e10vq
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
Form 10-Q
 
 
     
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the quarterly period ended September 30, 2007
or
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to          
 
 
Commission file number: 001-31216
 
McAfee, Inc.
(Exact name of registrant as specified in its charter)
 
 
     
Delaware
  77-0316593
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification Number)
     
3965 Freedom Circle
Santa Clara, California
(Address of principal executive offices)
  95054
(Zip Code)
 
 
Registrant’s telephone number, including area code:
(408) 988-3832
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes o     No 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
 
As of December 7, 2007, 159,908,615 shares of the registrant’s common stock, $0.01 par value, were outstanding.
 


 

 
MCAFEE, INC.
FORM 10-Q
 
September 30, 2007
 
          
 
CONTENTS
 
                 
Item
       
Number
      Page
 
      Financial Statements (Unaudited)        
        Condensed Consolidated Balance Sheets: September 30, 2007 and December 31, 2006     3  
        Condensed Consolidated Statements of Income and Comprehensive Income: Three and nine months ended September 30, 2007 and September 30, 2006     4  
        Condensed Consolidated Statements of Cash Flows: Nine months ended September 30, 2007 and September 30, 2006     5  
        Notes to Condensed Consolidated Financial Statements     6  
      Management’s Discussion and Analysis of Financial Condition and Results of Operations     29  
      Quantitative and Qualitative Disclosures about Market Risk     48  
      Controls and Procedures     48  
 
      Legal Proceedings     50  
      Risk Factors     50  
      Unregistered Sales of Equity Securities and Use of Proceeds     50  
      Defaults upon Senior Securities     51  
      Submission of Matters to a Vote of Security Holders     51  
      Other Information     51  
      Exhibits      51  
    52  
    53  
 Certification of CEO and CFO Pursuant to Section 302
 Certification of CEO and CFO Pursuant to Section 906


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PART I: FINANCIAL INFORMATION
 
Item 1.   Financial Statements (Unaudited)
 
MCAFEE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED BALANCE SHEETS
 
                 
    September 30,
    December 31,
 
    2007     2006  
    (In thousands, except share data) (Unaudited)  
 
ASSETS
Current assets:
               
Cash and cash equivalents
  $ 500,339     $ 389,627  
Short-term marketable securities
    370,280       215,722  
Accounts receivable, net of allowance for doubtful accounts of $3,197 and $2,015, respectively
    156,570       170,855  
Prepaid expenses and prepaid taxes
    148,019       132,203  
Deferred income taxes
    234,105       236,310  
Other current assets
    16,512       31,915  
                 
Total current assets
    1,425,825       1,176,632  
Long-term marketable securities
    673,259       634,820  
Restricted cash
    559       950  
Property and equipment, net
    91,849       91,999  
Deferred income taxes
    348,096       228,103  
Intangible assets, net
    89,781       113,574  
Goodwill
    535,693       530,477  
Other assets
    28,689       23,715  
                 
Total assets
  $ 3,193,751     $ 2,800,270  
                 
 
LIABILITIES
Current liabilities:
               
Accounts payable
  $ 37,371     $ 35,652  
Accrued income taxes
    53,462       118,589  
Other accrued liabilities
    206,117       171,331  
Deferred revenue
    737,419       704,807  
                 
Total current liabilities
    1,034,369       1,030,379  
Deferred revenue, less current portion
    217,505       192,718  
Accrued taxes and other long-term liabilities
    66,521       149,924  
                 
Total liabilities
    1,318,395       1,373,021  
                 
Commitments and contingencies (Notes 11 and 12)
               
 
STOCKHOLDERS’ EQUITY
Preferred stock, $0.01 par value:
               
Authorized: 5,000,000 shares; Issued and outstanding: none in 2007 and 2006
           
Common stock, $0.01 par value:
               
Authorized: 300,000,000 shares; Issued: 172,512,046 shares at September 30, 2007 and December 31, 2006; Outstanding: 159,908,615 shares at September 30, 2007 and 159,915,439 shares at December 31, 2006
    1,726       1,726  
Treasury stock, at cost: 12,603,431 shares at September 30, 2007 and 12,596,607 shares at December 31, 2006
    (303,270 )     (303,074 )
Additional paid-in capital
    1,789,431       1,527,843  
Accumulated other comprehensive income
    35,579       31,472  
Retained earnings
    351,890       169,282  
                 
Total stockholders’ equity
    1,875,356       1,427,249  
                 
Total liabilities and stockholders’ equity
  $ 3,193,751     $ 2,800,270  
                 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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MCAFEE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
    (In thousands, except per share data)
 
    (Unaudited)  
 
Net revenue:
                               
Service and support
  $ 164,171     $ 160,388     $ 496,938     $ 466,298  
Subscription
    140,366       110,822       402,025       299,197  
Product
    17,449       15,853       52,731       74,422  
                                 
Total net revenue
    321,986       287,063       951,694       839,917  
Cost of net revenue:
                               
Service and support
    11,470       13,127       35,698       39,736  
Subscription
    44,089       29,624       121,090       76,077  
Product
    14,886       15,415       38,210       45,810  
Amortization of purchased technology
    7,420       5,987       24,304       16,180  
                                 
Total cost of net revenue
    77,865       64,153       219,302       177,803  
Operating costs:
                               
Research and development
    54,399       50,641       163,831       144,426  
Marketing and sales
    90,989       91,260       279,217       264,990  
General and administrative
    38,140       35,055       125,093       127,101  
SEC and compliance costs
    10,885       7,901       25,085       11,673  
Amortization of intangibles
    2,959       2,656       9,197       8,305  
Restructuring charges (benefit)
    109       (1,393 )     3,158       (274 )
In-process research and development
                      460  
                                 
Total operating costs
    197,481       186,120       605,581       556,681  
                                 
Income from operations
    46,640       36,790       126,811       105,433  
Interest and other income
    19,450       13,922       52,480       32,585  
Gain on investments, net
    371       154       631       68  
                                 
Income before provision for income taxes
    66,461       50,866       179,922       138,086  
Provision for income taxes
    3,060       16,776       25,127       33,491  
                                 
Net income
  $ 63,401     $ 34,090     $ 154,795     $ 104,595  
                                 
Other comprehensive income:
                               
Unrealized gains on marketable securities, net of reclassification adjustment for gains recognized on marketable securities during the period and income tax
  $ 1,156     $ 878     $ 1,059     $ 1,457  
Foreign currency translation (loss) gain
    (1,320 )     1,791       3,049       (4,742 )
                                 
Comprehensive income
  $ 63,237     $ 36,759     $ 158,903     $ 101,310  
                                 
Net income per share — Basic
  $ 0.40     $ 0.21     $ 0.97     $ 0.65  
                                 
Net income per share — Diluted
  $ 0.39     $ 0.21     $ 0.94     $ 0.64  
                                 
Shares used in per share calculation — Basic
    159,808       159,728       159,802       161,343  
                                 
Shares used in per share calculation — Diluted
    164,513       161,485       163,871       163,132  
                                 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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MCAFEE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                 
    Nine Months Ended
 
    September 30,  
    2007     2006  
    (In thousands)
 
    (Unaudited)  
 
Cash flows from operating activities:
               
Net income
  $ 154,795     $ 104,595  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    59,858       50,688  
Provision for (recovery of) doubtful accounts, net
    382       (197 )
Non-cash restructuring charge (benefit)
    1,375       (286 )
Interest released from restricted cash
          489  
Acquired in-process research and development
          460  
Discount amortization on marketable securities
    (4,377 )     (5,438 )
(Gain) loss on sale of assets and technology
    (24 )     207  
Gain on sale of investments
    (631 )     (68 )
Deferred income taxes
    10,679       (22,224 )
Increase in fair value of options accounted for as liabilities
    1,689        
Non-cash stock-based compensation expense
    41,218       37,988  
Excess tax benefits from stock-based compensation
    (12 )     (4,811 )
Changes in assets and liabilities, net of acquisitions and divestitures:
               
Accounts receivable
    20,021       31,328  
Prepaid expenses, prepaid taxes and other assets
    (10,392 )     (45,839 )
Accounts payable
    627       939  
Accrued taxes and other liabilities
    (934 )     (9,281 )
Deferred revenue
    27,403       65,723  
                 
Net cash provided by operating activities
    301,677       204,273  
                 
Cash flows from investing activities:
               
Purchase of marketable securities
    (714,007 )     (1,034,796 )
Proceeds from sales of marketable securities
    360,238       471,990  
Proceeds from maturities of marketable securities
    167,545       246,694  
Decrease in restricted cash
    391       49,896  
Purchase of patents
    (9,300 )      
Purchase of property, equipment and leasehold improvements
    (25,704 )     (30,707 )
Proceeds from sale of assets and technology
    4,105        
Acquisitions, net of cash acquired
          (65,871 )
                 
Net cash used in investing activities
    (216,732 )     (362,794 )
                 
Cash flows from financing activities:
               
Proceeds from issuance of common stock from option and stock purchase plans
          32,007  
Excess tax benefits from stock-based compensation
    12       4,811  
Repurchase of common stock
    (196 )     (234,679 )
                 
Net cash used in financing activities
    (184 )     (197,861 )
                 
Effect of exchange rate fluctuations on cash
    25,951       9,752  
                 
Net increase (decrease) in cash and cash equivalents
    110,712       (346,630 )
Cash and cash equivalents at beginning of period
    389,627       728,592  
                 
Cash and cash equivalents at end of period
  $ 500,339     $ 381,962  
                 
Non-cash investing activities:
               
Unrealized gain on marketable securities, net
  $ 1,059     $ 1,457  
                 
Accrual for purchase of property, equipment and leasehold improvements
  $ 1,321     $ 1,849  
                 
Fair value of assets acquired in business combinations, excluding cash acquired
  $     $ 75,158  
                 
Liabilities assumed in business combinations
  $     $ 9,289  
                 
Non-cash financing activities:
               
Modification of stock options — reclassification from equity to liability award
  $ 4,326     $  
                 
Supplemental disclosure of cash flow information:
               
Cash paid for income taxes
  $ 22,998     $ 50,844  
                 
Cash received from income tax refunds
  $ 11,838     $ 2,972  
                 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
1.   Organization and Business
 
McAfee, Inc. and our wholly-owned subsidiaries (“we”, “us” or “our”) are a worldwide security technology company that secures systems and networks from known and unknown threats around the world. Our security solutions are offered primarily to large enterprises, governments, small and medium-sized businesses and consumers through a network of qualified partners. We operate our business in five geographic regions: North America; Europe, Middle East and Africa, or EMEA; Japan; Asia-Pacific, excluding Japan; and Latin America.
 
2.   Summary of Significant Accounting Policies and Basis of Presentation
 
The accompanying condensed consolidated financial statements include our accounts as of September 30, 2007 and December 31, 2006 and for the three and nine months ended September 30, 2007 and September 30, 2006. All intercompany accounts and transactions have been eliminated in consolidation. These condensed consolidated financial statements have been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, or SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The December 31, 2006 consolidated balance sheet was derived from audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. However, we believe that all disclosures are adequate to make the information presented not misleading. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto, included in our annual report on Form 10-K for the year ended December 31, 2006.
 
In the opinion of our management, all adjustments (which consist of normal recurring adjustments, except as disclosed herein) necessary to fairly present our financial position, results of operations and cash flows for the interim periods presented have been included. The results of operations for the three and nine months ended September 30, 2007 are not necessarily indicative of the results to be expected for the full year or for any future periods.
 
Significant Accounting Policies
 
On January 1, 2007, we adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109,” (“FIN 48”) as discussed more fully below. Other than this change, we have had no significant changes in our accounting policies during the nine months ended September 30, 2007 as compared to the significant accounting policies described in our annual report on Form 10-K for the year ended December 31, 2006.
 
Income Taxes
 
We adopted the provisions of FIN 48 effective January 1, 2007. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition.
 
FIN 48 prescribes a two-step process to determine the amount of tax benefit to be recognized. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to estimate and measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. It is inherently difficult and subjective to estimate such amounts, as this requires determination of the probability of various possible outcomes. We reevaluate these uncertain tax positions on a quarterly basis. This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit, and new audit activity. Such a


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision in the period. See Note 9 for further discussion of the impact of adoption of FIN 48.
 
Inventory
 
Inventory, which consists primarily of finished goods owned at fulfillment partner locations and inventory sold into our channel which has not been sold through to the end-user, is stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first in, first out basis. Inventory balances are included in other current assets in our condensed consolidated balance sheets, and are $2.9 million as of September 30, 2007 and $2.7 million as of December 31, 2006.
 
Deferred Costs of Revenue
 
Deferred costs of revenue, which consist primarily of costs related to revenue-sharing and royalty arrangements, are included in prepaid expenses and prepaid taxes and other assets on our condensed consolidated balance sheets. We only defer direct and incremental costs related to revenue-sharing arrangements and recognize such deferred costs proportionate to the related revenue recognized. Our deferred costs as of September 30, 2007 are $94.1 million, and $70.2 million as of December 31, 2006.
 
SEC and Compliance Costs
 
SEC and compliance costs include expenses associated with independent consultants engaged to examine and recommend improvements to our internal controls to ensure compliance with federal securities laws as required by our settlement with the SEC, which was finalized in 2006, and expenses related to the investigation into our stock option granting practices.
 
Recent Accounting Pronouncements
 
Noncontrolling Interests
 
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”). SFAS 160 amends Accounting Research Bulletin No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 is effective for us beginning January 1, 2009. We do not expect the adoption of SFAS 160 to have a material impact on our consolidated financial position, results of operations or cash flows.
 
Business Combinations
 
In December 2007, the FASB revised SFAS No. 141, “Business Combinations” (“SFAS 141(R)”), to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. SFAS 141(R) establishes principles and requirements for recognizing and measuring identifiable assets and goodwill acquired, liabilities assumed, and any noncontrolling interest in an acquisition, at their fair value as of the acquisition date. SFAS 141(R) is effective for us beginning January 1, 2009. We are currently assessing how the adoption of SFAS 141(R) will impact our consolidated financial position, results of operations and cash flows.
 
Fair Value Option
 
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB Statement No. 1” (“SFAS 159”). SFAS 159 permits entities to choose to measure certain financial instruments and other items at fair value that are not currently required to be measured at fair value, with unrealized gains and losses related to these financial instruments reported in earnings at


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
each subsequent reporting date. SFAS 159 is effective for us beginning January 1, 2008. We do not expect the adoption of SFAS 159 to have a material impact on our consolidated financial position, results of operations or cash flows.
 
Fair Value Measurements
 
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value, and expands disclosure requirements regarding fair value measurement. Where applicable, SFAS 157 simplifies and codifies fair value related guidance previously issued within generally accepted accounting principles. Although, SFAS 157 does not require any new fair value measurements, its application may, for some entities, change current practice. SFAS 157 is effective for us beginning January 1, 2008. We do not expect the adoption of SFAS 157 to have a material impact on our consolidated financial position, results of operations or cash flows.
 
How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement
 
In March 2006, the FASB’s Emerging Issues Task Force released Issue 06-3, “How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement(“EITF 06-3”). A consensus was reached that entities may adopt a policy of presenting sales taxes in the income statement on either a gross or net basis. If taxes are significant, an entity should disclose its policy of presenting taxes and the amount of taxes if reflected on a gross basis in the income statement. EITF 06-3 was effective for us beginning January 1, 2007. We present revenue net of sales taxes in our condensed consolidated statements of income and comprehensive income and did not change our policy as a result of EITF 06-3.
 
3.   Employee Stock Benefit Plans
 
We record compensation expense for stock-based awards issued to employees and directors in exchange for services provided based on the estimated fair value of the awards on their grant dates. Compensation expense is recognized over the required service period of the awards. Our stock-based awards include stock options, restricted stock awards, restricted stock units and our Employee Stock Purchase Plan (“ESPP”).
 
The following table summarizes stock-based compensation expense in accordance with the provisions of SFAS No. 123(R) “Share Based Payment” (“SFAS 123(R)”) (in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Amortization of fair value of options issued to employees
  $ 4,808     $ 6,955     $ 14,080     $ 24,677  
Former employees — extension of post-termination exercise period
    128             11,206        
Cash settlement of options
    (76 )     2,668       2,114       2,668  
Restricted stock awards and units
    5,785       4,984       15,932       11,447  
Employee Stock Purchase Plan
          257             1,864  
                                 
Total stock-based compensation expense
  $ 10,645     $ 14,864     $ 43,332     $ 40,656  
                                 
 
Amortization of fair value of options issued to employees.  We recognize the fair value of stock options issued to employees as stock-based compensation expense over the vesting period of the awards. As we adopted SFAS 123(R) using the modified prospective method, these charges include compensation expense for stock options granted prior to January 1, 2006 but not yet vested as of January 1, 2006, based on the grant date fair value


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
estimated in accordance with the pro forma provisions of SFAS 123, and compensation expense for stock options granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R).
 
Former employees — extension of post-termination exercise period.  From July 2006, when we announced that we might have to restate our historical financial statements as a result of our ongoing stock option investigation, through the date we become current on our reporting obligations under the Securities Exchange Act of 1934, as amended, (“blackout period”), 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 vested options held by certain former employees and outside directors who terminated and whose stock options would have expired during the blackout period. We recognized $0.1 million and $11.2 million of stock-based compensation expense in the three and nine months ended September 30, 2007, respectively, based on the fair value of the modified options. The stock-based compensation expense in the three months ended September 30, 2007 was based on modified options held by former employees that vested during the three months ended September 30, 2007. The stock-based compensation expense in the nine months ended September 30, 2007 was based on modified options held by former employees that terminated from January 1, 2007 through September 30, 2007, and which were vested as of the modification date and through September 30, 2007. The expense was calculated in accordance with the guidance in SFAS 123(R). The options were deemed to have no value prior to the extension of the life beyond the blackout period.
 
Based on the guidance in SFAS 123(R) and related 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 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 condensed consolidated statements of income and comprehensive income in the period of change until the options are exercised, expire or are otherwise settled. We recognized a benefit of $0.2 million and expense of $1.7 million related to the change in fair value of these options in the three and nine months ended September 30, 2007, respectively. Such amounts are included in general and administrative expense in our condensed consolidated statements of income and comprehensive income, and are not reflected as stock-based compensation expense in the table above. 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. 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. Such amounts will be included in general and administrative expense in our condensed consolidated statements of income and comprehensive 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.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Cash settlement of options.  Certain stock options held by terminated employees expired during the blackout period as they could not be exercised during the 90 day period subsequent to termination. The cash payment to settle these options will be based upon an average closing price of our common stock subsequent to us becoming current on our reporting obligations under the Securities Exchange Act of 1934, as amended. We have recorded a liability based on the intrinsic value of these options as of September 30, 2007. We will continue to adjust this amount in future reporting periods based on the closing price of our common stock.
 
Restricted stock awards and units.  We recognize stock-based compensation expense for the fair value of restricted stock awards and restricted stock units. Fair value is determined as the difference between the closing price of our common stock on the grant date and the purchase price of the restricted stock awards and units. The fair value of these awards is recognized to expense over the requisite service period of the awards.
 
Employee Stock Purchase Plan.  We recognize stock-based compensation expense for the fair value of employee stock purchase rights issued pursuant to our ESPP. The estimated fair value of employee stock purchase rights is based on the Black-Scholes pricing model. Expense is recognized ratably based on contributions and the total fair value of the employee stock purchase rights estimated to be issued. We had no stock-based compensation expense related to our employee stock purchase plan during the nine months ended September 30, 2007 due to suspension of this plan in July 2006.
 
The following table summarizes the stock-based compensation expense by income statement line item that we recorded in accordance with the provisions of SFAS 123(R) (in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Cost of net revenue — service and support
  $ 276     $ 546     $ 1,231     $ 1,503  
Cost of net revenue — subscription
    189       180       732       485  
Cost of net revenue — product
    145       190       602       576  
                                 
Stock-based compensation expense included in cost of net revenue
    610       916       2,565       2,564  
Research and development
    2,752       4,299       11,017       11,637  
Marketing and sales
    3,486       6,158       16,811       16,257  
General and administrative
    3,797       3,491       12,939       10,198  
                                 
Stock-based compensation expense included in operating expenses
    10,035       13,948       40,767       38,092  
                                 
Total stock-based compensation expense related to stock-based equity awards
    10,645       14,864       43,332       40,656  
Deferred tax benefit
    (2,914 )     (2,966 )     (12,602 )     (10,014 )
                                 
Total stock-based compensation expense related to stock-based equity awards, net of tax
  $ 7,731     $ 11,898     $ 30,730     $ 30,642  
                                 
 
At September 30, 2007, the estimated fair value of all unvested stock options, restricted stock units, and restricted stock awards that have not yet been recognized as compensation expense was $63.5 million, net of expected forfeitures. We expect to recognize this amount over a weighted-average period of 2.4 years.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Under SFAS 123(R), we used the Black-Scholes model to estimate the fair value of our option awards and employee stock purchase rights issued under the ESPP. The key assumptions used in the model during the three and nine months ended September 30, 2007 and 2006, respectively, are provided below:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Stock option grants:
                               
Risk free interest rate
    4.7 %     4.9 %     4.7 %     4.8 %
Weighted average expected lives (years)
    5.7       5.9       6.1       5.6  
Volatility
    38.0 %     34.0 %     32.0 %     38.4 %
Dividend yield
                       
ESPP:
                               
Risk free interest rate
                            4.6 %
Weighted average expected lives (years)
                            0.5  
Volatility
                            38.0 %
Dividend yield
                             
 
During the three and nine months ended September 30, 2007, and the three months ended September 30, 2006, we did not have any ESPP grants.
 
We derive the expected term of our options through the use of a lattice model that factors in historical data on employee exercise and post-vesting employment termination behavior. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. Since January 1, 2006, we have used the implied volatility of options traded on our stock with a term of six months or more to calculate the expected volatility of our option grants. We have not declared any dividends on our stock in the past and do not expect to do so in the foreseeable future.
 
Internal Revenue Code Section 409A
 
Adverse tax consequences will result from our revision of accounting measurement dates for stock options that vest subsequent to December 31, 2004 (“409A affected options”). These adverse tax consequences include a penalty tax payable by the option holder under Internal Revenue Code (“IRC”) Section 409A (and, as applicable, similar penalty taxes under state tax laws). As virtually all holders of options with revised measurement dates were not involved in or aware of their incorrect option exercise prices, we took certain actions to deal with the adverse tax consequences that may be incurred by the holders of such options.
 
Section 16(a) Officers and Directors
 
In December 2006, our board of directors approved the amendment of 409A affected options for those who were Section 16(a) officers upon the receipt of 409A affected options to increase the exercise price to the fair market value of our common stock on the revised measurement date. These amended options would not be subject to taxation under IRC Section 409A. Under Internal Revenue Service (“IRS”) regulations, these option amendments had to be completed by December 31, 2006 for anyone subject to Section 16(a) requirements upon receipt of the 409A affected options. There were no costs associated with this action, as the modifications increased the exercise price, which results in no incremental expense.
 
IRS Announcement 2007-18 Compliance
 
In February 2007, our board of directors approved our participation in a voluntary program under Internal Revenue Service Announcement 2007-18 and a similar state of California Announcement, whereby we will pay


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
additional 409A taxes on behalf of certain former United States employees who have already exercised 409A affected options for the additional taxes they incur under IRC Section 409A (and, as applicable, similar state of California tax law). Current and former Section 16(a) officers and directors are specifically excluded from the program. Through September 30, 2007, we recorded $1.3 million of costs associated with this program for Section 409A affected options exercised during this period.
 
Certain Former Employees Future Exercises of 409A Affected Options
 
In May 2007, our board of directors approved cash payments as necessary to certain former employees who exercised 409A affected options during 2006 that may exercise 409A affected options in the future. In the three months ended September 30, 2007, we recorded no costs associated with former employees’ exercises of certain 409A affected options. In the nine months ended September 30, 2007, we recorded $0.9 million of costs associated with former employees’ exercises of certain 409A affected options. We may incur additional costs in future periods associated with former employees’ expected exercises of certain 409A affected options but we do not expect the costs to be material.
 
In November 2007, our board of directors approved the unilateral amendment of 409A affected options held by certain former employees who did not exercise 409A affected options during 2006 to increase the exercise price to the fair market value of our common stock on the revised measurement date, and to make cash payments as compensation for the increase in the exercise prices of amended options. These amended options would not be subject to taxation under IRC Section 409A. We expect to incur additional costs of $0.5 million associated with former employees’ future exercises of certain 409A affected options once we become current on our reporting obligations under the Security Exchange Act of 1934, as amended.
 
The following table summarizes, for the periods indicated, costs associated with actions taken by us with respect to IRC Section 409A (in thousands):
 
         
    Nine Months Ended
 
    September 30, 2007  
 
Cost of net revenue
  $  
Research and development
    874  
Marketing and sales
    589  
General and administrative
    788  
         
Costs associated with IRC Section 409A
  $ 2,251  
         
 
We are also considering offering active employees who are option holders the opportunity to amend or exchange their options to avoid the adverse consequences of 409A.
 
4.   Business Combinations and Divestitures
 
Citadel Security Software
 
In December 2006, we acquired substantially all of the assets of Citadel Security Software Inc. (“Citadel”) a security software provider focused on solutions in security policy compliance and vulnerability remediation, for $56.1 million in cash, plus $3.9 million in working capital reimbursements and $1.2 million in direct acquisition costs, totaling $61.2 million. We have incorporated Citadel’s technology into our existing consumer products.
 
Our management determined the purchase price allocation based on estimates of the fair values of the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived at utilizing recognized valuation techniques. We recorded $41.7 million of goodwill. We recorded no in-process research and development related to this acquisition.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The intangible assets, other than goodwill, are being amortized over their useful lives of 2.0 to 5.0 years or a weighted-average period of 4.0 years. As part of the acquisition, we did not assume any outstanding stock options or warrants. A performance and retention plan, which provides for payment of up to $0.6 million through 2008, was established at the close of the acquisition. At September 30, 2007, $0.5 million had been expensed and $0.2 million had been paid related to this performance plan.
 
Onigma
 
In October 2006, we acquired 100% of the capital shares of Onigma Ltd. (“Onigma”) a provider of data protection solutions that monitor, report and prevent confidential data from leaving an enterprise, for $18.9 million in cash and $0.2 million in direct acquisition costs, totaling $19.1 million. We have incorporated Onigma’s technology into our existing corporate security products.
 
Our management determined the purchase price allocation based on estimates of the fair values of the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived at utilizing recognized valuation techniques. There was no goodwill associated with this acquisition. We recorded no in-process research and development related to this acquisition.
 
The intangible assets are being amortized over their useful lives of 2.0 to 4.0 years or a weighted-average period of 3.9 years. As part of the acquisition, we did not assume any outstanding stock options or warrants. A performance and retention plan, which provides for payment of up to $0.9 million through 2007, was established at the close of the acquisition. At September 30, 2007, $0.5 million had been expensed and $0.3 million had been paid related to this performance plan.
 
Preventsys
 
In June 2006, we acquired 100% of the outstanding capital shares of Preventsys, Inc. (“Preventsys”), a creator of security risk management and automated security compliance reporting, for $4.4 million in cash and $0.4 million in direct acquisition costs, totaling $4.8 million. We have added Preventsys products to our existing portfolio of corporate security offerings.
 
Our management determined the purchase price allocation based on estimates of the fair values of the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived at utilizing recognized valuation techniques. We recorded $0.2 million of goodwill (none of which was deductible for tax purposes).
 
We recorded $0.5 million for in-process research and development, which was fully expensed upon purchase because technological feasibility had not been achieved, and there was no alternative use for the projects under development. The in-process research and development included the development of a new version of the security risk management system that will include increased functionality and new features. We introduced this version during the fourth quarter of 2006. At the date of acquisition, we estimated that 40% of the development effort had been completed and that the remaining 60% of development would take approximately two months to complete. As of December 31, 2006, all development was complete, and costs were $0.5 million. The intangible assets, other than goodwill, are being amortized over their useful lives of 3.0 to 5.0 years or a weighted-average period of 3.2 years. As part of the acquisition, we did not assume any outstanding stock options or warrants. A performance and retention plan, which provides for payment of up to $0.8 million through 2007, was established at the close of the acquisition. At September 30, 2007, $0.8 million had been expensed and paid related to this performance plan.
 
SiteAdvisor
 
In April 2006, we acquired 100% of the outstanding capital shares of SiteAdvisor, Inc. (“SiteAdvisor”), a web safety consumer software company that tests and rates internet sites on an ongoing basis, for $60.8 million in cash and $0.2 million in direct acquisition costs, totaling $61.0 million. We have bundled the SiteAdvisor technology with our existing consumer product offerings.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Our management determined the purchase price allocation based on estimates of the fair values of the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived at utilizing recognized valuation techniques. We recorded $50.6 million of goodwill (none of which was deductible for tax purposes). We recorded no in-process research and development related to this acquisition.
 
The intangible assets, other than goodwill, are being amortized over their useful lives of 2.0 to 4.0 years or a weighted-average period of 3.0 years. As part of the acquisition, we did not assume any outstanding stock options or warrants. A performance and retention plan, which provides for payment of up to $9.1 million through 2008, was established at the close of the acquisition. At September 30, 2007, $8.6 million had been expensed and $8.5 had been paid related to this performance plan.
 
The following is a summary of the assets acquired and liabilities assumed in the acquisition of Citadel, Onigma, Preventsys and SiteAdvisor as adjusted for the resolution of ongoing purchase price valuation procedures (in thousands):
 
                                         
    SiteAdvisor     Preventsys     Onigma     Citadel     Total  
 
Technology
  $ 15,450     $ 3,540     $ 23,139     $ 15,900     $ 58,029  
Other intangibles
    420       890       1,889       6,500       9,699  
Goodwill
    50,397       269             42,041       92,707  
Cash
    29       23       125             177  
Other assets
    485       661       281       1,117       2,544  
Deferred tax assets
    587       1,978       530             3,095  
                                         
Total assets acquired
    67,368       7,361       25,964       65,558       166,251  
Accrued liabilities
    37       1,024       372       426       1,859  
Deferred revenue
          203             3,937       4,140  
Deferred tax liabilities
    6,269       1,750       6,429             14,448  
                                         
Total liabilities assumed
    6,306       2,977       6,801       4,363       20,447  
                                         
Net assets acquired
    61,062       4,384       19,163       61,195       145,804  
                                         
In-process research and development expensed
          460                   460  
                                         
Total acquisition cost
  $ 61,062     $ 4,844     $ 19,163     $ 61,195     $ 146,264  
                                         
 
The results of operations for Citadel, Onigma, Preventsys and SiteAdvisor have been included in our results of operations since the date of acquisition.
 
The following unaudited pro forma financial information presents our combined results with Citadel and Preventsys as if the acquisitions had occurred at the beginning of 2006 (in thousands, except per share data):
 
                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2006     September 30, 2006  
 
Net revenue
  $ 289,093     $ 850,966  
Net income
    28,434       91,129  
Basic net income per share
  $ 0.18     $ 0.56  
                 
Diluted net income per share
  $ 0.18     $ 0.56  
                 
Shares used in per share calculation — basic
    159,728       161,343  
                 
Shares used in per share calculation — diluted
    161,485       163,132  
                 


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The above unaudited pro forma financial information includes adjustments for amortization of identifiable intangible assets that were acquired. The pro forma financial information excludes the effects of the in-process research and development totaling $0.5 million that was expensed immediately. In management’s opinion, the unaudited pro forma combined results of operations are not indicative of the actual results that would have occurred had the acquisition been consummated at the beginning of 2006, nor are they indicative of future operations of the combined companies.
 
Pro forma results of operations for Onigma and SiteAdvisor have not been presented because the effects of these acquisitions, individually or in the aggregate, were not material to our results of operations.
 
5.   Goodwill and Other Intangible Assets
 
We account for goodwill and other intangible assets in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” Specifically, we perform an impairment review of our goodwill on at least an annual basis and amortize all other intangible assets over their estimated useful lives.
 
Our goodwill impairment review is conducted as of October 1 of each fiscal year or earlier if indicators of impairment exist. In 2006, this analysis indicated that goodwill was not impaired. The fair value of the reporting units was estimated using the average of the expected present value of future cash flows and of the market multiple value. We will continue to test for impairment on an annual basis and on an interim basis if an event occurs or circumstances change that would more likely than not reduce the fair value of our reporting units below their carrying amounts.
 
Goodwill by geographic region is as follows (in thousands):
 
                                 
    December 31,
          Effects of Foreign
    September 30,
 
    2006     Adjustments     Currency Exchange     2007  
 
North America
  $ 412,453     $ 2,607     $ 1,382     $ 416,442  
EMEA
    75,445       686       148       76,279  
Japan
    18,771       107             18,878  
Asia-Pacific (excluding Japan)
    11,960       69             12,029  
Latin America
    11,848       69       148       12,065  
                                 
Total
  $ 530,477     $ 3,538     $ 1,678     $ 535,693  
                                 
 
The adjustment to goodwill during the nine months ended September 30, 2007 included purchase price adjustments of $0.2 million related to Citadel, Preventsys and SiteAdvisor and adjustments of $3.4 million related to certain historical acquisitions resulting from our adoption of FIN 48 on January 1, 2007.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The components of intangible assets are as follows (in thousands):
 
                                                         
    September 30, 2007     December 31, 2006  
                Accumulated
                Accumulated
       
                Amortization
                Amortization
       
                (Including
                (Including
       
    Weighted
          Effects of
                Effects of
       
    Average
    Gross
    Foreign
    Net
    Gross
    Foreign
    Net
 
    Useful
    Carrying
    Currency
    Carrying
    Carrying
    Currency
    Carrying
 
    Life     Amount     Exchange)     Amount     Amount     Exchange)     Amount  
 
Other intangible assets:
                                                       
Purchased technologies
    4.4 years     $ 188,864     $ (128,208 )   $ 60,656     $ 203,790     $ (119,202 )   $ 84,588  
Trademarks and patents
    5.2 years       38,244       (29,761 )     8,483       29,444       (28,830 )     614  
Customer base and other intangibles
    5.9 years       71,021       (50,379 )     20,642       72,161       (43,789 )     28,372  
                                                         
            $ 298,129     $ (208,348 )   $ 89,781     $ 305,395     $ (191,821 )   $ 113,574  
                                                         
 
The aggregate amortization expenses for the intangible assets listed above totaled $10.4 million and $8.6 million in the three months ended September 30, 2007 and 2006, respectively, and $33.5 million and $24.5 million in the nine months ended September 30, 2007 and 2006, respectively.
 
Expected future intangible asset amortization expense as of September 30, 2007 is as follows (in thousands):
 
         
Fiscal Years:
       
Remainder of 2007
  $ 9,635  
2008
    35,094  
2009
    24,103  
2010
    15,529  
2011
    3,122  
Thereafter
    2,298  
         
    $ 89,781  
         
 
6.   Restructuring Charges
 
2006 Restructuring
 
In 2006, we initiated certain restructuring actions to reduce our cost structure and, at the same time, enable us to invest in certain strategic growth initiatives to enhance our competitive position.
 
In the fourth quarter of 2006, we recorded a $2.4 million restructuring charge related to a reduction of primarily marketing and sales employees. The charge related to the severance of 75 employees, of which $1.0 million, $1.1 million, $0.1 million and $0.2 million was recorded in our North America, EMEA, Japan and Asia-Pacific operating segments, respectively.
 
During the first nine months of 2007, we completed these restructuring activities when we permanently vacated several leased facilities and recorded a $0.3 million accrual for estimated lease related costs associated with the permanently vacated facilities. The remaining costs associated with vacating the facilities are primarily comprised of the present value of remaining lease obligations. We also recorded a net restructuring charge of $2.4 million related to a reduction in headcount of 33 employees, of which $0.2 million, $2.1 million and $0.1 million was recorded in our North America, EMEA and Asia-Pacific operating segments, respectively.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The following table summarizes our restructuring accrual established in 2006 and activity through September 30, 2007 (in thousands):
 
                         
    Lease
             
    Termination
    Severance and
       
    Costs     Other benefits     Total  
 
Balance, January 1, 2006
  $     $     $  
Restructuring accrual
          2,404       2,404  
Cash payments
          (14 )     (14 )
                         
Balance, December 31, 2006
          2,390       2,390  
Restructuring accrual
    330       2,634       2,964  
Adjustment to liability
          (181 )     (181 )
Cash payments
    (212 )     (4,491 )     (4,703 )
Effects of foreign currency exchange
    4             4  
                         
Balance, September 30, 2007
  $ 122     $ 352     $ 474  
                         
 
As of September 30, 2007, $0.4 million of the restructuring accrual is due within 12 months and has been classified as current accrued liabilities, while the remaining balance of $0.1 million has been classified as other long-term liabilities, and will be paid through 2009.
 
2005 Restructuring
 
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. The remaining costs associated with vacating the facilities are primarily comprised of the present value of remaining lease obligations, along with estimated costs associated with subleasing the vacated facility, net of estimated sublease rental income. We also recorded a restructuring charge of $0.2 million related to a reduction in headcount of 14 employees.
 
The following table summarizes our restructuring accrual established in 2005 and activity through September 30, 2007 (in thousands):
 
                                 
    Lease
                   
    Termination
    Severance and
    Other
       
    Costs     Other benefits     Costs     Total  
 
Balance, January 1, 2005
  $     $     $     $  
Restructuring accrual
    1,800       216       4       2,020  
Cash payments
    (1,205 )     (216 )     (4 )     (1,425 )
Effects of foreign currency exchange
    (14 )                 (14 )
Accretion
    23                   23  
                                 
Balance, December 31, 2005
    604                   604  
Cash payments
    (577 )                 (577 )
Adjustment to liability
    4                   4  
Effects of foreign currency exchange
    (19 )                 (19 )
Accretion
    12                   12  
                                 
Balance, December 31, 2006
    24                   24  
Cash payments
    (71 )                 (71 )
Restructuring accrual
    47                   47  
                                 
Balance, September 30, 2007
  $     $     $     $  
                                 


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
2004 Restructuring
 
During 2004, we recorded several restructuring charges primarily due to the sale of Magic in January 2004, announced cost-savings measures, the move of our European headquarters to Ireland, permanently vacating an additional two floors in our Santa Clara headquarters building and permanently vacating several other leased facilities. During 2004, we reduced our workforce by 441 employees in our sales, technical support and general and administrative functions. We recorded several restructuring charges totaling $8.4 million, of which $2.8 million related to North America, $4.7 million related to EMEA, $0.7 million related to Latin America, and $0.2 million to Asia-Pacific, excluding Japan.
 
We recorded an additional $10.0 million accrual in 2004 for the estimated lease related costs associated with permanently vacating two additional floors in our Santa Clara headquarters building and other leased facilities, partially offset by a $1.3 million write-off of a deferred rent liability. The remaining costs associated with vacating the facility are primarily comprised of the present value of remaining lease obligations, net of estimated sublease income along with estimated costs associated with subleasing the vacated facility. The remaining costs will generally be paid over the remaining lease term ending in 2013. We also recorded a non- cash charge of $0.8 million related to asset disposals and discontinued use of certain leasehold improvements and furniture and equipment.
 
During 2004, we adjusted the restructuring accruals related to severance costs and lease termination costs recorded in 2004. We recorded a $0.3 million adjustment to reduce the EMEA severance accrual for amounts that were no longer necessary after paying out the former employees. We also recorded a $0.2 million reduction in lease termination costs due to changes in estimates related to the sublease income to be received over the remaining lease term of our Santa Clara headquarters building.
 
During 2005, we completed the move of our European headquarters to Ireland and vacated the planned space in Amsterdam. We recorded an additional $1.5 million restructuring charge for estimated lease related costs associated with the permanently vacated facilities and a $1.4 million restructuring charge for severance costs. All of these restructuring charges were related to the EMEA operating segment. During 2005, we also made adjustments to our restructuring accrual totaling $0.8 million due to a change in assumptions related to utility costs and sublease income.
 
During 2006, we decreased our restructuring accrual by $0.6 million attributable to commissions on new subleases, a change in assumptions related to commissions on existing subleases and favorable changes in market rates associated with subleased facilities in Amsterdam and Santa Clara.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The following table summarizes our restructuring accruals established in 2004 and activity through September 30, 2007 (in thousands):
 
                                 
    Lease
                   
    Termination
    Severance and
    Other
       
    Costs     Other Benefits     Costs     Total  
 
Balance, January 1, 2004
  $     $     $     $  
Restructuring accrual
    9,973       7,932       480       18,385  
Cash payments
    (579 )     (4,175 )     (63 )     (4,817 )
Adjustment to liability
    (231 )     (275 )           (506 )
Accretion
    74                   74  
                                 
Balance, December 31, 2004
    9,237       3,482       417       13,136  
Restructuring accrual
    1,454       1,382       20       2,856  
Cash payments
    (2,747 )     (4,864 )     (297 )     (7,908 )
Adjustment to liability
    (810 )           (140 )     (950 )
Effects of foreign currency exchange
    (46 )                 (46 )
Accretion
    341                   341  
                                 
Balance, December 31, 2005
    7,429                   7,429  
Cash payments
    (2,111 )                 (2,111 )
Adjustment to liability
    (598 )                 (598 )
Effects of foreign currency exchange
    97                   97  
Accretion
    256                   256  
                                 
Balance, December 31, 2006
    5,073                   5,073  
Cash payments
    (916 )                 (916 )
Adjustment to liability
    3                   3  
Effects of foreign currency exchange
    99                   99  
Accretion
    128                   128  
                                 
Balance, September 30, 2007
  $ 4,387     $     $     $ 4,387  
                                 
 
As of September 30, 2007, $1.2 million of the restructuring accrual is due within 12 months and has been classified as current accrued liabilities, while the remaining balance of $3.2 million has been classified as other long-term liabilities, and will be paid through 2013. Lease termination costs are net of estimated sublease income of $4.9 million at September 30, 2007.
 
2003 Restructuring
 
In January 2003, as part of a restructuring effort to gain operational efficiencies, we consolidated operations formerly housed in three leased facilities in the Dallas, Texas area into our regional headquarters facility in Plano, Texas. The facility houses employees working in finance, information technology, legal, human resources, field sales and the customer support and telesales groups.
 
As part of the consolidation of activities into the Plano facility, we relocated employees from the Santa Clara, California headquarters site. As a result of this consolidation, in March 2003, we recorded a $15.7 million accrual for estimated lease related costs associated with the permanently vacated facilities, partially offset by a $1.9 million write-off of deferred rent liability. The remaining costs associated with vacating the facility are primarily comprised of the present value of remaining lease obligations, net of estimated sublease income, along with estimated costs associated with subleasing the vacated facility. The remaining costs will generally be paid over the remaining lease term ending in 2013. We also recorded a non-cash charge of $2.1 million related to asset disposals and discontinued use of certain leasehold improvements and furniture and equipment. This restructuring charge was allocated to our North American segment.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
During 2003, we recorded restructuring charges of $7.4 million, which consisted of $6.7 million related to a headcount reduction of 210 employees and $0.7 million related to other expenses such as legal expenses incurred in international locations in conjunction with the headcount reduction. The restructuring charge related to headcount reductions was $0.9 million and $5.8 million in our North American and EMEA operating segments, respectively. The employees were primarily in the sales, product development and customer support areas. In 2003, we reversed a total of $0.7 million of restructuring accrual in EMEA that was no longer necessary after paying out substantially all accrued amounts to the former employees. We also decreased the restructuring accrual related to lease termination costs as a result of changes in estimates for sublease income and related commissions of $0.3 million.
 
In 2004, we adjusted the restructuring accrual related to lease termination costs previously recorded in 2003. The adjustments decreased the liability by $0.5 million in 2004, due to favorable changes in estimates related to the sublease income to be received over the remaining lease term. Also in 2004, we recorded a $0.1 million adjustment to reduce the restructuring accrual for severance and benefits from our EMEA operating segment that would not be utilized.
 
During 2005, we made adjustments to our restructuring accrual totaling $1.0 million due to a change in assumptions related to utility costs and sublease income.
 
During 2006, we decreased our restructuring accrual by $1.9 million attributable to a change in assumptions related to commissions on new and existing subleases and favorable changes in market rates associated with our subleased space.
 
The following table summarizes our restructuring accrual established in 2003 and activity through September 30, 2007 (in thousands):
 
                                 
    Lease
                   
    Termination
    Severance and
    Other
       
    Costs     Other Benefits     Costs     Total  
 
Balance, January 1, 2003
  $     $     $     $  
Restructuring accrual
    15,734       6,692       739       23,165  
Cash payments
    (1,707 )     (6,259 )     (167 )     (8,133 )
Adjustment to liability
    (273 )     (116 )     (572 )     (961 )
Accretion
    463                   463  
                                 
Balance, December 31, 2003
    14,217       317             14,534  
Cash payments
    (1,841 )     (194 )           (2,035 )
Adjustment to liability
    (483 )     (123 )           (606 )
Accretion
    548                   548  
                                 
Balance, December 31, 2004
    12,441                   12,441  
Cash payments
    (1,279 )                 (1,279 )
Adjustment to liability
    (1,006 )                 (1,006 )
Accretion
    498                   498  
                                 
Balance, December 31, 2005
    10,654                   10,654  
Cash payments
    (1,960 )                 (1,960 )
Adjustment to liability
    (1,908 )                 (1,908 )
Accretion
    389                   389  
                                 
Balance, December 31, 2006
    7,175                   7,175  
Cash payments
    (1,067 )                 (1,067 )
Accretion
    202                   202  
                                 
Balance, September 30, 2007
  $ 6,310     $     $     $ 6,310  
                                 


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
As of September 30, 2007, $1.1 million of the restructuring accrual is due within 12 months and has been classified as current accrued liabilities, while the remaining balance of $5.2 million has been classified as other long-term liabilities and will be paid through 2013. Lease termination costs are net of estimated sublease income of $9.0 million at September 30, 2007.
 
Our estimate of the excess facilities charges recorded may vary significantly depending, in part, on factors which may be beyond our control, such as our success in negotiating with our lessor, the time periods required to locate and contract suitable subleases, the market rates at the time of such subleases and the amount of commissions paid in association with sublease activities. Adjustments to the facilities accrual will be made if actual lease exit costs or sublease income differ from amounts currently expected. The facility restructuring charges in 2007 were in the North America, EMEA, Japan, Asia-Pacific, excluding Japan, and Latin America operating segments. The facility restructuring charges in 2005 were primarily in the EMEA, Japan and North America operating segments, and the facility restructuring charges in 2004 and 2003 were primarily in the North America operating segment.
 
7.   Line of Credit
 
We have a 14.0 million Euro credit facility with a bank. The credit facility is available on an offering basis, meaning that transactions under the credit facility will be on such terms and conditions, including interest rate, maturity, representations, covenants and events of default, as mutually agreed between us and the bank at the time of each specific transaction. The credit facility is intended to be used for short-term credit requirements, with terms of one year or less. The credit facility can be cancelled at any time. No balances were outstanding as of September 30, 2007 and December 31, 2006.
 
8.   Net Income Per Share
 
A reconciliation of the numerator and denominator of basic and diluted net income per share is provided as follows (in thousands, except per share amounts):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Numerator — Basic and diluted net income
  $ 63,401     $ 34,090     $ 154,795     $ 104,595  
                                 
Denominator — Basic
                               
Basic weighted average common stock outstanding
    159,808       159,728       159,802       161,343  
                                 
Denominator — Diluted
                               
Basic weighted average common stock outstanding
    159,808       159,728       159,802       161,343  
Effect of dilutive securities:
                               
Common stock options and restricted stock units, Employee Stock Purchase Plan shares and shares subject to repurchase(1)
    4,705       1,757       4,069       1,789  
                                 
Diluted weighted average shares
    164,513       161,485       163,871       163,132  
                                 
Net income per share — Basic
  $ 0.40     $ 0.21     $ 0.97     $ 0.65  
                                 
Net income per share — Diluted
  $ 0.39     $ 0.21     $ 0.94     $ 0.64  
                                 
 
 
(1) In the three months ended September 30, 2007 and 2006, 2.2 million and 8.2 million options to purchase common stock and restricted stock units, respectively, were excluded from the calculation since the effect was anti-dilutive. In the nine months ended September 30, 2007 and 2006, 2.8 million and 8.1 million options to purchase common stock, respectively, were excluded from the calculation since the effect was anti-dilutive.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
 
9.   Income Taxes
 
In June 2006, the FASB issued FIN 48, which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that we recognize in our financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of 2007, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. As a result of the implementation of FIN 48, as of January 1, 2007, we recognized a decrease of $125.6 million in the liability for unrecognized tax benefits, a $3.4 million increase in acquisition related goodwill, $101.2 million increase in additional paid-in capital, and a $27.8 million increase in retained earnings. As of January 1, 2007 and after the impact of changes noted above, unrecognized tax benefits totaled $40.2 million and accrued interest and penalties totaled $10.7 million (net of any tax benefit) for an aggregate amount of $50.9 million. Of the $50.9 million, $47.5 million, if recognized, would favorably affect our effective tax rate while the remaining amount would reduce goodwill.
 
We file numerous consolidated and separate income tax returns in the United States federal and state jurisdictions and in many foreign jurisdictions. On an ongoing basis we are routinely subject to examination by taxing authorities throughout the world, including jurisdictions such as Australia, Canada, France, Germany, India, Ireland, Italy, Japan, the Netherlands and the United Kingdom. With few exceptions, we are no longer subject to United States federal income tax examinations for years before 2002 and are no longer subject to state and local or foreign income tax examinations by tax authorities for years before 1997.
 
We are presently under audit in many jurisdictions, including notably the United States, California and the Netherlands. The IRS is presently conducting a limited scope examination of our United States federal income tax returns for the calendar years 2002, 2003, 2004 and 2005. The State of California is auditing our income tax returns for the years 2004 and 2005. We are also in pre-filing discussions with the Netherlands’ tax authorities with respect to tax years 2004 and 2005. Currently, we are not able to predict the conclusion of these examinations. Given the various stages of completion of our exams, we cannot currently estimate significant changes to the amount of unrecognized income tax benefits over the next year.
 
We accrue potential interest and penalties related to unrecognized tax benefits through income tax expense. Upon recognition of these tax benefits, interest and penalty amounts accrued will generally be released as a benefit in the income tax provision. During the three and nine months ended September 30, 2007, we recognized a net increase of $0.7 million and $2.1 million, respectively, in potential interest and penalties associated with uncertain tax positions.
 
Our consolidated provision for income taxes for the three months ended September 30, 2007 and 2006 was $3.1 million and $16.8 million, respectively, reflecting an effective tax rate of 5% and 33%, respectively. The effective tax rate for the three months ended September 30, 2007 differs from the United States federal statutory rate (“statutory rate”) primarily due to the benefit of lower tax rates in certain foreign jurisdictions. The effective tax rate for the three months ended September 30, 2006 differs from the statutory rate primarily due to the benefit of lower tax rates in certain foreign jurisdictions offset by the impact of adjustments to tax reserves. Our consolidated provision for income taxes for the nine months ended September 30, 2007 and 2006 was $25.1 million and $33.5 million, respectively, reflecting an effective tax rate of 14% and 24%, respectively. The effective tax rate for the nine months ended September 30, 2007 differs from the statutory rate primarily due to the benefit of lower tax rates in certain foreign jurisdictions. The effective tax rate for the nine months ended September 30, 2006 differs from the statutory rate primarily due to the benefit of lower tax rates in certain foreign jurisdictions and adjustments to valuation allowances partially offset by the adjustments to tax reserves.
 
10.   Business Segment Information
 
We have concluded that we have one business and operate in one industry. We develop, market, distribute and support computer security solutions for large enterprises, small and medium-sized business and consumer users, as


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
well as resellers and distributors. Management measures operations based on our five operating segments: North America; Europe, Middle East and Africa (“EMEA”); Japan; Asia-Pacific, excluding Japan; and Latin America. Our chief operating decision maker is our chief executive officer.
 
We market and sell anti-virus and security software, hardware and services through our geographic regions. These products and services are marketed and sold worldwide primarily through resellers, distributors, systems integrators, retailers, original equipment manufacturers, internet service providers and directly by us. In addition, we offer web sites, which provide suites of online products and services personalized for the user based on the users’ personal computer configuration, attached peripherals and resident software. We also offer managed security and availability applications to corporations and governments on the internet.
 
Summarized financial information concerning our net revenue and income from operations by geographic region is as follows (in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Net revenue by region:
                               
North America
  $ 165,156     $ 164,166     $ 492,631     $ 466,249  
EMEA
    105,264       87,417       310,300       260,685  
Japan
    25,880       18,535       76,116       63,537  
Asia-Pacific, excluding Japan
    15,905       11,241       43,848       30,733  
Latin America
    9,781       5,704       28,799       18,713  
                                 
Net revenue
  $ 321,986     $ 287,063     $ 951,694     $ 839,917  
                                 
Operating income by region:
                               
North America
  $ 54,896     $ 62,369     $ 166,341     $ 170,212  
Europe
    59,337       46,761       178,017       138,805  
Japan
    16,570       10,062       48,815       36,533  
Asia-Pacific, excluding Japan
    2,025       436       5,761       416  
Latin America
    5,132       2,981       17,373       10,132  
Corporate
    (91,320 )     (85,819 )     (289,496 )     (250,665 )
                                 
Income from operations
  $ 46,640     $ 36,790     $ 126,811     $ 105,433  
                                 
 
The difference between income from operations and income before provision for income taxes is reflected on the face of our condensed consolidated statements of income and comprehensive income.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The corporate expenses, which are not considered attributable to any specific geographic region, are as follows (in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
General and administrative and other operating costs
  $ 44,455     $ 39,675     $ 133,650     $ 125,007  
Corporate marketing
    14,028       13,929       45,280       43,042  
Stock-based compensation
    10,645       14,864       43,332       40,656  
Amortization of purchased technology and other intangibles
    10,379       8,643       33,501       24,485  
SEC and compliance costs
    10,885       7,901       25,085       11,673  
Acquisition and retention bonuses
    854       2,146       5,514       5,409  
Restructuring charges (benefit)
    109       (1,393 )     3,158       (274 )
In-process research and development
                      460  
(Gain) loss on sale of assets and technology
    (35 )     54       (24 )     207  
                                 
Corporate expenses
  $ 91,320     $ 85,819     $ 289,496     $ 250,665  
                                 
 
11.   Litigation
 
Settled Cases
 
In February 2007, we reached a confidential settlement of a breach of contract, fraud and bad faith lawsuit filed in June 2002 in the United States District Court, District of Massachusetts. As part of the settlement, we acquired and recorded ownership of intangible assets valued at $9.3 million with all remaining claims settled for $6.2 million, of which $5.0 million was recognized as expense in the three months ended June 30, 2006 with the balance of $1.2 million being expensed in 2004 and prior periods. The case was dismissed on March 1, 2007 and final payment of the settlement was tendered on May 4, 2007.
 
On March 22, 2002, the SEC notified us that it had commenced a “Formal Order of Private Investigation” into our accounting practices. 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.
 
Open Cases
 
We have described below our material legal proceedings and investigations that are currently pending and are not in the ordinary course of business. If management believes that a loss arising from these matters is probable and can reasonably be estimated, we record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary. While we cannot predict the likelihood of future claims or inquiries, we expect that new matters may be initiated against us from time to time. The results of claims, lawsuits and investigations also cannot be predicted, and it is possible that the ultimate resolution of these matters, individually and in the aggregate, may have a material adverse effect on our business, financial condition, results of operations or cash flows.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
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 option grants from January 1, 1995 through the date of the subpoena. At or around the same time, we received a notice of informal inquiry from the 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 6, 2006, we received a document request from the SEC for option grant data for McAfee.com, previously one of our consolidated subsidiaries that was a publicly traded company from December 1999 through September 2002.
 
On November 2, 2006, the investigative team met with the Enforcement Staff of the SEC in Washington D.C. and presented the initial findings of the investigation. Pursuant to discussions between the investigative team and the SEC during that meeting, the scope of the investigation was expanded to include a review of the historical McAfee.com option grants, our historical exercise activity to consider potential exercise date manipulation and post-employment arrangements with former executives.
 
We have provided documents requested by, and we are cooperating with, the SEC and DOJ. The SEC investigation is still in its preliminary stages thus we are unable to determine the ultimate outcome at this time. As such, no provision has been recorded in the financial statements for this matter.
 
Securities Cases
 
On May 31, 2006, a purported stockholder derivative lawsuit — styled Dossett v. McAfee, Inc., No. 5:06CV3484 (JF) — was filed in the United States District Court for the Northern District of California against certain of our current and former directors and officers (“Dossett”). On June 7, 2006, another purported stockholder’s derivative lawsuit — styled Heavy & General Laborers Locals 472 & 172 Pension & Annuity Funds v. McAfee, Inc., No. 5:06CV03620 (JF) — was filed in the United States District Court for the Northern District of California against certain of our current and former directors and officers (“Laborers”). The Dossett and Laborers actions generally allege that we improperly backdated stock option grants between 1997 and the present, and that certain of our current and former officers or directors either participated in this backdating or allowed it to happen. The Dossett and Laborers actions assert claims purportedly on behalf of us for, inter alia, breach of fiduciary duty, abuse of control, constructive fraud, corporate waste, unjust enrichment, gross mismanagement, and violations of the federal securities laws. On July 13, 2006, the United States District Court for the Northern District of California entered an order consolidating the Dossett and Laborers actions as In re McAfee, Inc. Derivative Litigation, Master File No. 5:06CV03484 (JF) (the “Consolidated Action”). On January 22, 2007, we moved to dismiss the complaint in the Consolidated Action on the grounds that plaintiffs lack standing to sue on our behalf because, inter alia, they did not make a pre-suit demand on our board of directors. At the parties’ request, the Court 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


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
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.
 
Certain investment bank underwriters, our company, and certain of our directors and officers have been named in a putative class action for violation of the federal securities laws in the United States District Court for the Southern District of New York, captioned In re McAfee.com Corp. Initial Public Offering Securities Litigation, 01 Civ. 7034 (SAS). This is one of a number of cases challenging underwriting practices in the initial public offerings (“IPOs”), of more than 300 companies. These cases have been coordinated for pretrial proceedings as In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). Plaintiffs generally allege that certain underwriters engaged in undisclosed and improper underwriting activities, namely the receipt of excessive brokerage commissions and customer agreements regarding post-offering purchases of stock in exchange for allocations of IPO shares. Plaintiffs also allege that various investment bank securities analysts issued false and misleading analyst reports. The complaint against us claims that the purported improper underwriting activities were not disclosed in the registration statements for McAfee.com’s IPO and seeks unspecified damages on behalf of a purported class of persons who purchased our securities or sold put options during the time period from December 1, 1999 to December 6, 2000. On February 19, 2003, the Court issued an Opinion and Order dismissing certain of the claims against us with leave to amend. We accepted a settlement proposal on July 15, 2003.
 
We, together with the other issuer defendants and plaintiffs, entered into a stipulation of settlement and release of claims against the issuer defendants that was submitted to the Court for approval in June 2004. On August 31, 2005, the Court preliminarily approved the settlement which, among other things, was conditioned upon class certification. In December 2006, the appellate court overturned the certification of classes making it unlikely that the proposed settlement would receive final Court approval. As a result, on June 25, 2007, the Court entered an order terminating the proposed settlement. Plaintiffs have indicated that they will seek to amend their allegations and file amended complaints. It is uncertain whether there will be any revised or future settlement. Thus, the ultimate outcome, and any ultimate effect on us, cannot be precisely determined at this time.
 
Other
 
On January 7, 2007, a former executive filed an arbitration demand with the American Arbitration Association, Dallas Texas, (the “Texas arbitration”) seeking the arbitration of claims associated with his employment. The Texas arbitration is scheduled to begin on April 7, 2008. On September 5, 2007, a “Complaint for Damages and Other Relief” was also filed by the same former executive, in the Superior Court of the State of California, County of Santa Clara, No. 107CV-093592 (the “California litigation”). The California litigation generally contains the same claims as were filed in the Texas arbitration. A Motion to Compel Arbitration of the California litigation with the Texas arbitration was granted in December 2007. We have filed counterclaims against the former executive, who was terminated for cause. We believe the claims associated with the Texas arbitration and the California litigation


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
are without merit. We intend to vigorously contest these claims, and no provision has been recorded in the financial statements for either the Texas arbitration or the California litigation.
 
On August 17, 2006, a patent infringement lawsuit — captioned Deep Nines v. McAfee, Inc., No. 9:06CV174, (“Deep Nines litigation”) was filed in the United States District Court for the Eastern District of Texas. The lawsuit asserts that (i) several of our Enterprise products infringe on a Deep Nines’ patent, and (ii) we falsely marked certain of its products with a McAfee patent which was abandoned after its issuance. The lawsuit seeks preliminary and permanent injunctions against the sale of certain products as well as damages. We have counter-asserted that Deep Nines has infringed various McAfee patents. The Deep Nines litigation is still in its preliminary stages thus we are unable to determine the ultimate outcome at this time. However, we believe that we have meritorious defenses to this lawsuit and intend to vigorously defend against it. No provision has been recorded in the financial statements for this matter.
 
In addition, we are engaged in certain legal and administrative proceedings incidental to our normal business activities and believe that these matters will not have a material adverse effect on our financial position, results of operations or cash flows.
 
12.   Warranty Accrual and Guarantees
 
We offer a 90 day warranty on our hardware and software products and record a liability for the estimated future costs associated with warranty claims, which is based upon historical experience and our estimate of the level of future costs. A reconciliation of the change in our warranty obligation as of September 30, 2007 and December 31, 2006 follows (in thousands):
 
         
    Warranty
 
    Accrual  
 
Balance, January 1, 2006
  $ 1,083  
Additional accruals
    1,937  
Costs incurred during the period
    (2,358 )
         
Balance, December 31, 2006
    662  
Additional accruals
    1,296  
Costs incurred during the period
    (1,431 )
         
Balance, September 30, 2007
  $ 527  
         
 
The following is a summary of certain guarantee and indemnification agreements as of September 30, 2007:
 
  •  Under the terms of our software license agreements with our customers, we agree that in the event the software sold infringes upon any patent, copyright, trademark, or any other proprietary right of a third-party, we will indemnify our customer licensees against any loss, expense, or liability from any damages that may be awarded against our customer. We include this infringement indemnification in our software license agreements and selected managed service arrangements. In the event the customer cannot use the software or service due to infringement and we can not obtain the right to use, replace or modify the license or service in a commercially feasible manner so that it no longer infringes, then we may terminate the license and provide the customer a pro-rata refund of the fees paid by the customer for the infringing license or service. We have recorded no liability associated with this indemnification, as we are not aware of any pending or threatened infringement actions that are probable losses. We believe the estimated fair value of these intellectual property indemnification clauses is minimal.
 
  •  Under the terms of certain vendor agreements, in particular, vendors used as part of our managed services, we have agreed that in the event the service provided to the customer by the vendor on behalf of us infringes upon any patent, copyright, trademark, or any other proprietary right of a third-party, we will indemnify our


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
  vendor, against any loss, expense, or liability from any damages that may be awarded against our vendor. No maximum liability is stipulated in these vendor agreements. We have recorded no liability associated with this indemnification, as we are not aware of any pending or threatened infringement actions or claims that are probable losses. We believe the estimated fair value of these indemnification clauses is minimal.
 
  •  As permitted under Delaware law, we have agreements 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 exposure and may enable us to recover a portion or all of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.
 
  •  Under the terms of our agreement to sell Magic in January 2004, we agreed to indemnify the purchaser for any breach of representations or warranties in the agreement as well as for any liabilities related to the assets prior to sale that were not included in the purchaser assumed liabilities (undiscovered liabilities). Subject to limited exceptions, the maximum potential loss related to the indemnification is $10.0 million. To date, we have paid no amounts under the representations and warranties indemnification. We have not recorded any accruals related to these agreements.
 
  •  Under the terms of our agreement to sell Sniffer in July 2004, we agreed to indemnify the purchaser for any breach of representations or warranties in the agreement as well as for any liabilities related to the assets prior to sale that were not included in the purchaser assumed liabilities (undiscovered liabilities). Subject to limited exceptions, the maximum potential loss related to the indemnification is $200.0 million. To date, we have paid no amounts under the representations and warranties indemnification. We have not recorded any accruals related to these agreements.
 
  •  Under the terms of our agreement to sell McAfee Labs assets in December 2004, we agreed to indemnify the purchaser for any breach of representations or warranties in the agreement as well as for any liabilities related to the assets prior to sale that were not included in the purchaser assumed liabilities (undiscovered liabilities). Subject to limited exceptions, the maximum potential loss related to the indemnification is $1.5 million. We have not recorded any accruals related to these agreements.
 
If we believe a liability associated with any of the aforementioned indemnifications becomes probable and the amount of the liability is reasonably estimable or the minimum amount of a range of loss is reasonably estimable, then an appropriate liability will be established.
 
13.   Subsequent Events
 
On November 19, 2007, we acquired 100% of the outstanding shares of Safeboot Holding B.V., an enterprise security software vendor for data protection via encryption and access control, for $350.0 million in cash. We believe that adding Safeboot’s technologies and products to our centralized management console for enterprise customers will further advance our enterprise data protection offerings and help our customers address the challenges for managing data security. The financial results of Safeboot will be included in our results of operations from the date of acquisition. We have not completed the preliminary purchase price allocation of the acquired assets and liabilities.
 
In October 2007, we entered into a definitive agreement to acquire ScanAlert, Inc., the creator of a vulnerability assessment and certification service for e-commerce sites, for $51.0 million and up to an additional $24.0 million if certain performance targets are met. We believe that we will enhance our offerings by integrating ScanAlert’s e-commerce security certification into our SiteAdvisor web rating system. The financial results of ScanAlert will be included in our results of operations from the date of acquisition, which we expect to be during the first three months of 2008.


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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Forward-Looking Statements; Trademarks
 
This Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. These statements include, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Report on Form 10-Q 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. In some cases, you can identify forward-looking statements 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. 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 “Risk Factors” in Part II, Item 1A in this quarterly report and in Part I, Item 1A in our annual report on Form 10-K for the fiscal year ended December 31, 2006. We undertake no obligation to revise or update publicly any forward-looking statements for any reason. We encourage you to read these sections carefully.
 
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,” “ePO,” “ePolicy Orchestrator,” “VirusScan,” “IntruShield,” “Entercept,” “Foundstone,” “McAfee SiteAdvisor,” “Avert,” “Preventsys” and “Hercules.”
 
The following discussion should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this report. The results shown herein are not necessarily indicative of the results to be expected for the full year or any future periods.
 
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 ability 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 from primarily three sources (i) service 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 2006. Onigma, acquired in October 2006, complements


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our enterprise offerings by providing businesses with data loss prevention. The acquisition of Citadel Security Software’s assets in December 2006 broadens our capabilities for security policy compliance enforcement and vulnerability remediation.
 
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 the three months ended September 30, 2007 grew by 12% to $322.0 million from $287.1 million in the three months ended September 30, 2006. Our net revenue in the nine months ended September 30, 2007 grew by 13% to $951.7 million from $839.9 million in the nine months ended September 30, 2006. 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 the three months ended September 30, 2007 grew by 86% to $63.4 million from $34.1 million for the three months ended September 30, 2006. Our net income for the nine months ended September 30, 2007 grew by 48% to $154.8 million from $104.6 million for the nine months ended September 30, 2006.
 
Critical Accounting Policies and Estimates
 
On January 1, 2007, we adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48 “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109,” (“FIN 48”) as discussed more fully below. Other than this change, we have had no significant changes in our critical accounting policies and estimates during the nine months ended September 30, 2007 as compared to the critical accounting policies and estimates disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our annual report on Form 10-K for the year ended December 31, 2006.
 
Income Taxes
 
We adopted the provisions of FIN 48, effective January 1, 2007. FIN 48 clarifies the accounting for income taxes, by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition.
 
FIN 48 prescribes a two-step process to determine the amount of tax benefit to be recognized. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step requires us to estimate and measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. It is inherently difficult and subjective to estimate such amounts, as this requires us to determine the probability of various possible outcomes. We reevaluate these uncertain tax positions on a quarterly basis. This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit, and new audit activity. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision in the period. See Note 9 to the condensed consolidated financial statements for further discussion of the impact of adoption of FIN 48.


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Results of Operations
 
Net Revenue
 
The following table sets forth, for the periods indicated, a year-over-year comparison of the key components of our net revenue:
 
                                                                 
    Three Months Ended
          Nine Months Ended
       
    September 30,     2007 vs. 2006     September 30,     2007 vs. 2006  
    2007     2006     $     %     2007     2006     $     %  
    (Dollars in thousands)  
 
Net revenue:
                                                               
Service and support
  $ 164,171     $ 160,388     $ 3,783       2 %   $ 496,938     $ 466,298     $ 30,640       7 %
Subscription
    140,366       110,822       29,544       27       402,025       299,197       102,828       34  
Product
    17,449       15,853       1,596       10       52,731       74,422       (21,691 )     (29 )
                                                                 
Total net revenue
  $ 321,986     $ 287,063     $ 34,923       12 %   $ 951,694     $ 839,917     $ 111,777       13 %
                                                                 
Percentage of total net revenue:
                                                               
Service and support
    51 %     56 %                     52 %     55 %                
Subscription
    44       39                       42       36                  
Product
    5       5                       6       9                  
                                                                 
Total net revenue
    100 %     100 %                     100 %     100 %                
                                                                 
 
The increase in net revenue in the three months ended September 30, 2007 compared to the three months ended September 30, 2006 reflected (i) a $17.5 million increase in our corporate business due to increased corporate spending on McAfee security products and (ii) a $17.4 million increase in our consumer business.
 
The increase in net revenue in the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 reflected (i) a $59.1 million increase in our corporate business due to increased corporate spending on McAfee security products and (ii) a $52.6 million increase in our consumer business.
 
Net revenue from our corporate business increased during the three and nine months ended September 30, 2007 compared to the three and nine months ended September 30, 2006 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 product line increased $6.2 million in the three months ended September 30, 2007 and $8.9 million in the nine months ended September 30, 2007. Net revenue from our Foundstone product line increased $0.1 million in the three months ended September 30, 2007 and $9.0 million in the nine months ended September 30, 2007.
 
Net revenue from our consumer market increased during the three and nine months ended September 30, 2007 compared to the three and nine months ended September 30, 2006 primarily due to (i) online subscriber growth due partly to an increase in our customer base and expansion to additional countries and (ii) increased online renewal subscriptions.


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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:
 
                                                                 
    Three Months Ended
          Nine Months Ended
       
    September 30,     2007 vs. 2006     September 30,     2007 vs. 2006  
    2007     2006     $     %     2007     2006     $     %  
    (Dollars in thousands)  
 
Net revenue:
                                                               
North America
  $ 165,156     $ 164,166     $ 990       1 %   $ 492,631     $ 466,249     $ 26,382       6 %
EMEA
    105,264       87,417       17,847       20       310,300       260,685       49,615       19  
Japan
    25,880       18,535       7,345       40       76,116       63,537       12,579       20  
Asia-Pacific, excluding Japan
    15,905       11,241       4,664       41       43,848       30,733       13,115       43  
Latin America
    9,781       5,704       4,077       71       28,799       18,713       10,086       54  
                                                                 
Total net revenue
  $ 321,986     $ 287,063     $ 34,923       12 %   $ 951,694     $ 839,917     $ 111,777       13 %
                                                                 
Percentage of total net revenue:
                                                               
North America
    51 %     57 %                     52 %     55 %                
EMEA
    33       30                       32       31                  
Japan
    8       7                       8       8                  
Asia-Pacific, excluding Japan
    5       4                       5       4                  
Latin America
    3       2                       3       2                  
                                                                 
Total net revenue
    100 %     100 %                     100 %     100 %                
                                                                 
 
Net revenue outside of North America accounted for approximately 49% and 43% of net revenue in the three months ended September 30, 2007 and 2006, respectively, and 48% and 45% of net revenue in the nine months ended September 30, 2007 and 2006, 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 the three months ended September 30, 2007 primarily related to (i) a $4.6 million increase in corporate revenue in North America due to increased corporate spending on McAfee products and increased revenue from for our McAfee Foundstone and McAfee IntruShield offerings partially offset by (ii) a $3.6 million decrease in consumer revenue in North America due to a slight decrease in online subscribers.
 
The increase in total net revenue in North America during the nine months ended September 30, 2007 primarily related to (i) a $22.2 million increase in corporate revenue in North America due to increased corporate spending on McAfee products and increased revenue from our McAfee Foundstone and McAfee IntruShield offerings and (ii) a $4.2 million increase in consumer revenue in North America primarily due to an increase in retail subscription revenue associated with the launch of our McAfee Consumer Suites in September 2006.
 
The increase in total net revenue in EMEA during the three months ended September 30, 2007 was attributable to (i) a $9.2 million increase in corporate revenue due to increased corporate spending on McAfee security products and increased revenue from our McAfee Foundstone offering and (ii) a $8.6 million increase in consumer revenue due to an increase in our customer base and expansion to additional countries. These increases include the positive impact of the strengthening Euro against the U.S. Dollar, which resulted in an approximate $6.4 million impact to EMEA net revenue in the three months ended September 30, 2007 compared to the three months ended September 30, 2006.
 
The increase in total net revenue in EMEA during the nine months ended September 30, 2007 was attributable to (i) a $31.6 million increase in corporate revenue due to increased corporate spending on McAfee security products and increased revenue from our McAfee Foundstone offering and (ii) an $18.0 million increase in


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consumer revenue due to an increase in our customer base and expansion to additional countries. These increases include the positive impact of the strengthening Euro against the U.S. Dollar, which resulted in an approximate $22.9 million impact to EMEA net revenue in the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006.
 
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 both the three and nine months ended September 30, 2007 compared to the three and nine months ended September 30, 2006, the weakening Japanese Yen against the U.S. Dollar resulted in an approximate $0.8 million and $2.4 million negative impact to Japanese net revenue, respectively.
 
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 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, the two categories of our service and support revenue as a percent of total service and support revenue:
 
                                                                 
    Three Months Ended
          Nine Months Ended
       
    September 30,     2007 vs. 2006     September 30,     2007 vs. 2006  
    2007     2006     $     %     2007     2006     $     %  
    (Dollars in thousands)  
 
Net service and support revenue:
                                                               
Support and maintenance
  $ 157,173     $ 153,635     $ 3,538       2 %   $ 475,153     $ 450,080     $ 25,073       6 %
Consulting and training
    6,998       6,753       245       4       21,785       16,218       5,567       34  
                                                                 
Total service and support revenue
  $ 164,171     $ 160,388     $ 3,783       2 %   $ 496,938     $ 466,298     $ 30,640       7 %
                                                                 
Percentage of service and support revenue:
                                                               
Support and maintenance
    96 %     96 %                     96 %     97 %                
Consulting and training
    4       4                       4       3                  
                                                                 
Total service and support revenue
    100 %     100 %                     100 %     100 %                
                                                                 
 
Service and support revenue includes revenue from software support and maintenance contracts, training and consulting. The increase in service and support revenue in the three and nine months ended September 30, 2007 compared to the three and nine months ended September 30, 2006 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. In addition, revenue from consulting increased due to both our Foundstone Consulting Services, which includes threat modeling, security assessments and education, and McAfee Consulting Services, which provide product design and deployment support.
 
Although we expect our service and support revenue will increase, 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 subscription model. In the event customers choose not to renew their support arrangements under the perpetual-plus model, revenue could be negatively impacted.


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Subscription Revenue
 
The following table sets forth, for the periods indicated, the change in subscription revenue from September 30, 2006 to September 30, 2007:
 
                                                                 
    Three Months Ended
      Nine Months Ended
   
    September 30,   2007 vs. 2006   September 30,   2007 vs. 2006
    2007   2006   $   %   2007   2006   $   %
    (Dollars in thousands)
 
Total subscription revenue
  $ 140,366     $ 110,822     $ 29,544       27 %   $ 402,025     $ 299,197     $ 102,828       34 %
 
Subscription revenue includes revenue from online subscription arrangements. The increase in subscription revenue in the three and nine months ended September 30, 2007 compared to the three and nine months ended September 30, 2006 was attributable to (i) an increase in our online subscription arrangements due to our continued relationships with strategic channel partners, such as Gateway, AOL and Dell, (ii) an increase in revenue from our McAfee Managed VirusScan online service for small and medium-sized businesses, (iii) an increase in royalties from sales by our strategic channel partners and (iv) an increase due to our launch of McAfee Consumer Suites, including McAfee VirusScan Plus, McAfee PC Protection Plus, McAfee Internet Security, and McAfee Total Protection in September 2006, as these suites utilize a subscription-based model.
 
Product Revenue
 
The following table sets forth, for the periods indicated, each major category of our product revenue as a percent of product revenue:
 
                                                                 
    Three Months Ended
          Nine Months Ended
       
    September 30,     2007 vs. 2006     September 30,     2007 vs. 2006  
    2007     2006     $     %     2007     2006     $     %  
    (Dollars in thousands)  
 
Net product revenue:
                                                               
Licenses
  $ 7,194     $ 10,678     $ (3,484 )     (33 )%   $ 25,412     $ 44,800     $ (19,388 )     (43 )%
Hardware
    7,130       7,755       (625 )     (8 )     19,643       26,915       (7,272 )     (27 )
Retail and other
    3,125       (2,580 )     5,705       221       7,676       2,707       4,969       184  
                                                                 
Total product revenue
  $ 17,449     $ 15,853     $ 1,596       10 %   $ 52,731     $ 74,422     $ (21,691 )     (29 )%
                                                                 
Percentage of product revenue:
                                                               
Licenses
    41 %     67 %                     48 %     60 %                
Hardware
    41       49                       37       36                  
Retail and other
    18       (16 )                     15       4                  
                                                                 
Total product revenue
    100 %     100 %                     100 %     100 %                
                                                                 
 
Product revenue includes revenue from software licenses, hardware and retail product. With the launch of our McAfee Consumer Suites in September 2006, all future consumer licenses are subscription-based. The continued use of a subscription-based model for licenses has resulted in product revenue declines with corresponding increases in subscription revenue. The increase in product revenue for the three months ended September 30, 2007, compared to the three months ended September 30, 2006, was attributable to decreased incentive rebates and funds provided to our partners for marketing which are recorded as an offset to revenue and included in retail and other revenue in the table above, partially offset by a decrease in license revenue as a result of the launch of our McAfee Consumer Suites in September 2006. The decrease in product revenue for the nine months ended September 30, 2007, compared to the nine months ended September 30, 2006, was attributable to (i) a decrease in license revenue as a result of the launch of our McAfee Consumer Suites in September 2006, (ii) a decrease in revenue associated with McAfee hardware products, partially offset by (iii) decreased incentive rebates and funds provided to our partners for marketing.
 
For the three months ended September 30, 2006, the amount of incentive rebates and funds provided to our partners for marketing exceeded revenue, resulting in a decrease to total product revenue.


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Cost of Net Revenue
 
The following table sets forth, for the periods indicated, cost of net revenue:
 
                                                                 
    Three Months Ended
          Nine Months Ended
       
    September 30,     2007 vs. 2006     September 30,     2007 vs. 2006  
    2007     2006     $     %     2007     2006     $     %  
    (Dollars in thousands)  
 
Cost of net revenue:
                                                               
Service and support
  $ 11,470     $ 13,127     $ (1,657 )     (13 )%   $ 35,698     $ 39,736     $ (4,038 )     (10 )%
Subscription
    44,089       29,624       14,465       49       121,090       76,077       45,013       59  
Product
    14,886       15,415       (529 )     (3 )     38,210       45,810       (7,600 )     (17 )
Amortization of purchased technology
    7,420       5,987       1,433       24       24,304       16,180       8,124       50  
                                                                 
Total cost of net revenue
  $ 77,865     $ 64,153     $ 13,712       21 %   $ 219,302     $ 177,803     $ 41,499       23 %
                                                                 
Components of Gross margin:
                                                               
Service and support
  $ 152,701     $ 147,261                     $ 461,240     $ 426,562                  
Subscription
    96,277       81,198                       280,935       223,120                  
Product
    2,563       438                       14,521       28,612                  
Amortization of purchased technology
    (7,420 )     (5,987 )                     (24,304 )     (16,180 )                
                                                                 
Total gross margin
  $ 244,121     $ 222,910                     $ 732,392     $ 662,114                  
                                                                 
Total gross margin percentage
    76 %     78 %                     77 %     79 %                
                                                                 
 
Cost of Service and Support Revenue
 
Cost of service and support revenue consists principally of salaries, benefits and stock-based compensation related to employees providing customer support, training and consulting services. The cost of service and support revenue decreased for the three and nine months ended September 30, 2007 compared to the three and nine months ended September 30, 2006 due to the shift in focus from perpetual retail-boxed products to our McAfee Consumer Suites subscription model for consumers. As consumers purchase subscription-based products, the costs to support those products are classified as cost of subscription revenue. For the three and nine months ended September 30, 2007 a greater percentage of total cost of service and support revenue relates to subscription-based consumer licenses. The cost of service and support revenue as a percentage of service and support net revenue for the three and nine months ended September 30, 2007 remained consistent when compared to the same periods in 2006.
 
We anticipate that the cost of service and support revenue will increase in future periods due to increased support and maintenance revenue.
 
Cost of Subscription Revenue
 
Cost of subscription revenue consists primarily of costs related to the sale of online subscription arrangements, the majority of which include revenue-share arrangements and royalties paid to our strategic channel partners. The increase in subscription costs for the three and nine months ended September 30, 2007 compared to the three and nine months ended September 30, 2006 was primarily attributed to (i) an increase in the volume of online subscription arrangements and royalties paid to our online strategic channel partners and (ii) an increase in the cost to support subscription-based consumer licenses. These increased costs are also the cause for the increase in cost of subscription revenue as a percentage of subscription revenue, when comparing the same periods.
 
We anticipate that the cost of subscription revenue will increase due to increased demand for our subscription-based products with associated revenue-sharing costs.


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Cost of Product Revenue
 
Cost of product revenue consists primarily of the cost of media, manuals and packaging for products distributed through traditional channels and, with respect to hardware-based security products, computer platforms and other hardware components. The cost of product revenue for the three months ended September 30, 2007 remained consistent when compared to the same period in 2006, but decreased as a percentage of product revenue due primarily to a decrease in incentive rebates and marketing funds.
 
The decrease in the cost of product revenue for the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 was attributable to a decrease in product units sold, consistent with our shift in focus from retail-boxed products to our online subscription model. As a percentage of product revenue, cost of product revenue increased for the nine months ended September 30, 2007 when compared to the same period in 2006 due to (i) decreased margins on hardware product sales (ii) a shift in product mix from higher margin licensing revenue to lower margin hardware revenue, partially offset by (iii) decreased incentive rebates and marketing funds. Upon the launch of our McAfee Consumer Suites, all related license revenue and cost of revenue are included in subscription revenue and cost of subscription revenue.
 
We anticipate that cost of product revenue will increase or decrease depending on the extent and size of certain enterprise-related transactions.
 
Amortization of Purchased Technology
 
The increase in amortization of purchased technology in the three and nine months ended September 30, 2007 compared to the three and nine months ended September 30, 2006 is due to the acquisitions of SiteAdvisor in April 2006, Preventsys in June 2006, Onigma in October 2006 and Citadel in December 2006. Purchased technology related to these four acquisitions totaled $58.0 million. Amortization for these items was $4.1 million in the three months ended September 30, 2007 and $12.2 million in the nine months ended September 30, 2007.
 
Our purchased technology is being amortized over estimated useful lives of up to seven years. Amortization associated with purchased technology recorded as of September 30, 2007 is expected to be an aggregate of approximately $7.0 to $8.0 million for the remainder of 2007.
 
Operating Costs
 
Stock-based Compensation Expense
 
We recognize stock-based compensation expense for all stock-based awards made to our employees and directors based on the estimated fair value of the awards. The following table summarizes stock-based compensation expense in accordance with the provisions of SFAS 123(R) (in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Amortization of fair value of options issued to employees
  $ 4,808     $ 6,955     $ 14,080     $ 24,677  
Former employees — extension of post-termination exercise period
    128             11,206        
Cash settlement of options
    (76 )     2,668       2,114       2,668  
Restricted stock awards and units
    5,785       4,984       15,932       11,447  
Employee Stock Purchase Plan
          257             1,864  
                                 
Total stock-based compensation expense
  $ 10,645     $ 14,864     $ 43,332     $ 40,656  
                                 
 
Amortization of fair value of options issued to employees.  We recognize the fair value of stock options issued to employees as stock-based compensation expense over the vesting period of the awards. As we adopted SFAS 123(R) using the modified prospective method, these charges include compensation expense for stock options granted prior to January 1, 2006 but not yet vested as of January 1, 2006, based on the grant date fair value


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estimated in accordance with the pro forma provisions of SFAS 123, and compensation expense for stock options granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R).
 
Former employees — extension of post-termination exercise period.  From July 2006, when we announced that we might have to restate our historical financial statements as a result of our ongoing stock option investigation, through the date we become current on our reporting obligations under the Securities Exchange Act of 1934, as amended, (“blackout period”), 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 vested options held by certain former employees and outside directors who terminated and whose stock options would have expired during the blackout period. We recognized $0.1 million and $11.2 million of stock-based compensation expense in the three and nine months ended September 30, 2007, respectively, based on the fair value of the modified options. The stock-based compensation expense in the three months ended September 30, 2007 was based on modified options held by former employees that vested during the three months ended September 30, 2007. The stock-based compensation expense in the nine months ended September 30, 2007 was based on modified options held by former employees that terminated from January 1, 2007 through September 30, 2007, and which were vested as of the modification date and through September 30, 2007. The expense was calculated in accordance with the guidance in SFAS 123(R). The options were deemed to have no value prior to the extension of the life beyond the blackout period.
 
Based on the guidance in SFAS 123(R) and related 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 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. We recognized a benefit of $0.2 million and expense of $1.7 million related to the change in fair value of these options in the three and nine months ended September 30, 2007, respectively. Such amounts are included in general and administrative expense in our consolidated statements of income, and are not reflected as stock-based compensation expense in the table above. 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. Such amounts 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.
 
Cash settlement of options.  Certain stock options held by terminated employees expired during the blackout period as they could not be exercised during the 90 day period subsequent to termination. The cash payment to settle these options will be based upon an average closing price of our common stock subsequent to us becoming current on our reporting obligations under the Securities Exchange Act of 1934, as amended. We have recorded a liability based on the intrinsic value of these options as of September 30, 2007. We will continue to adjust this amount in future reporting periods based on the closing price of our common stock.


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Restricted stock awards and units.  We recognize stock-based compensation expense for the fair value of restricted stock awards and restricted stock units. Fair value is determined as the difference between the closing price of our common stock on the grant date and the purchase price of the restricted stock awards and units. The fair value of these awards is recognized to expense over the requisite service period of the awards.
 
Employee Stock Purchase Plan.  We recognize stock-based compensation expense for the fair value of employee stock purchase rights issued pursuant to our ESPP. The estimated fair value of employee stock purchase rights is based on the Black-Scholes pricing model. Expense is recognized ratably based on contributions and the total fair value of the employee stock purchase rights estimated to be issued. We had no stock-based compensation expense related to our employee stock purchase plan during the nine months ended September 30, 2007 due to our suspension of this plan in July 2006 until we become current on our reporting obligations under the Securities Exchange Act of 1934, as amended.
 
The following table summarizes the stock-based compensation expense by income statement line item in the three and nine months ended September 30, 2007 and 2006 (in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
 
Cost of net revenue — service and support
  $ 276     $ 546     $ 1,231     $ 1,503  
Cost of net revenue — subscription
    189       180       732       485  
Cost of net revenue — product
    145       190       602       576  
                                 
Stock-based compensation expense included in cost of net revenue
    610       916       2,565       2,564  
Research and development
    2,752       4,299       11,017       11,637  
Marketing and sales
    3,486       6,158       16,811       16,257  
General and administrative
    3,797       3,491       12,939       10,198  
                                 
Stock-based compensation expense included in operating expenses
    10,035       13,948       40,767       38,092  
                                 
Total stock-based compensation expense related to stock-based equity awards
    10,645       14,864       43,332       40,656  
Deferred tax benefit
    (2,914 )     (2,966 )     (12,602 )     (10,014 )
                                 
Total stock-based compensation expense related to stock-based equity awards, net of tax
  $ 7,731     $ 11,898     $ 30,730     $ 30,642  
                                 
 
See Note 3 in the condensed consolidated financial statements for additional information regarding stock-based compensation.
 
During 2006, we changed our equity compensation program for existing employees by starting to grant, in certain instances, restricted stock units that vest over a specified period of time in addition to awarding stock options. For new employees, we continue to grant stock options. Going forward, our management and compensation committee will consider utilizing all types of equity compensation to reward top-performing employees, including performance-based restricted stock units.
 
As of September 30, 2007, total compensation cost related to unvested stock options, restricted stock units, and restricted stock awards not yet recognized and reduced by estimated forfeitures was $63.5 million. This amount is expected to be recognized over a weighted-average period of approximately 2.4 years.
 
Internal Revenue Code Section 409A
 
Adverse tax consequences will result from our revision of accounting measurement dates for stock options that vest subsequent to December 31, 2004, (“409A affected options”). These adverse tax consequences include a penalty tax payable by the option holder under Internal Revenue Code (“IRC”) Section 409A (and, as applicable, similar penalty taxes under state tax laws). As virtually all holders of options with revised measurement dates were


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not involved in or aware of their incorrect option exercise prices, we took certain actions to deal with the adverse tax consequences that may be incurred by the holders of such options.
 
Section 16(a) Officers and Directors
 
In December 2006, our board of directors approved the amendment of 409A affected options for those who were Section 16(a) officers upon the receipt of 409A affected options to increase the exercise price to the fair market value of our common stock on the revised measurement date. These amended options would not be subject to taxation under IRC Section 409A. Under IRS regulations, these option amendments had to be completed by December 31, 2006 for anyone subject to Section 16(a) requirements upon receipt of the 409A affected options. There were no costs associated with this action, as the modifications increased the exercise price, which results in no incremental expense.
 
IRS Announcement 2007-18 Compliance
 
In February 2007, our board of directors approved our participation in a voluntary program under Internal Revenue Service Announcement 2007-18 and a similar state of California Announcement, whereby we will pay additional 409A taxes on behalf of certain former United States employees who have already exercised 409A affected options for the additional taxes they incur under IRC Section 409A (and, as applicable, similar state of California tax law). Current and former Section 16(a) officers and directors are specifically excluded from the program. Through September 30, 2007, we recorded $1.3 million of costs associated with this program for Section 409A affected options exercised during this period.
 
Certain Former Employees Future Exercises of 409A Affected Options
 
In May 2007, our board of directors approved cash payments as necessary to certain former employees who exercised 409A affected options during 2006 that may exercise 409A affected options in the future. In the three months ended September 30, 2007, we recorded no costs associated with former employees’ exercises of certain Section 409A affected options. In the nine months ended September 30, 2007, we recorded $0.9 million of costs associated with former employees’ exercises of certain 409A affected options. We may incur additional costs in future periods associated with former employees’ expected exercises of certain 409A affected options but we do not expect the costs to be material.
 
In November 2007, our board of directors approved the unilateral amendment of 409A affected options held by certain former employees who did not exercise 409A affected options during 2006 to increase the exercise price to the fair market value of our common stock on the revised measurement date, and to make cash payments as compensation for the increase in the exercise prices of amended options. These amended options would not be subject to taxation under IRC 409A. We expect to incur additional costs of $0.5 million associated with former employees’ future exercises of certain 409A affected options once we become current on our reporting obligations under the Security Exchange Act of 1934, as amended.
 
The following table summarizes, for the period indicated, costs associated with actions taken by us with respect to IRC Section 409A (in thousands):
 
         
    Nine Months Ended
 
    September 30, 2007  
 
Cost of net revenue
  $  
Research and development
    874  
Marketing and sales
    589  
General and administrative
    788  
         
Costs associated with IRC Section 409A
  $ 2,251  
         
 
We are also considering offering active employees who are option holders the opportunity to amend or exchange their options to avoid the adverse consequences of 409A.


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Research and Development
 
The following table sets forth, for the periods indicated, a comparison of our research and development expenses:
 
                                                                 
    Three Months Ended
                Nine Months Ended
             
    September 30,     2007 vs. 2006     September 30,     2007 vs. 2006  
    2007     2006     $     %     2007     2006     $     %  
    (Dollars in thousands)  
 
Research and development(1)
  $ 54,399     $ 50,641     $ 3,758       7 %   $ 163,831     $ 144,426     $ 19,405       13 %
Percentage of net revenue
    17 %     18 %                     17 %     17 %                
 
 
(1) Includes stock-based compensation charges of $2,752 and $4,299 in the three months ended September 30, 2007 and 2006, respectively, and $11,017 and $11,637 in the nine months ended September 30, 2007 and 2006, respectively.
 
Research and development expenses consist primarily of salary, benefits, and stock compensation for our development and a portion of our technical support staff, contractors’ fees and other costs associated with the enhancements of existing products and services and development of new products and services. The increase in research and development expenses in the three months ended September 30, 2007 was primarily attributable to (i) a $5.8 million increase in salary and benefit expense for individuals performing research and development activities due to an increase in average headcount and (ii) a $0.6 million increase due to strengthening foreign currencies in EMEA against the U.S. Dollar in the three months ended September 30, 2007 compared to the same prior-year period, partially offset by (iii) a $1.5 million decrease in stock-based compensation expense, (iv) a $1.2 million decrease attributable to acquisition-related bonuses, primarily related to the SiteAdvisor acquisition, and (v) a $0.5 million decrease in use of third-party contractors.
 
The increase in research and development expenses in the nine months ended September 30, 2007 was primarily attributable to (i) a $18.0 million increase in salary and benefit expense for individuals performing research and development activities due to an increase in average headcount, (ii) a $2.2 million increase due to strengthening foreign currencies in EMEA against the U.S. Dollar in the nine months ended September 30, 2007 compared to the same prior-year period, (iii) a $0.9 million charge for actions taken by us with respect to IRC Section 409A discussed in “Stock-based Compensation Expense” above, and (iv) a $0.7 million increase attributable to acquisition-related bonuses, primarily related to the Citadel and Onigma acquisitions, partially offset by (v) a $1.3 million decrease in the use of third-party contractors, and (vi) a $0.6 million decrease in stock-based compensation expense.
 
We believe that continued investment in product development is critical to attaining our strategic objectives. We expect research and development expenses will increase during the remainder of 2007.
 
Marketing and Sales
 
The following table sets forth, for the periods indicated, a comparison of our marketing and sales expenses:
 
                                                                 
    Three Months Ended
      Nine Months Ended
   
    September 30,   2007 vs. 2006   September 30,   2007 vs. 2006
    2007   2006   $   %   2007   2006   $   %
    (Dollars in thousands)
 
Marketing and sales(1)
  $ 90,989     $ 91,260     $ (271 )     %   $ 279,217     $ 264,990     $ 14,227       5 %
Percentage of net revenue
    28 %     32 %                     29 %     32 %                
 
 
(1) Includes stock-based compensation charges of $3,486 and $6,158 in the three months ended September 30, 2007 and 2006, respectively, and $16,811 and $16,257 in the nine months ended September 30, 2007 and 2006, respectively.
 
Marketing and sales expenses consist primarily of salary, commissions, stock compensation and benefits for marketing and sales personnel and costs associated with advertising and promotions. The decrease in marketing and sales expenses during the three months ended September 30, 2007 compared to the three months ended


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September 30, 2006 reflected (i) a $2.7 million decrease in stock-based compensation expense, (ii) a $0.3 million decrease due to reduction on third-party contractors and (iii) a $0.3 million decrease in sales, marketing, promotion and advertising programs, partially offset by (iv) a $1.9 million increase in salary and benefit expense, including commissions, for individuals performing marketing and sales activities due to an increase in average headcount, (v) a $1.1 million increase due to strengthening foreign currencies in EMEA against the U.S. Dollar in the three months ended September 30, 2007 compared to the same prior-year period and (vi) a $0.5 million increase related to worldwide travel expense.
 
The increase in marketing and sales expenses during the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 reflected (i) a $6.6 million increase in salary and benefit expense, including commissions, for individuals performing marketing and sales activities due to an increase in average headcount, (ii) a $4.0 million increase due to strengthening foreign currencies in EMEA against the U.S. Dollar in the nine months ended September 30, 2007 compared to the same prior-year period, (iii) a $2.3 million increase in sales, marketing, promotion and advertising programs, (iv) a $1.9 million increase due to the additional use of third-party contractors, (v) a $0.6 million charge for actions taken by us with respect to IRC Section 409A discussed in “Stock-based Compensation Expense” above, and (vi) a $0.6 million increase in stock-based compensation expense, partially offset by a $1.6 million decrease related to worldwide travel expense.
 
We anticipate that marketing and sales expenses will increase primarily due to our planned branding initiatives for 2007.
 
General and Administrative
 
The following table sets forth, for the periods indicated, a comparison of our general and administrative expenses:
 
                                                                 
    Three Months Ended
      Nine Months Ended
   
    September 30,   2007 vs. 2006   September 30,   2007 vs. 2006
    2007   2006   $   %   2007   2006   $   %
    (Dollars in thousands)
 
General and administrative(1)
  $ 38,140     $ 35,055     $ 3,085       9 %   $ 125,093     $ 127,101     $ (2,008 )     (2 )%
Percentage of net revenue
    12 %     12 %                     13 %     15 %                
 
 
(1) Includes stock-based compensation charges of $3,797 and $3,491 in the three months ended September 30, 2007 and 2006, respectively, and $12,939 and $10,198 in the nine months ended September 30, 2007 and 2006, respectively.
 
General and administrative expenses consist principally of salary, stock compensation and benefit costs for executive and administrative personnel, professional services and other general corporate activities. The increase in general and administrative expenses during the three months ended September 30, 2007 compared to the three months ended September 30, 2006 reflected (i) a $1.6 million increase in salary and benefit expense for individuals performing general and administrative activities due to an increase in average headcount and (ii) a $0.3 million increase in stock-based compensation expense, partially offset by a $0.2 million benefit related to the change in fair value of certain stock options subject to the provisions of EITF 00-19.
 
The decrease in general and administrative expenses during the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 reflected a $11.5 million decline in legal fees and legal settlements, partially offset by (i) a $4.0 million increase in salary and benefit expense for individuals performing general and administrative activities due to an increase in average headcount, (ii) a $2.7 million increase in stock-based compensation expense, (iii) a $1.7 million increase related to the change in fair value of certain stock options subject to the provisions of EITF 00-19, and (iv) a $0.8 million charge for actions taken by us with respect to IRC Section 409A discussed in “Stock-based Compensation Expense” above.
 
We anticipate that general and administrative expenses will increase during the remainder of 2007.


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SEC and Compliance Costs
 
The following table sets forth, for the periods indicated, a comparison of SEC and compliance costs:
 
                                                                 
    Three Months Ended
      Nine Months Ended
   
    September 30,   2007 vs. 2006   September 30,   2007 vs. 2006
    2007   2006   $   %   2007   2006   $   %
    (Dollars in thousands)
 
SEC and compliance costs
  $ 10,885     $ 7,901     $ 2,984       38 %   $ 25,085     $ 11,673     $ 13,412       115 %
 
SEC and compliance costs consist principally of costs associated with the investigation into our stock option granting practices and costs associated with independent consultants engaged to examine and recommend improvements to our internal controls to ensure compliance with federal securities laws as required by our settlement with the SEC finalized in 2006. The increase in SEC and compliance costs during the three months ended September 30, 2007 compared to the three months ended September 30, 2006 reflected (i) a $4.5 million increase in expense related to the investigation into our stock option granting practices partially offset by (ii) a $1.5 million decrease in costs related to independent consultants engaged in 2006 to examine and recommend improvements to our internal controls to ensure compliance with federal securities laws as required by our previous settlement with the SEC.
 
The increase in SEC and compliance costs during the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 reflected (i) a $17.3 million increase in expense related to the investigation into our stock option granting practices partially offset by (ii) a $3.9 million decrease in costs related to independent consultants engaged in 2006 to examine and recommend improvements to our internal controls to ensure compliance with federal securities laws as required by our previous settlement with the SEC.
 
Amortization of Intangibles
 
The following table sets forth, for the periods indicated, a comparison of the amortization of intangibles:
 
                                                                 
    Three Months Ended
      Nine Months Ended
   
    September 30,   2007 vs. 2006   September 30,   2007 vs. 2006
    2007   2006   $   %   2007   2006   $   %
    (Dollars in thousands)
 
Amortization of intangibles
  $ 2,959     $ 2,656     $ 303       11 %   $ 9,197     $ 8,305     $ 892       11 %
 
Intangibles consist of identifiable intangible assets such as trademarks, patents and customer lists. The increase in amortization of intangibles was attributable to our 2006 acquisitions, in which we acquired approximately $9.7 million of intangible assets and patents and the addition of $9.3 million in patents during the first quarter of 2007.
 
Restructuring Charges
 
The following table sets forth, for the periods indicated, a comparison of our restructuring charges:
 
                                                                 
    Three Months Ended
          Nine Months Ended
       
    September 30,     2007 vs. 2006     September 30,     2007 vs. 2006  
    2007     2006     $     %     2007     2006     $     %  
    (Dollars in thousands)  
 
Restructuring charges (benefit)
  $ 109     $ (1,393 )   $ 1,502       108 %   $ 3,158     $ (274 )   $ 3,432       1,253 %
 
During 2006, we initiated certain restructuring actions designed to realign our go-to-market model with our customers’ requirements and product offerings. As a result, we recorded a restructuring charge of approximately $2.4 million during the fourth quarter of 2006 related to a reduction in headcount of 75 employees. These actions were taken to reduce our cost structure and, at the same time, enable us to invest in certain strategic growth initiatives in an effort to enhance our competitive position. These actions were completed during the first quarter of 2007. During the nine months ended September 30, 2007, we permanently vacated several leased facilities and recorded a $0.3 million accrual for estimated lease related costs associated with the permanently vacated facilities. We also recorded a restructuring charge of $2.4 million related to a reduction in headcount of 33 employees.


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Additionally, in 2005, 2004 and 2003, we recorded restructuring charges related to vacating several facilities and reductions in headcount. Accretion on prior year restructurings totaled $0.1 million and $0.3 million in the three and nine months ended September 30, 2007, respectively. See further information on these actions in Note 6 to our condensed consolidated financial statements included elsewhere in this report.
 
In-process Research and Development
 
During the nine months ended September 30, 2006, we expensed $0.5 million of in-process research and development related to the acquisition of Preventsys, Inc. in June 2006. There were no acquisitions during the nine months ended September 30, 2007.
 
Interest and Other Income
 
The following table sets forth, for the periods indicated, a comparison of our interest and other income:
 
                                                                 
    Three Months Ended
      Nine Months Ended
   
    September 30,   2007 vs. 2006   September 30,   2007 vs. 2006
    2007   2006   $   %   2007   2006   $   %
    (Dollars in thousands)
 
Interest and other income
  $ 19,450     $ 13,922     $ 5,528       40 %   $ 52,480     $ 32,585     $ 19,895       61 %
 
Interest and other income includes interest earned on investments, as well as net foreign currency transaction gains or losses. The increase in interest and other income is partially due to the rising average rate of annualized return on our investments from approximately 4% in the nine months ended September 30, 2006 to approximately 5% in the nine months ended September 30, 2007. In addition, our average balance of cash, marketable securities and restricted cash increased in the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 by $176.4 million.
 
During the three months ended September 30, 2007 and 2006, we recorded a net foreign currency transaction gain in our condensed consolidated statements of income of $2.1 million and $0.4 million, respectively. During the nine months ended September 30, 2007, we recorded a net foreign currency transaction gain of $1.0 million in our condensed consolidated statements of income compared to a net foreign currency transaction loss of $6.5 million during the nine months ended September 30, 2006.
 
Provision for Income Taxes
 
The following table sets forth, for the periods indicated, a comparison of our provision for income taxes:
 
                                                                 
    Three Months Ended
          Nine Months Ended
       
    September 30,     2007 vs. 2006     September 30,     2007 vs. 2006  
    2007     2006     $     %     2007     2006     $     %  
    (Dollars in thousands)  
 
Provision for income taxes
  $ 3,060     $ 16,776     $ (13,716 )     (82 )%   $ 25,127     $ 33,491     $ (8,364 )     (25 )%
Effective tax rate
    5 %     33 %                     14 %     24 %                
 
We estimate our annual effective tax rate based on year to date operating results and our forecast of operating results for the remainder of the year, by jurisdiction, and apply this rate to the year to date operating results. If our actual results, by jurisdiction, differ from each successive interim period’s forecasted operating results or if we change our forecast of operating results for the remainder of the year, our effective tax rate will change accordingly, affecting tax expense for both that successive interim period as well as year-to-date interim results.
 
The effective tax rate for the three months ended September 30, 2007 differs from the United States federal statutory rate (“statutory rate”) primarily due to a decrease in our estimated annual effective tax rate and the resultant quarterly adjustment necessary to adjust year to date expense to our revised estimate of our annual effective rate. The effective tax rate for the three months ended September 30, 2006 differs from the statutory rate primarily due to the benefit of lower tax rates in certain foreign jurisdictions offset by the impact of adjustments to tax reserves. The effective tax rate for the nine months ended September 30, 2007 differs from the statutory rate primarily due to the benefit of lower tax rates in certain foreign jurisdictions. The effective tax rate for the nine months ended September 30, 2006 differs from the statutory rate primarily due to the benefit of lower tax rates in


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certain foreign jurisdictions and adjustments to valuation allowances partially offset by adjustments to tax reserves. The reduction in the effective tax rate for the nine months ended September 30, 2007 as compared to the prior year period is primarily the result of an increase in pretax earnings in lower tax jurisdictions in 2007 and adjustments to tax reserves recorded in the nine months ended September 30, 2006.
 
The earnings from our foreign operations in India are subject to a tax holiday from a grant effective through March 31, 2009. The tax holiday provides for zero percent taxation on certain classes of income and requires certain conditions to be met. We are in compliance with these conditions as of September 30, 2007.
 
Recent Accounting Pronouncements
 
See Note 2 to the condensed consolidated financial statements.
 
Liquidity and Capital Resources
 
                 
    Nine Months Ended
 
    September 30,  
    2007     2006  
    (In thousands)  
 
Net cash provided by operating activities
  $ 301,677     $ 204,273  
Net cash used in investing activities
    (216,732 )     (362,794 )
Net cash used in financing activities
    (184 )     (197,861 )
 
Overview
 
At September 30, 2007, our cash, cash equivalents and marketable securities totaled $1,543.9 million and we did not have any debt. Our management plans to use these amounts for future operations, potential acquisitions and repurchases of our common stock on the open market.
 
At September 30, 2007, we had cash and cash equivalents totaling $500.3 million, as compared to $389.6 million at December 31, 2006. In the nine months ended September 30, 2007, we generated positive operating cash flows of $301.7 million. Cash flows were positively impacted by an increase in net cash of $26.0 million due to foreign exchange rate fluctuations. Uses of cash during the nine months ended September 30, 2007 included the net purchases of marketable securities of $186.2 million and purchases of property and equipment of $25.7 million.
 
Our working capital, defined as current assets minus current liabilities, was $391.5 million and $146.3 million at September 30, 2007 and December 31, 2006, respectively. The increase in working capital of approximately $245.2 million from December 31, 2006 to September 30, 2007 was primarily attributable to a $265.3 million increase in cash and short-term marketable securities balances due to positive operating cash flows. A more detailed discussion of changes in our liquidity follows.
 
Operating Activities
 
Net cash provided by operating activities in the nine months ended September 30, 2007 and 2006 was primarily the result of our net income of $154.8 million and $104.6 million, respectively. Net income for the nine months ended September 30, 2007 was adjusted for non-cash items such as depreciation and amortization of $59.9 million, non-cash stock-based compensation expense of $41.2 million, changes in deferred income taxes of $10.7 million, discount amortization of marketable securities of $4.4 million, and changes in various assets and liabilities such as an increase in deferred revenue of $27.4 million due to increased sales, an increase in prepaid expenses, prepaid taxes and other assets of $10.4 million, and a decrease in accounts receivable of $20.0 million.
 
Net income for the nine months ended September 30, 2006 was adjusted for non-cash items such as depreciation and amortization of $50.7 million, non-cash stock compensation expense of $38.0 million, changes in deferred income taxes of $22.2 million, discount amortization of marketable securities of $5.4 million, and changes in various assets and liabilities such as an increase in deferred revenue of $65.7 million due to increased sales, an increase in prepaid expenses, prepaid taxes, and other assets of $45.8 million, a decrease in accrued taxes and other liabilities of $9.3 million and a decrease in accounts receivable of $31.3 million.


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Historically, our primary source of operating cash flow was the collection of accounts receivable from our customers and the timing of payments to our vendors and service providers. One measure of the effectiveness of our collection efforts is average accounts receivable days sales outstanding, or “DSO”. DSOs were 44 days and 42 days in the three months ended September 30, 2007 and 2006, respectively. We calculate accounts receivable DSO on a “net” basis by dividing the net accounts receivable balance at the end of the quarter by the amount of net revenue recognized for the quarter multiplied by 90 days. We expect DSOs to vary from period to period because of changes in quarterly revenue and the effectiveness of our collection efforts. In 2007 and 2006, we did not make any significant changes to our payment terms for our customers, which are generally “net 30.”
 
Our operating cash flows, including changes in accounts payable and accrued liabilities, are impacted by the timing of payments to our vendors for accounts payable and taxing authorities. We typically pay our vendors and service providers in accordance with invoice terms and conditions, and take advantage of invoice discounts when available. The timing of future cash payments in future periods will be impacted by the nature of accounts payable arrangements. In the nine months ended September 30, 2007 and 2006, we did not make any significant changes to our payment timing to our vendors.
 
Our cash and marketable securities balances are held in numerous locations throughout the world, including substantial amounts held outside the United States. As of September 30, 2007, approximately $604.6 million was held outside the United States. We utilize a variety of tax planning and financing strategies to ensure that our worldwide cash is available in the locations in which it is needed.
 
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. We expect to pay for these expense, fines, and/or penalties with available cash.
 
We expect to meet our obligations as they become due through available cash and internally generated funds. We expect to continue generating positive working capital through our operations. However, we cannot predict whether current trends and conditions will continue or what the effect on our business might be from the competitive environment in which we operate. In addition, we currently cannot predict the outcome of the litigation described in Note 11. We do believe the working capital available to us will be sufficient to meet our cash requirements for at least the next 12 months.
 
Investing Activities
 
Our investing activities for the nine months ended September 30, 2007 and 2006 are as follows (in thousands):
 
                 
    Nine Months Ended
 
    September 30,  
    2007     2006  
 
Net purchases of marketable securities
  $ (186,224 )   $ (316,112 )
Decrease in restricted cash
    391       49,896  
Purchase of patents
    (9,300 )      
Purchase of property, equipment and leasehold improvements
    (25,704 )     (30,707 )
Proceeds from sale of assets and technology
    4,105        
Acquisitions, net of cash acquired
          (65,871 )
                 
Net cash used in investing activities
  $ (216,732 )   $ (362,794 )
                 


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Investments
 
In the nine months ended September 30, 2007, net purchases of marketable securities were $186.2 million compared to net purchases of marketable securities of $316.1 million in the nine months ended September 30, 2006. We have classified our investment portfolio as “available-for-sale,” and our investments are made with a policy of capital preservation and liquidity as the primary objectives. We generally hold investments in money market, U.S. government fixed income, U.S. government agency fixed income, mortgage-backed and investment grade corporate fixed income securities to maturity; however, we may sell an investment at any time if the quality rating of the investment declines, the yield on the investment is no longer attractive or we are in need of cash. Because we invest only in investment securities that are highly liquid with a ready market, we believe that the purchase, maturity or sale of our investments has no material impact on our overall liquidity. We expect to continue our investing activities, including investment securities of a short-term and long-term nature.
 
Restricted Cash
 
The non-current restricted cash balance of $0.6 million and $1.0 million at September 30, 2007 and December 31, 2006 consisted primarily of cash collateral related to leases in the United States and India, as well as workers’ compensation insurance coverage.
 
On February 9, 2006, the SEC entered the final judgment for settlement with us. On our consolidated statement of cash flow for the nine months ended September 30, 2006, the $50.0 million released from escrow for payment to the SEC was reflected as cash provided by investing activities and cash used in operating activities. The interest earned on the escrow was released to cash upon payment to the SEC.
 
Property and Equipment
 
The $25.7 million of property and equipment purchased during the nine months ended September 30, 2007 was primarily for purchases of computers, equipment and software for ongoing projects and approximately $1.3 million for leasehold improvements related to our expanded research and development facility in Beaverton, Oregon.
 
We anticipate that we will continue to purchase property and equipment necessary in the normal course of our business. The amount and timing of these purchases and the related cash outflows in future periods is difficult to predict and is dependent on a number of factors including our hiring of employees, the rate of change in computer hardware/software used in our business and our business outlook.
 
Proceeds from the sale of assets and technology
 
The $4.1 million of proceeds from the sale of assets during the three months ended March 31, 2007 was primarily related to the sale of all of our fractional interests in corporate aircraft.
 
Acquisitions
 
Our available cash and equity securities may be used to acquire or invest in complementary companies, products and technologies. For example, in November 2007, we paid $350.0 million to purchase 100% of the outstanding shares of Safeboot Holding B.V. In October 2007, we entered into a definitive agreement to acquire ScanAlert, Inc. for $51.0 million and up to an additional $24.0 million if certain performance targets are met.


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Financing Activities
 
Our financing activities for the nine months ended September 30, 2007 and 2006 are as follows (in thousands):
 
                 
    Nine Months Ended
 
    September 30,  
    2007     2006  
 
Proceeds from issuance of common stock from option and stock purchase plans
  $     $ 32,007  
Excess tax benefits from stock-based compensation
    12       4,811  
Repurchase of common stock
    (196 )     (234,679 )
                 
Net cash used in financing activities
  $ (184 )   $ (197,861 )
                 
 
Stock Option and Stock Purchase Plans
 
Historically, our recurring cash flows provided by financing activities have been from the receipt of cash from the issuance of common stock under stock option and employee stock purchase plans. We received cash proceeds from these plans in the amount of $32.0 million in the nine months ended September 30, 2006. Beginning in July 2006, we suspended purchases under our employee stock purchase plan, returned all withholdings to our participating employees, including interest based on a 5% per annum interest rate, and prohibited our employees from exercising stock options due to the announced investigation into our historical stock option granting practices and our inability to become current on our reporting obligations under the Securities Exchange Act of 1934, as amended. Therefore, in the nine months ended September 30, 2007, we received no proceeds from the issuance of common stock under stock option and stock purchase plans. While we expect to continue to receive these proceeds in future periods, the timing and amount of such proceeds are difficult to predict and are contingent on a number of factors including our ability to become current on our reporting obligations under the Securities Exchange Act of 1934, as amended, the price of our common stock, the number of employees participating in the plans and general market conditions. In addition, in 2006, we changed our equity compensation program for existing employees by starting to grant, in certain instances, restricted stock units in addition to awarding stock options. We continued to grant stock options to new employees. Although management and our compensation committee have not determined what type of equity compensation we will use to reward top-performing employees in the future, if management and our compensation committee decide to grant only restricted stock units, which provide no proceeds to us, going forward, our proceeds from issuance of common stock will be significantly less than proceeds that we received historically.
 
Excess Tax Benefits from Stock-Based Compensation
 
The excess tax benefit reflected as a financing cash inflow in the nine months ended September 30, 2007 and 2006 represents excess tax benefits realized relating to stock-based payments to our employees, in accordance with SFAS 123(R). There is a corresponding cash outflow included in cash flows from operating activities.
 
Repurchase of Common Stock
 
Our board of directors has authorized the repurchase of our common stock in the open market from time to time, depending upon market conditions, share price and other factors. During the nine months ended September 30, 2006, we used $234.2 million to repurchase 9.8 million shares of our common stock in the open market, including commissions paid on these transactions. 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, in the nine months ended September 30, 2007, we had no repurchases of our common stock pursuant to a publicly announced plan or program.
 
During the nine months ended September 30, 2007 and 2006, we used $0.2 million and $0.5 million, respectively, to repurchase shares of common stock in connection with our obligation to certain holders of restricted stock to withhold the number of shares required to satisfy such holder’s tax liability in connection with the vesting of such shares. These shares were not part of the publicly announced repurchase program.


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Credit Facility
 
We have a 14.0 million Euro credit facility with a bank. The credit facility is available on an offering basis, meaning that transactions under the credit facility will be on such terms and conditions, including interest rate, maturity, representations, covenants and events of default, as mutually agreed between us and the bank at the time of each specific transaction. The credit facility is intended to be used for short-term credit requirements, with terms of one year or less. The credit facility can be cancelled at any time. No balances were outstanding as of September 30, 2007 and December 31, 2006.
 
Item 3.   Quantitative and Qualitative Disclosures about Market Risk
 
Our market risks at September 30, 2007, are consistent with those discussed in Item 7A of our annual report on Form 10-K for the year ended December 31, 2006 filed with the Securities and Exchange Commission.
 
Item 4.   Controls and Procedures
 
Background of the Restatement
 
As described in the “Explanatory Note Regarding Restatement” preceding Part I, Item 1 and in Note 3 to the consolidated financial statements of our annual report on Form 10-K for the year ended December 31, 2006, during 2007 and 2006 a special committee of our board of directors carried out an independent investigation related to our historical stock option granting practices. As a result of the investigation, we concluded that incorrect measurement dates were used for financial accounting purposes for certain stock option grants made in prior periods. The original accounting measurement dates for approximately 15,600 grants were revised in the periods 1995 through 2005, errors to variable awards were corrected and charges for modifications previously unaccounted for were recorded, resulting in a total of $137.4 million additional pre-tax, non-cash stock-based compensation expense to be recognized over the applicable vesting periods.
 
Evaluation of Disclosure Controls and Procedures
 
Our management, with the participation of our chief executive officer and our chief financial officer, have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) and concluded that because of the material weaknesses in our internal controls over financial reporting discussed below, our disclosure controls and procedures were not effective as of September 30, 2007.
 
A control system, no matter how well conceived and operated, can provide only reasonable assurance that the objectives of the control system are met. Our management, including our chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures or internal control over financial reporting will prevent all errors and fraud. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within our company have been detected. These inherent limitations include the reality that judgments in decision-making can be faulty, and that breakdowns can occur because of simple errors or mistakes. The design of any control system is also based, in part, upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a control system, misstatements due to error or fraud may occur and not be detected.
 
Material Weaknesses in Internal Control over Financial Reporting
 
A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. Our management identified the following material weaknesses in our internal controls over financial reporting as of September 30, 2007.


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Stock Administration Process
 
As noted above, during 2007 and 2006, our management identified, calculated and recorded additional stock-based compensation expense resulting from errors identified during an independent investigation of our historical stock option granting practices. While the additional stock-based compensation related to 2006 and prior years, the errors material to our financial statements were related to option grants made between 1995 and 2003. These errors were a result of internal control deficiencies in our stock option granting and accounting practices, including the recording and disclosure of stock-based compensation expense in our financial statements since 1995. Specifically, effective controls, including monitoring, were not designed and in place to provide reasonable assurance regarding the existence, completeness, accuracy, valuation and presentation of activity related to our granting of stock options in the financial statements.
 
Due to the ongoing discovery of prior period errors that resulted from these internal control deficiencies and the absence of mitigating controls, management has concluded that, as of September 30, 2007, we did not maintain effective controls over our stock option granting and accounting practices, including the recording and disclosure of stock-based compensation expense in our financial statements. These internal control deficiencies resulted in errors in (i) stock-based compensation expense, additional paid-in capital, related income tax accounts and weighted average diluted shares outstanding and (ii) related financial statement disclosures. Management has concluded that these internal control deficiencies constitute a material weakness in internal control because there is a reasonable possibility that a material misstatement of the interim and annual financial statements would not have been prevented or detected on a timely basis.
 
As described below under the heading “Changes in Internal Controls Over Financial Reporting,” we have taken a number of steps designed to improve our stock administration process.
 
Accounting for Income Taxes
 
Our management identified errors in the tax calculations for the quarterly and annual financial statements resulting from: (i) historical analyses not being prepared in sufficient detail, (ii) current period tax calculations not being accurately prepared, and (iii) reviews of tax calculations not being performed with sufficient precision. Due to the number and amount of the errors identified resulting from these internal control deficiencies and the absence of mitigating controls, management has concluded that these internal control deficiencies constitute a material weakness in internal control because there is a reasonable possibility that a material misstatement of the interim and annual financial statements would not have been prevented or detected on a timely basis.
 
As described below under the heading “Changes in Internal Controls Over Financial Reporting,” we have taken a number of steps designed to improve our accounting for income taxes.
 
Changes in Internal Controls Over Financial Reporting
 
Except for those described below, there have been no changes in our internal control over financial reporting since December 31, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
Stock Administration Process
 
To improve the completeness and accuracy of all stock-based compensation expense resulting from the independent investigation, our management is implementing the following controls:
 
  •  Accumulation and tracking of stock-based compensation expense:  Monitoring and tracking procedures for stock-based compensation expense resulting from the stock option investigation within a secure controlled directory.
 
  •  Processing and reconciliation of stock-based compensation expense:   Processes to ensure that all stock-based expenses are properly calculated, independently approved and reconciled from the database to our stock administration accounting system.


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  •  Independent approval and recording of stock-based compensation expense:  Procedures to ensure that stock-based compensation expenses are recorded via journal entries that are independently approved by corporate accounting management and evidenced by complete supporting documentation.
 
Accounting for Income Taxes
 
We have begun the process of remediating the material weakness in accounting for income taxes by hiring more tax accounting personnel, with an emphasis on hiring personnel having international tax expertise. We will continue to make personnel additions and changes, and as necessary, implement additional remedial steps as indicated below:
 
  •  We are enhancing the training and education of our tax accounting personnel.
 
  •  We are automating key elements of the calculation of the provision for income taxes and the account reconciliation processes by implementing a new tax accounting system.
 
  •  We are improving our interim and annual review processes for various calculations including the tax provision computation process.
 
We believe the above steps will provide us with the infrastructure and processes necessary to accurately record stock-based compensation expense and to accurately calculate our tax provision on a quarterly basis. We will continue to implement these remedial steps to ensure operating effectiveness of the improved internal controls over financial reporting.
 
PART II: OTHER INFORMATION
 
Item 1.   Legal Proceedings
 
Information with respect to this item is incorporated by reference to Note 11 of the notes to the condensed consolidated financial statements included in this Report on Form 10-Q and as set forth in Part I, Item 3, of our annual report on Form 10-K for the year ended December 31, 2006.
 
Item 1A.   Risk Factors
 
A description of the risks associated with our business, financial condition, and results of operations is set forth in Part I, Item 1A, of our annual report on Form 10-K for the year ended December 31, 2006. We have no material changes in our risks from such description.
 
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds
 
Stock Repurchases
 
Our board of directors has authorized the repurchase of our common stock in the open market from time to time, 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, in the three months ended September 30, 2007, we had no repurchases of our common stock that were pursuant to a publicly announced plan or program. As of September 30, 2007, we had remaining authorization to repurchase $246.2 million of our common stock; 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.
 
During the nine months ended September 30, 2007, we used $0.2 million to repurchase 6,824 shares of common stock in connection with our obligation to a holder of restricted stock to withhold the number of shares required to satisfy such holder’s tax liability in connection with the vesting of such shares. These shares were not part of the publicly announced repurchase program.


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Item 3.   Defaults upon Senior Securities
 
None.
 
Item 4.   Submission of Matters to a Vote of Security Holders
 
None.
 
Item 5.   Other Information
 
We did not hold an annual meeting of stockholders in 2007. We currently expect that our 2008 annual meeting of stockholders will be held in May 2008. For a stockholder proposal to be considered for inclusion in McAfee’s proxy statement for our 2008 annual meeting, the written proposal must be received by the Secretary of McAfee at our principal executive offices within a reasonable time before we begin to print and send our proxy materials. The proposal will need to comply with Rule 14a-8 of the Securities Exchange Act of 1934, as amended, which sets forth the requirements for the inclusion of stockholder proposals in company-sponsored proxy materials.
 
If you intend to present a proposal at our 2008 annual meeting, but do not intend to have it included in our proxy statement, your proposal must be delivered to the Secretary of McAfee by the tenth day following the day that we first publicly announce the date of our 2008 annual meeting of stockholders. The proposal will need to comply with the requirements set fourth in Article I, Section 7 of our Second Amended and Restated Bylaws.
 
Item 6.   Exhibits
 
(a) Exhibits.  The exhibits listed in the accompanying Exhibit Index are filed or incorporated by reference as part of this Report.


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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
McAfee Inc.
 
/s/  Eric F. Brown
Eric F. Brown
Executive Vice President, Chief Financial Officer
and Chief Operating Officer
 
December 21, 2007


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EXHIBIT INDEX
 
                                     
        Incorporated by Reference    
Exhibit
          File
  Exhibit
      Filed with
Number
 
Description
 
Form
 
Number
 
Number
 
Filing Date
 
this 10-Q
 
  3 .1   Second Restated Certificate of Incorporation of the Registrant, as amended on December 1, 1997   S-4   333-48593     3 .1   March 25, 1998        
  3 .2   Certificate of Ownership and Merger between Registrant and McAfee, Inc.    10-Q   001-31216     3 .2   November 8, 2004        
  3 .3   Second Amended and Restated Bylaws of the Registrant.   10-Q   001-31216     3 .3   November 8, 2004        
  3 .4   Certificate of Designation of Series A Preferred Stock of the Registrant   10-Q   000-20558     3 .3   November 14, 1996        
  3 .5   Certificate of Designation of Rights, Preferences and Privileges of Series B Participating Preferred Stock of the Registrant   8-A   000-20558     5 .0   October 22, 1998        
  31 .1   Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                         X  
  32 .1   Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                         X  


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