used DB dates as revised measurement dates, however, DB dates were not available for these grants. We located hard-copy stock administration system reports with a date

stamp that provides evidence of the latest date a grant could have been entered into the stock administration database. We used these system report dates as revised measurement dates, with the exception of certain grants for which signed and dated grant notification letters were located. If the signature date on the letters was prior to the system report date, the revised measurement date was the letter signature date.

 

For annual merit grants for which we located evidence of substantially completed allocations, not all grants were included in allocations. These grants were revised to DB dates. If these grants had been revised to the date of the last substantially complete allocation for the respective annual merit grant, we would have recognized $1.6 million less in stock-based compensation expense from 1998 through 2005.

 

Incorrect or Inconsistent Approval and Employment Commencement Date Documentation

 

We identified certain grants to executives and directors for which the approval documentation and/or employment commencement date documentation were incorrect or inconsistent. These grants were assigned an original grant date other than the approval date, or prior to the actual employment commencement date. In these instances, the occurrence of the meeting on the stated date in the approval documentation was validated based on director payment records or the billing records of external legal counsel who attended the meeting. We were able to determine the correct employment commencement date based on human resources and payroll records. The actual meeting date for the approval of such grants, or employment commencement date if later, was used as the revised measurement date.

 

Lack of Approval Documentation

 

For grants totaling 2.2 million options, primarily in the years from 1996 through 2001, we were unable to locate approval documentation. In these instances, we examined available evidence, including email communications and grant communication letters, to determine the revised measurement date. We also performed an analysis to determine whether these grants were recorded on dates where the stock price was at a low point, which would result in a lower exercise price. It does not appear that these grants were priced opportunistically, and we did not discover any evidence that contradicted the original measurement date. Therefore, we did not revise the measurement dates for these grants.

 

If we had used the stock administration database entry date, which was available only for grants subsequent to June 1998, the additional stock-based compensation expense would have been $2.5 million from 1998 through 2005. If we had used the highest stock price within 30 days subsequent to the original measurement date, the additional stock-based compensation expense would have been $4.2 million from 1995 through 2005.

 

Communication Dates

 

For certain grants, we were unable to locate evidence of communication of the key terms (i.e., number of options and exercise price) to the employee for certain grants. We did not discover any evidence during the investigation that the communication of key terms was intentionally delayed, or there were any significant delays. In the absence of evidence to the contrary, we have concluded that communication of the key terms occurred prior to or within a reasonable period of time of the completion of all required granting actions.

 

We believe that our methodology, based on the reasonable evidence, results in the most likely measurement dates for our stock option grants. However, we also conducted a sensitivity analysis to assess how the restatement adjustments would have varied based on different measurement date methodologies. Based on the alternative measurement dates discussed above, the total additional stock-based compensation expense resulting from grant date intrinsic value could have ranged from $96.0 million to $128.4 million.

 

Stock-based Compensation Expense

 

On January 1, 2006, we adopted SFAS 123(R), which is a revision of SFAS 123, and supersedes APB 25. SFAS 123(R) requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors based on the estimated fair values of the awards on their grant dates.

Our share-based awards include stock options, restricted stock awards, restricted stock units and our employee stock purchase plan, or ESPP.

 

For the year ended December 31, 2006, we recognized stock-based compensation expense of $57.8 million. Prior to our adoption of SFAS 123(R), we applied the intrinsic value method set forth in APB 25 to calculate the compensation expense for share-based awards. During 2005, we recognized a charge of $4.5 million under APB 25 related to grant date intrinsic value resulting from revised accounting measurement dates, the exchange of McAfee.com options in 2002, options which were repriced in 1999 and restricted stock awards. During 2004, we recognized a charge of $25.2 million under APB 25 related to grant date intrinsic value resulting from revised accounting measurement dates, the exchange of McAfee.com options in 2002, options which were repriced in 1999, restricted stock awards and modifications of certain option awards. See Note 16 to the consolidated financial statements for additional information.

 

We use the Black-Scholes model to estimate the fair value of our option awards and employee stock purchase rights issued under the ESPP. The Black-Scholes model requires estimates of the expected term of the option, as well as future volatility and the risk-free interest rate.

 

For options issued during 2006, we estimated the weighted-average fair value to be $10.47. For employee stock purchase rights issued during 2006, we estimated the weighted-average fair value to be $6.11. The key assumptions that we used to calculate these values are provided below:

 

 

We derive the expected term of our options through 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 expected 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 six months or more to calculate the expected volatility of our option grants. Prior to that time, the expected volatility was based solely on the historical volatility of our stock. We have not declared any dividends on our stock in the past and do not expect to do so in the foreseeable future.

 

The assumptions that we have made represent our management’s best estimate, but they are highly subjective and inherently uncertain. If management had made different assumptions, our calculation of the options’ fair value and the resulting stock-based compensation expense could differ, perhaps materially, from the amounts recognized in our financial statements. For example, if we increased the assumption regarding our stock’s volatility for options granted during 2006 by 10%, our stock-based compensation expense would increase by $2.2 million, net of expected forfeitures. This increased expense would be amortized over the options’ 4.0 year vesting period. Likewise, if we increased our assumption of the expected lives of options granted during 2006 by one year, our stock-based compensation expense would increase by $1.2 million, net of expected forfeitures. This increased expense would be amortized over the options’ 4.0 year vesting period.

 

In addition to the assumptions used to calculate the fair value of our options, we are required to estimate the expected forfeiture rate of all share-based awards and only recognize expense for those awards we expect to vest.

The stock-based compensation expense recognized in our consolidated statement of income for the year ended December 31, 2006 has been reduced for estimated forfeitures. If we were to change our estimate of forfeiture rates, the amount of share-based compensation could differ, perhaps materially, from the amount recognized in our financial statements. For example, if we had decreased our estimate of expected forfeitures by 50%, our stock-based compensation expense for the year ended December 31, 2006, net of expected forfeitures, would have increased by $5.6 million. This decrease in our estimate of expected forfeitures would increase the amount of expense for all unvested stock options, restricted stock awards and units, and employee stock purchase rights that have not yet been recognized by $13.1 million, amortized over a weighted-average period of 2.4 years.

 

Revenue Recognition

 

As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments or utilized different estimates. These estimates affect the deferred revenue line item on our consolidated balance sheet and the net revenue line item on our consolidated statement of income. Estimates regarding revenue affect all of our operating geographies.

 

Our revenue is derived primarily from three sources (i) services and support revenue, which includes maintenance, training and consulting revenue, (ii) subscription revenue, which includes revenue from subscription-based offerings and (iii) product revenue, which includes hardware and perpetual licenses revenue.

 

We apply the provisions of Statement of Position 97-2, “Software Revenue Recognition” (“SOP 97-2”), and related interpretations to all transactions involving the sale of software products and hardware products that include software. For hardware transactions where software is not incidental, we do not separate the license fee and we do not apply separate accounting guidance to the hardware and software elements. For hardware transactions where no software is involved or software is incidental, we apply the provisions of Staff Accounting Bulletin 104 “Revenue Recognition” (“SAB 104”).

 

We market and distribute our software products both as standalone software products and as comprehensive security solutions. We recognize revenue from the sale of software licenses when all of the following are met:

 

 

Persuasive evidence is generally a binding purchase order or license agreement. Delivery generally occurs when product is delivered to a common carrier or upon delivery of a grant letter and license key, if applicable. If a significant portion of a fee is due after our normal payment terms of typically 30 to 90 days, we recognize revenue as the fees become due. If we determine that collection of a fee is not reasonably assured, we defer the fees and recognize revenue upon cash receipt, provided all other revenue recognition criteria are met.

 

We enter into perpetual and subscription software license agreements through direct sales to customers and indirect sales with partners, distributors and resellers. We recognize revenue from the indirect sales channel upon sell-through by the partner or distributor. The license agreements generally include service and support agreements, for which the related revenue is deferred and recognized ratably over the performance period. All revenue derived from our online subscription products is deferred and recognized ratably over the performance period. Professional services revenue is generally recognized as services are performed or if required, upon customer acceptance.

 

For arrangements with multiple elements, including software licenses, maintenance and/or services, we allocate and defer revenue equivalent to the vendor-specific objective evidence (“VSOE”), of fair value for the undelivered elements and recognize the difference between the total arrangement fee and the amount deferred for the undelivered elements as product revenue. VSOE of fair value is based upon the price for which the undelivered element is sold separately or upon substantive renewal rates stated in a contract. We determine fair value of the undelivered elements based on historical evidence of stand-alone sales of these elements to our customers. When

VSOE does not exist for undelivered elements such as maintenance and support, the entire arrangement fee is recognized ratably over the performance period generally as services and support revenue.

 

Sales Incentives and Sales Returns

 

We reduce revenue for estimates of sales incentives and sales returns. We offer sales incentives, including channel rebates, marketing funds and end-user rebates for products in our corporate and consumer product lines. Additionally, end-users may return our products, subject to varying limitations, through distributors and resellers or to us directly for a refund within a reasonably short period from the date of purchase. We estimate and record reserves for sales incentives and sales returns based on our historical experience. In each accounting period, we must make judgments and estimates of sales incentives and potential future sales returns related to current period revenue. These estimates affect our net revenue line item on our consolidated statement of income and affect our net accounts receivable, deferred revenue or accrued liabilities line items on our consolidated balance sheet. These estimates affect all of our operating geographies.

 

At December 31, 2006, our allowance for sales returns and incentives was $39.8 million compared to $31.9 million at December 31, 2005. If our allowance for sales returns and incentives were to increase by 10%, or $4.0 million, our net revenue would decrease by $1.9 million and our deferred revenue would decrease by $2.1 million for the year ended December 31, 2006.

 

Deferred Costs of Revenue

 

Deferred costs of revenue, which consist primarily of costs related to revenue-sharing arrangements and costs of inventory sold into our channel which have not been sold through to the end-user, are included in prepaid expenses and prepaid taxes and other current assets on our consolidated balance sheet. We only defer direct and incremental costs related to revenue-sharing arrangements and recognize such deferred costs proportionate to the related revenue recognized. At December 31, 2006, our deferred costs were $70.2 million compared to $28.8 million at December 31, 2005.

 

Allowance for Doubtful Accounts

 

We also make estimates of the uncollectibility of our accounts receivables. Management specifically analyzes accounts receivable balances, current and historical bad debt trends, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. We specifically reserve for any account receivable for which there are identified collection issues. These estimates affect the general and administrative line item on our statement of income and the net accounts receivable line item on the consolidated balance sheet. The estimation of uncollectible accounts affects all of our operating geographies.

 

At December 31, 2006, our allowance for doubtful accounts was $2.0 million compared to $2.4 million at December 31, 2005. If an additional 1% of our gross accounts receivable were deemed to be uncollectible at December 31, 2006, our allowance for doubtful accounts would increase by $2.1 million and our provision for bad debt expense, revenue and deferred revenue would also be affected.

 

Estimation of Restructuring Accrual and Litigation

 

Restructuring Accrual.  During 2005, we permanently vacated several leased facilities and recorded a $1.8 million accrual for estimated lease related costs associated with the permanently vacated facilities. During 2004, we permanently vacated several leased facilities, including an additional two floors in our Santa Clara headquarters building and recorded a $10.0 million restructuring accrual. In 2003, as part of a consolidation of activities into our Plano, Texas facility from our headquarters in Santa Clara, California, we recorded a restructuring charge of $15.7 million. We recorded these facility restructuring charges in accordance with Statement of Financial Accounting Standards No. 146, “Accounting for Exit Costs Associated With Exit or Disposal Activities” (“SFAS 146”). To determine our restructuring charges and the corresponding liabilities, SFAS 146 required us to make a number of assumptions. These assumptions included estimated sublease income over the remaining lease period, estimated term of subleases, estimated utility and real estate broker fees, as well as estimated discount rates

for use in calculating the present value of our liability. We developed these assumptions based on our understanding of the current real estate market in the respective locations as well as current market interest rates. The assumptions used are our management’s best estimate at the time of the accrual, and adjustments are made on a periodic basis if better information is obtained. If, at December 31, 2006, our estimated sublease income were to decrease 10%, the restructuring reserve and related expense would have increased by $1.6 million.

 

The estimates regarding our restructuring accruals affect our current liabilities and other long-term liabilities line items in our consolidated balance sheet, since these liabilities will be settled each year through 2013. These estimates affect our statement of income in the restructuring line item.

 

Litigation.  Management’s current estimated range of liability related to litigation that is brought against us from time to time is based on claims for which our management can estimate the amount and range of loss. We recorded the minimum estimated liability related to those claims, where there is a range of loss as there is no better point of estimate. Because of the uncertainties related to an unfavorable outcome of litigation, and the amount and range of loss on pending litigation, management is often unable to make a reasonable estimate of the liability that could result from an unfavorable outcome. As litigation progresses, we continue to assess our potential liability and revise our estimates. Such revisions in our estimates could materially impact our results of operations and financial position. Estimates of litigation liability affect our accrued liability line item on our consolidated balance sheet and our general and administrative expense line item on our statement of income. See Note 20 in our Notes to the Consolidated Financial Statements.

 

Accounting for Income Taxes

 

As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess and make significant estimates regarding the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of income. Estimates related to income taxes affect the deferred tax asset and liability line items and accrued liabilities in our consolidated balance sheet and our income tax expense line item in our statement of income.

 

The net deferred tax asset as of December 31, 2006 is $464.4 million, net of a valuation allowance of $70.1 million. The valuation allowance is recorded due to the uncertainty of our ability to utilize some of the deferred tax assets related to foreign tax credits and net operating losses of acquired companies. The valuation allowance is based on our historical experience and estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods we may need to establish an additional valuation allowance which could materially impact our financial position and results of operations.

 

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

 

Valuation of Goodwill, Intangibles, and Long-lived Assets

 

We account for goodwill and other indefinite-lived intangible assets in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). SFAS 142 requires, among other things, the discontinuance

of amortization for goodwill and indefinite-lived intangibles and at least an annual test for impairment. An impairment review may be performed more frequently in the event circumstances indicate that the carrying value may not be recoverable.

 

We are required to make estimates regarding the fair value of our reporting units when testing for potential impairment. We estimate the fair value of our reporting units using a combination of the income approach and the market approach. Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future cash flows. Under the market approach, we estimate the fair value based on market multiples of revenue or earnings for comparable companies. We estimate cash flows for these purposes using internal budgets based on recent and historical trends. We base these estimates on assumptions we believe to be reasonable, but which are unpredictable and inherently uncertain. We also make certain judgments about the selection of comparable companies used in the market approach in valuing our reporting units, as well as certain assumptions to allocate shared assets and liabilities to calculate the carrying value for each of our reporting units. If an impairment were present, these estimates would affect an impairment line item on our consolidated statement of income and would affect the goodwill in our consolidated balance sheet. As goodwill is allocated to all of our reporting units, any impairment could potentially affect each operating geography.

 

Based on our most recent impairment test, there would have to be a significant change in assumptions used in such calculation in order for an impairment to occur as of December 31, 2006.

 

We account for finite-lived intangibles and long-lived assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Under this standard we will record an impairment charge on finite-lived intangibles or long-lived assets to be held and used when we determine that the carrying value of intangibles and long-lived assets may not be recoverable.

 

Based upon the existence of one or more indicators of impairment, we measure any impairment of intangibles or long-lived assets based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. Our estimates of cash flows require significant judgment based on our historical results and anticipated results and are subject to many of the factors, noted below as triggering factors, which may change in the near term.

 

Factors considered important, which could trigger an impairment review include, but are not limited to:

 

 

Goodwill amounted to $530.5 million and $437.5 million as of December 31, 2006 and 2005, respectively. We did not hold any other indefinite-lived intangibles as of December 31, 2006 and 2005. Net finite-lived intangible assets and long-lived assets amounted to $205.6 million and $165.8 million as of December 31, 2006 and 2005, respectively.

Results of Operations

 

Years Ended December 31, 2006, 2005 and 2004

 

Net Revenue

 

The following table sets forth, for the periods indicated, a year-over-year comparison of the key components of our net revenue:

 

 

The increase in net revenue from 2005 to 2006 reflected (i) a $104.1 million increase in our corporate business and (ii) a $61.3 million increase in our consumer business. This increase was partially offset by a $1.9 million decrease attributable to McAfee Labs, which was sold in April 2005.

 

Net revenue from our corporate business increased during 2006 compared to 2005 primarily due to (i) increased corporate spending on McAfee security products and (ii) increased revenue from our McAfee Intrushield and McAfee Foundstone offerings. Net revenue from our Intrushield and Foundstone product lines increased $25.1 million and $18.2 million, respectively. Net revenue from our consumer market increased during 2006 compared to 2005 primarily due to (i) online subscriber growth due to our increased customer base, (ii) increased online renewal subscriptions and (iii) increased royalty revenue from our strategic channel partners, such as AOL, Dell, Gateway and Samsung.

 

The increase in net revenue from 2004 to 2005 reflected (i) a $151.4 million increase in our consumer business and (ii) a $21.4 million increase in our corporate business due to decreased corporate spending related to security. These increases were partially offset by (i) a $91.4 million decrease in revenue attributable to our Sniffer product line, which was sold in July 2004, (ii) a $4.5 million decrease attributable to McAfee Labs, which was sold in April 2005, (iii) a $2.8 million decrease attributable to Magic Solutions, which was sold in January 2004 and (iv) the introduction of our perpetual-plus licensing arrangements, which experience lower rates of up-front revenue recognition, in the United States in the first quarter of 2004 and in EMEA and Asia-Pacific, excluding Japan, in mid-2003.

 

Net revenue from our consumer market increased during 2005 primarily due to (i) online subscriber growth due to our increased customer base and expansion to additional countries and (ii) increased online renewal rates.

Net Revenue by Geography

 

The following table sets forth, for the periods indicated, net revenue in each of the five geographic regions in which we operate:

 

 

Net revenue outside of North America accounted for 45%, 43%, and 39% of net revenue for 2006, 2005 and 2004, respectively. Net revenue from North America and EMEA has historically comprised between 80% and 90% of our business.

 

The increase in total net revenue in North America during 2006 primarily related to (i) a $46.2 million increase in corporate revenue in North America due to increased corporate spending on McAfee security products and increased revenue from our Foundstone and Intrushield product lines and (ii) a $25.2 million increase in consumer revenue in North America partially offset by a $1.9 million decrease attributable to McAfee Labs, which was sold in April 2005.

 

The increase in total net revenue in North America during 2005 primarily related to a $88.3 million increase in consumer revenue in North America due to our increased customer base, partially offset by (i) a $68.0 million decrease in Sniffer revenue in North America due to the sale of our Sniffer product line in July 2004, (ii) a $4.5 million decrease in McAfee Labs revenue in North America due to the sale of McAfee Labs in April 2005, (iii) a $1.3 million decrease in corporate revenue in North America, (iv) a $2.1 million decrease in Magic revenue in North America due to the sale of our Magic product line in January 2004 and (v) our perpetual-plus licensing arrangements which were introduced in 2004 and resulted in lower rates of up front revenue recognition and an increase in the amount of revenue deferred to future periods.

 

The increase in total net revenue in EMEA during 2006 was attributable to (i) a $45.5 million increase in corporate revenue due to increased corporate spending on McAfee security products and increased revenue from our Foundstone and Intrushield product lines and (ii) a $27.1 million increase in consumer revenue from online subscriber growth due to our increased customer base. Net revenue from EMEA was also positively impacted by the strengthening Euro against the U.S. Dollar, which resulted in an approximate $0.4 million impact to EMEA net revenue in 2006 compared to 2005.

 

The increase in total net revenue in EMEA during 2005 was attributable to (i) a $39.5 million increase in consumer revenue due to online subscriber growth due to our increased customer base and expansion to additional

countries and (ii) a $9.6 million increase in corporate revenue, partially offset by (i) a $9.7 million decrease in revenue related to the Sniffer product line that was sold in July 2004 and (ii) a $0.7 million decrease in Magic revenue in EMEA due to the sale of our Magic product line in January 2004. The average Euro to U.S. Dollar exchange rate in 2005 was comparable to the average Euro to Dollar exchange rate in 2004, therefore, we did not experience a significant impact to revenue related to changing foreign currency rates.

 

Net revenue from our consumer market in both North America and in EMEA increased during 2006 and 2005 primarily due to (i) online subscriber growth due to our increased customer base and expansion to additional countries and (ii) increased online renewal rates. Additionally, in 2005, net revenue from our consumer market increased due to increased retail revenue due to higher levels of contract support renewal revenue generated from our increased 2004 retail sales due to numerous virus outbreaks in 2003 through 2004 and new product offerings.

 

Our Japan, Latin America and Asia-Pacific operations combined have historically comprised less than 20% of our total net revenue and we expect this trend to continue. Although total net revenue from Japan increased in 2006 compared to 2005, the weakening Japanese Yen against the U.S. Dollar resulted in an approximate $5.3 million negative impact to Japanese net revenue.

 

Risks inherent in international revenue include the impact of longer payment cycles, greater difficulty in accounts receivable collection, unexpected changes in regulatory requirements, seasonality, political instability, tariffs and other trade barriers, currency fluctuations, a high incidence of software piracy in some countries, product localization, international labor laws, compliance with the Foreign Corrupt Practices Act and our relationship with our employees and regional work councils and difficulties staffing and managing foreign operations. These factors may have a material adverse effect on our future international revenue.

 

Service and Support Revenue

 

The following table sets forth, for the periods indicated, each major category of our service and support revenue as a percent of service and support revenue:

 

 

Service and support revenue includes revenue from software support and maintenance contracts, training and consulting. The increase in service and support revenue in 2006 compared to 2005 was attributable to an increase in support and maintenance primarily due to amortization of previously deferred revenue from support arrangements and an increase in sales of support renewals offset slightly by a decrease in consulting and training revenue.

 

The increase in service and support revenue in 2005 compared to 2004 was attributable to an increase in support and maintenance primarily due to maintenance renewals on our growing customer base and our perpetual-plus licensing model. In addition, in April 2005 we increased our support pricing on selected consumer products, including VirusScan and McAfee Internet Security.

Our growth rate and net revenue depend significantly on renewals of support arrangements as well as our ability to respond successfully to the pace of technological change and expand our customer base. If our renewal rate or our pace of new customer acquisition slows, our net revenue and operating results would be adversely affected. Additionally, support pricing under the perpetual-plus model is significantly higher than the previous model. In the event customers choose not to renew their support arrangements under the perpetual-plus model, revenue could be negatively impacted.

 

Subscription Revenue

 

The following table sets forth, for the periods indicated, the change in subscription revenue:

 

 

Subscription revenue includes revenue from online subscription arrangements. The increase in subscription revenue in 2006 compared to 2005 was attributable to (i) an increase in our on-line subscription arrangements due to our continued relationships with strategic channel partners, such as AOL, Gateway and Dell, (ii) an increase in revenue from our McAfee Managed VirusScan online service, (iii) an increase in royalties from sales by our strategic channel partners and (iv) an increase due to our McAfee Consumer Suites launch in September 2006, as these suites utilized a subscription-based model.

 

The increase in subscription revenue in 2005 compared to 2004 was attributable to (i) an increase in our online subscription arrangements with our continued relationships with strategic channel partners, such as AOL, Dell and others, (ii) as well as an increase in our McAfee Managed VirusScan online service for small and medium-sized businesses. Our future profitability and rate of growth, if any, will be directly affected by these partner relationships, increased price competition and the size of our revenue base.

 

Product Revenue

 

The following table sets forth, for the periods indicated, each major category of our product revenue as a percent of total product revenue: