Contact Center Solutions Industry News

TMCNet:  VMWARE, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

[February 27, 2013]

VMWARE, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) All dollar amounts expressed as numbers in this MD&A (except share and per share amounts) are in millions.

Overview We are the leader in virtualization infrastructure solutions utilized by organizations to help transform the way they build, deliver and consume information technology ("IT") resources. Our primary source of revenues is from the licensing and support of these solutions to organizations of all sizes and across numerous industries. The benefits of our solutions to our customers include substantially lower IT costs, cost-effective high availability across a wide range of applications and a more automated and resilient systems infrastructure capable of responding dynamically to variable business demands.

We pioneered the development and application of virtualization technologies with x86 server-based computing, separating application software from the underlying hardware. Since then, we have introduced a broad and proven suite of virtualization technologies that address a range of complex IT problems that include cost and operational inefficiencies, facilitating access to cloud computing capacity, business continuity, and corporate end-user computing device management. In 2012, we articulated a vision for the software-defined data center ("SDDC"), where increasingly infrastructure is virtualized and delivered as a service, and the control of this data center is entirely automated by software. To further this vision, in the third quarter of 2012, we released the VMware vCloud Suite, which is the first integrated solution designed to meet the requirements of the SDDC by pooling industry-standard hardware and running compute, networking, storage and management functions in the data center as software-defined services.

Our solutions are based upon our core virtualization technology and are organized into two main product groups: Cloud Infrastructure and Management and End-User Computing. The Cloud Infrastructure and Management product group is based upon our flagship virtualization platform, VMware vSphere. VMware vSphere not only decouples the entire software environment from its underlying hardware infrastructure but also enables the aggregation of multiple servers, storage infrastructures and networks into shared pools of resources that can be delivered dynamically, securely and reliably to applications as needed. The Cloud Infrastructure and Management group also encompasses the VMware vCloud Suite and various Cloud Management solutions that are optimized to work with vSphere environments and are designed to simplify and automate management of dynamic cloud infrastructures that enable enterprises to build, manage and automate their own private clouds. Our End-User Computing product group has solutions designed to enable a user-centric approach to personal computing, ensuring secure access to applications and data from a variety of devices and locations, and addresses the needs of IT departments by delivering existing end-user assets as a managed service.

We also offer Cloud Application Platform solutions to help organizations build, run and manage enterprise applications in public, private or hybrid clouds optimized for vSphere. In December 2012, we launched the Pivotal Initiative with EMC Corporation ("EMC"), our majority stockholder, pursuant to which both companies plan to commit technology, people and programs. The Pivotal Initiative is focused on Big Data and Cloud Application Platforms. Big Data, which is a primary contributor to the pace of overall data growth, refers to the large repositories of corporate and external data, including unstructured information created by new applications, social media and other web repositories.

We have developed a multi-channel distribution model to expand our presence and reach various segments of the market. We derive a significant majority of our sales from our indirect sales channel, which includes distributors, resellers, system vendors and systems integrators. Sales to our channel partners often involve three tiers of distribution: a distributor, a reseller and an end-user customer. Our sales force works collaboratively with our channel partners to introduce them to end-user customer accounts and new sales opportunities. As we expand geographically, we expect to continue to add additional channel partners.

We expect to grow our business by building long-term relationships with our customers through the adoption of enterprise license agreements ("ELAs"). ELAs are comprehensive volume license offerings offered both directly by us and through certain channel partners that provide for multi-year maintenance and support at discounted prices. Under a typical ELA, a portion of the revenues is attributed to the license revenues and the remainder is primarily attributed to software maintenance revenues. In addition, the initial maintenance period is typically longer for ELAs than for other types of license sales. ELAs enable us to build long-term relationships with our customers as they commit to our virtual infrastructure solutions in their data centers. ELAs also provide a base from which to sell additional products, such as our application platform products, our end-user computing products and our cloud infrastructure and management products. ELAs comprised between one-quarter and one-third of our overall sales during 2012 and 2011, with the balance represented by our non-ELA, or transactional business. In 2012, our overall sales growth rate declined compared to 2011, with the growth rate in transactional sales lower than the growth rate in ELAs. In 2013, we intend to also focus our selling and marketing efforts to improve the growth rate of our transactional business.

41-------------------------------------------------------------------------------- Table of Contents In January 2013, we announced a realignment of our strategy to refocus our resources and investments in support of three growth priorities that focus on our core opportunities as a provider of virtualization technologies that simplify IT infrastructure: the software-defined data center, the hybrid cloud and end-user computing. For the SDDC, we plan to continue to invest in the development and delivery of innovations in networking, security, storage and management as we continue to roll out and enhance the features of our vCloud Suite. For the hybrid cloud we plan to focus on expanding our capabilities with our partners to deliver enterprise-class cloud services that are complementary to private clouds in order to enhance our customer's flexibility to run applications on and off premise, as they choose on a compatible, high-quality, secure and resilient hybrid cloud platform. For end-user computing, we plan to enhance our offerings to enable a virtual workspace for both existing PC environments and emerging mobile devices in a secure enterprise environment.

We also announced a business plan to streamline our operations, subject to compliance with applicable legal obligations, to rationalize our portfolio and scale back investments in some areas of our business that we do not believe are directly related to our core growth opportunities. The plan includes the elimination of approximately 900 positions and personnel, which is expected to result in a charge in the range of $70 to $80. Any such proposals in countries outside the United States will be subject to a review of efficiency, resources and performance. Additionally, we are planning an exit of certain lines of business and consolidation of facilities, which are expected to result in a charge in the range of $20 to $30. The plan is expected to be completed by the end of 2013. Finalization of the plan will be subject to local information and consultation processes with employee representatives if required by law. The total charge resulting from this plan is expected to be between $90 and $110, with total cash expenditures associated with the plan expected to be in the range of $80 to $90. Despite these changes, we expect our total headcount to increase during 2013 by approximately 1,000 as we continue to make key investments in support of our long-term growth objectives. Our plan to exit certain lines of business resulted from an evaluation of our business in January 2013. At the end of 2012, we had performed an impairment test and determined that the assets associated with these certain lines of business were not impaired.

We continue to see substantial market opportunities in 2013 and beyond to deliver software innovations that bring agility, efficiency and choice to our customers, while simplifying the infrastructure and IT experience for them.

However, we currently expect our rate of year-over-year growth in both total revenues and license revenues to decline during the first half of 2013 due to several factors, including a difficult macroeconomic environment, the lack of large deals that we anticipate will close in the first quarter of 2013 as compared to the first quarter of 2012 and our business plan to streamline our operations, which we expect to have a short-term negative impact on our revenues. We currently expect stronger growth in the second half of 2013 versus the first half of 2013 on a year-over-year comparison basis. During 2013, we expect to continue to manage our resources prudently, while making key investments in support of our long-term growth objectives.

Results of Operations As we operate our business in one operating segment, our revenues and operating expenses are presented and discussed at the consolidated level.

We classify our revenues into two categories, i.e. license revenues and services revenues. See "Critical Accounting Policies" for further information regarding the accounting for our revenues.

Our current financial focus is on long-term revenue growth to generate free cash flows to fund our expansion of industry segment share and to evolve our virtualization-based products for data centers, end-user devices and cloud computing through a combination of internal development and acquisitions. See "Non-GAAP Financial Measures" for further information on free cash flows. In evaluating our results, we also focus on operating margin excluding certain expenses which are included in our total operating expenses calculated in accordance with GAAP. The expenses excluded are stock-based compensation, the net effect of the amortization and capitalization of software development costs and certain other expenses consisting of amortization of acquired intangible assets, employer payroll taxes on employee stock transactions and acquisition-related items. We believe these measures reflect our ongoing business in a manner that allows meaningful period-to-period comparisons. We are not currently focused on short-term operating margin expansion, but rather on investing at appropriate rates to support our growth and priorities in what may be a substantially more competitive environment.

42-------------------------------------------------------------------------------- Table of Contents Revenues Our revenues in the years ended 2012, 2011 and 2010 were as follows: For the Year Ended December 31, 2012 vs. 2011 2011 vs. 2010 2012 2011 2010 $ Change % Change $ Change % Change Revenues: License $ 2,087.0 $ 1,841.2 $ 1,401.4 $ 245.8 13 % $ 439.8 31 % Services: Software maintenance 2,153.0 1,640.4 1,217.0 512.6 31 423.4 35 Professional services 365.0 285.5 238.9 79.5 28 46.6 20 Total services 2,518.0 1,925.9 1,455.9 592.1 31 470.0 32 Total revenues $ 4,605.0 $ 3,767.1 $ 2,857.3 $ 837.9 22 $ 909.8 32 Revenues: United States $ 2,228.6 $ 1,824.2 $ 1,452.7 $ 404.4 22 % $ 371.5 26 % International 2,376.4 1,942.9 1,404.6 433.5 22 538.3 38 Total revenues $ 4,605.0 $ 3,767.1 $ 2,857.3 $ 837.9 22 $ 909.8 32 In both 2012 and 2011, we saw growth in license and services revenues, and growth in the United States and internationally, as compared with their respective prior years.

License Revenues License revenues in both 2012 and 2011 increased due to continued demand for our product offerings. The increases in license revenues year-over year were primarily due to growth in our Cloud Infrastructure and Management product group, which increased 13.4% in 2012 and 31.9% in 2011. The Cloud Infrastructure and Management product group is based upon our flagship virtualization platform, vSphere, and also encompasses our vCloud Suite and various Cloud Management solutions, which are optimized to work with vSphere environments. Despite the year-over-year increases in license revenues, we are noting a slowing in the rate of license revenue growth both in 2012 and anticipated into 2013. We attribute this to a variety of factors, including challenges in the macroeconomic environment, both across the U.S. and internationally in Europe, as well as a slowing in the number of ELAs greater than $10 that were closed towards the end of 2012 and are expected in the first half of 2013.

Services Revenues In 2012 and 2011, software maintenance revenues benefited from strong renewals, multi-year software maintenance contracts sold in previous periods, and additional maintenance contracts sold in conjunction with new software license sales. In each year presented, customers bought, on average, more than 24 months of support and maintenance with each new license purchased, which we believe illustrates our customers' commitment to VMware as a core element of their data center architecture and hybrid cloud strategy.

In 2012 and 2011, professional services revenues increased as growth in our license sales and installed-base led to additional demand for our professional services. As we continue to invest in our partners and expand our ecosystem of third-party professionals with expertise in our solutions to independently provide professional services to our customers, we do not expect our professional services revenues to constitute an increasing component of our revenue mix. As a result of this strategy, our professional services revenue can vary based on the delivery channels used in any given period as well as the timing of engagements.

Revenue Growth in Constant Currency We invoice and collect in the Euro, the British Pound, the Japanese Yen and the Australian Dollar in their respective regions. As a result, our total revenues are affected by changes in the value of the U.S. Dollar against these currencies. In order to provide a comparable framework for assessing how our business performed excluding the effect of foreign currency fluctuations, management analyzes year-over-year revenue growth on a constant currency basis.

Since we operate with the U.S. Dollar as our functional currency, unearned revenues for orders booked in currencies other than the U.S. Dollar are converted into U.S. Dollars at the exchange rate in effect for the month in which each order is booked and remain at their historical rate when recognized into revenue. We calculate constant currency on license revenues recognized during the current period that were originally booked in currencies other than U.S. Dollars by comparing the exchange rates used to recognize 43-------------------------------------------------------------------------------- Table of Contents revenue in the current period against the exchange rates used to recognize revenue in the comparable period. In 2012, the year-over-year growth in license revenues measured on a constant currency basis was 15% compared with 13% as reported. In 2011, the year-over-year growth in license revenues measured on a constant currency basis was 30% compared with 31% as reported. We do not calculate constant currency on services revenues, which include software maintenance revenues and professional services revenues.

Unearned Revenues Our unearned revenues as of December 31, 2012 and December 31, 2011 were as follows: December 31, 2012 2011 Unearned license revenues $ 462.7 $ 389.2 Unearned software maintenance revenues 2,755.0 2,133.5 Unearned professional services revenues 242.9 185.7 Total unearned revenues $ 3,460.6 $ 2,708.4 The complexity of our unearned revenues has increased over time as a result of acquisitions, an expanded product portfolio and a broader range of pricing and packaging alternatives. As of December 31, 2012, total unearned revenues increased by 28% from December 31, 2011. This increase was primarily due to growth in unearned software maintenance revenues, attributable to our growing base of maintenance contracts. As of December 31, 2012, 87% of our total unearned revenues are expected to be recognized ratably.

Unearned license revenues are either recognized ratably, recognized upon delivery of existing or future products or services, or will be recognized ratably upon delivery of future products or services. Future products include, in some cases, emerging products that are offered as part of product promotions where the purchaser of an existing product is entitled to receive a promotional product at no additional charge. We regularly offer product promotions as a strategy to improve awareness of our emerging products. To the extent promotional products have not been delivered and vendor-specific objective evidence ("VSOE") of fair value cannot be established, the revenue for the entire order is deferred until such time as all product delivery obligations have been fulfilled. Increasingly, unearned license revenue may also be recognized ratably, which is generally due to a right to receive unspecified future products or a lack of VSOE of fair value on the software maintenance element of the arrangement. At December 31, 2012, the ratable component represented over half of the total unearned license revenue balance. The amount of total unearned license revenues may vary over periods due to the type and level of promotions offered, the portion of license contracts sold with a ratable recognition element, and when promotional products are delivered upon general availability. Unearned software maintenance revenues are attributable to our maintenance contracts and are recognized ratably, typically over terms from one to five years with a weighted-average remaining term at December 31, 2012 of approximately 1.9 years. Unearned professional services revenues result primarily from prepaid professional services, including training, and are recognized as the services are delivered. We believe that our overall unearned revenue balance improves predictability of future revenues and that it is a key indicator of the health and growth of our business.

Operating Expenses Information about our operating expenses for the years ended 2012, 2011 and 2010 is as follows: For the Year Ended December 31, 2012 Capitalized Core Software Other Total Operating Stock-Based Development Operating Operating Expenses (1) Compensation Costs, net Expenses Expenses Cost of license revenue $ 92.7 $ 2.1 $ 70.6 $ 71.6 $ 237.0 Cost of services revenue 450.6 28.2 - 5.5 484.3 Research and development 778.8 210.4 - 10.0 999.2 Sales and marketing 1,477.9 149.9 - 17.0 1,644.8 General and administrative 314.1 48.1 - 5.6 367.8 Total operating expenses $ 3,114.1 $ 438.7 $ 70.6 $ 109.7 $ 3,733.1 Operating income $ 871.9 Operating margin 18.9 % 44-------------------------------------------------------------------------------- Table of Contents For the Year Ended December 31, 2011 Capitalized Core Software Other Total Operating Stock-Based Development Operating Operating Items (1) Compensation Costs, net Items Items Cost of license revenue $ 74.9 $ 1.6 $ 84.7 $ 46.2 $ 207.4 Cost of services revenue 384.9 23.4 - 6.3 414.6 Research and development 661.9 174.3 (74.0 ) 12.9 775.1 Sales and marketing 1,222.8 95.7 - 15.8 1,334.3 General and administrative 256.2 40.2 - 4.1 300.5 Total operating expenses $ 2,600.7 $ 335.2 $ 10.7 $ 85.3 $ 3,031.9 Operating income $ 735.2 Operating margin 19.5 % For the Year Ended December 31, 2010 Capitalized Core Software Other Total Operating Stock-Based Development Operating Operating Expenses (1) Compensation Costs, net Expenses Expenses Cost of license revenue $ 52.4 $ 1.7 $ 99.5 $ 23.9 $ 177.5 Cost of services revenue 292.3 18.5 - 5.5 316.3 Research and development 537.8 164.4 (60.7 ) 11.5 653.0 Sales and marketing 931.7 73.1 - 8.5 1,013.3 General and administrative 230.1 34.0 - 5.2 269.3 Total operating expenses $ 2,044.3 $ 291.7 $ 38.8 $ 54.6 $ 2,429.4 Operating income $ 428.0 Operating margin 15.0 % ____________________________ (1) Core operating expenses is a non-GAAP financial measure that excludes stock-based compensation, the net effect of the amortization and capitalization of software development costs and certain other expenses from our total operating expenses calculated in accordance with GAAP. The other operating expenses excluded are amortization of acquired intangible assets, employer payroll taxes on employee stock transactions and acquisition-related items. Our core operating expenses reflect our business in a manner that allows meaningful period-to-period comparisons. Our core operating expenses are reconciled to the most comparable GAAP measure, "total operating expenses," in the table above. See "Non-GAAP Financial Measures" for further information.

Our operating margin on total operating expenses decreased to 18.9% in 2012 from 19.5% in 2011. The decrease in our operating margin in 2012 compared with 2011 primarily related to the year-over-year decrease in capitalized software development costs, partially offset by the year-over-year increase in our revenues, which outpaced the increase in our core operating expenses. Our operating margin on total operating expenses increased to 19.5% in 2011 from 15.0% in 2010. The increase in our operating margin in 2011 compared with 2010 primarily related to the increase in our revenues, which outpaced the increases in our expenses.

Core Operating Expenses The following discussion of our core operating expenses and the components comprising our core operating expenses highlights the factors that we focus on when evaluating our operating margin and operating expenses. The increases or decreases in operating expenses discussed in this section do not include changes relating to stock-based compensation, the net effect of the amortization and capitalization of software development costs and certain other expenses, which consist of amortization of acquired intangible assets, employer payroll taxes on employee stock transactions and acquisition-related items.

Core operating expenses increased by $513.4 or 20% in 2012 compared with 2011 and increased by $556.4 or 27% in 2011 compared with 2010. As quantified below, these increases were primarily due to increases in employee-related expenses, which include salaries and benefits, bonuses, commissions, and recruiting and training, and which increased largely as a result of increases in headcount. Our headcount as of December 31, 2012 was approximately 13,800, compared with approximately 11,200 as of December 31, 2011 and compared with approximately 9,000 as of December 31, 2010. These increases in headcount were driven by strategic hiring, business growth and business acquisitions. A portion of our core operating expenses, primarily the cost of personnel to deliver technical support on our products and professional services, marketing, and research 45-------------------------------------------------------------------------------- Table of Contents and development, are denominated in foreign currencies and are thus exposed to foreign exchange rate fluctuations. Core operating expenses benefited by $53.6 in 2012 and were negatively impacted by $48.2 in 2011 as compared with their respective prior years due to the effect of fluctuations in the exchange rates between the U.S. Dollar and other currencies.

Cost of License Revenues Our core operating expenses for cost of license revenues principally consist of the cost of fulfillment of our software and royalty costs in connection with technology licensed from third-party providers. The cost of fulfillment of our software includes IT development efforts, personnel costs, product packaging and related overhead associated with the physical and electronic delivery of our software products.

Core operating expenses for cost of license revenues increased by $17.8 or 24% in 2012 compared with 2011 and by $22.4 or 43% in 2011 compared with 2010. The increases were due to increases of $8.0 and $7.6 in 2012 and 2011, respectively, for IT development costs. Additionally, cost of license revenues increased by $4.8 and $11.3 in 2012 and 2011, respectively, primarily related to royalty and licensing costs for technology licensed from third-party providers that is used in our products.

Cost of Services Revenues Our core operating expenses for cost of services revenues primarily include the costs of personnel and related overhead to deliver technical support for our products and to provide our professional services.

Core operating expenses for cost of services revenues increased by $65.8 or 17% in 2012 compared with 2011, and by $92.5 or 32% in 2011 compared with 2010. The increase in 2012 was primarily due to growth in employee-related expenses and travel and entertainment expenses of $61.4, which was largely driven by incremental growth in headcount to support increased revenues. Additionally, our third-party professional services costs increased by $17.0 to provide technical support and professional services primarily in connection with increased demand for services. These increases in 2012 were partially offset by a decrease of $8.0 due to the completion of certain IT development projects and the positive impact of fluctuations in the exchange rate between the U.S. Dollar and foreign currencies of $9.1. The increase in 2011 was primarily due to growth in employee-related expenses of $48.3, which was largely driven by incremental growth in headcount, as well as an increase in expenses of $16.2 for IT development costs. Additionally, our third-party professional services costs increased by $13.1 to provide technical support and professional services primarily in connection with increased services revenues. Fluctuations in the exchange rate between the U.S. Dollar and foreign currencies also contributed $9.4 to the overall increase in costs of services revenues.

Research and Development Expenses Our core operating expenses for research and development ("R&D") expenses include the personnel and related overhead associated with the R&D of new product offerings and the enhancement of our existing software offerings.

Core operating expenses for R&D increased by $116.9 or 18% in 2012 compared with 2011, and by $124.1 or 23% in 2011 compared with 2010. The increases were primarily due to growth in employee-related expenses of $105.5 and $95.0 in 2012 and 2011, respectively, which were primarily driven by incremental growth in headcount from strategic hiring and business acquisitions. In 2012 and 2011, facility-related expenses of $11.5 and $9.1, respectively, further contributed to the year-over-year increases. Additionally, the positive impact of $9.5 from fluctuations in the exchange rate between the U.S. Dollar and foreign currencies partially offset the increases in 2012.

Sales and Marketing Expenses Our core operating expenses for sales and marketing expenses include personnel costs, sales commissions and related overhead associated with the sale and marketing of our license and services offerings, as well as the cost of product launches. Sales commissions are generally earned and expensed when a firm order is received from the customer and may be expensed in a period other than the period in which the related revenue is recognized. Sales and marketing expenses also include the net impact from the expenses incurred and fees generated by certain marketing initiatives, including our annual VMworld conferences in the U.S. and Europe.

Core operating expenses for sales and marketing increased by $255.0 or 21% in 2012 compared with 2011, and by $291.2 or 31% in 2011 compared with 2010. The increase in 2012 was primarily due to growth in employee-related expenses of $213.8, driven by incremental growth in headcount and by higher commission expense due to increased sales volumes, as well as an increase of $50.0 in the costs of marketing programs. The increases in 2012 were partially offset by the positive impact of $28.9 from fluctuations in the exchange rate between the U.S.

Dollar and foreign currencies. The increase in 2011 was primarily due to growth in employee-related expenses of $168.8, driven by incremental growth in headcount and by higher commission expense due to increased sales volumes.

Additionally, the costs of marketing programs increased by $33.3 and travel and entertainment expense increased by $18.0 in support of our expanding markets and sales efforts. The negative impact of $30.5 from fluctuations in the exchange rate between the U.S. Dollar and foreign currencies further contributed to the increase.

46-------------------------------------------------------------------------------- Table of Contents General and Administrative Expenses Our core operating expenses for general and administrative expenses include personnel and related overhead costs to support the overall business. These expenses include the costs associated with our finance, human resources, IT infrastructure and legal departments, as well as expenses related to corporate costs and initiatives and facilities costs.

Core operating expenses for general and administrative increased by $57.9 or 23% in 2012 compared with 2011, and by $26.1 or 11% in 2011 compared with 2010. The increase in 2012 was primarily due to an increase of $24.3 related to employee-related expenses mostly due to incremental growth in headcount. General and administrative expenses also increased in 2012 due to an increase of $14.3 in corporate expenses, including contributions to our charitable foundation.

Also contributing to the increase in expenses in 2012 were equipment and depreciation expenses of $11.6 to support increased headcount and IT security initiatives and increased contractor costs of $11.2 related to IT security initiatives. The increase in 2011 was primarily due to an increase of $27.5 related to employee-related expenses primarily due to incremental growth in headcount.

Stock-Based Compensation Stock-based compensation in the years ended 2012, 2011 and 2010 was as follows: For the Year Ended December 31, 2012 2011 2010 Stock-based compensation, excluding amounts capitalized $ 438.7 $ 335.2 $ 291.7 Stock-based compensation capitalized - 12.4 10.9 Total stock-based compensation expense $ 438.7 $ 347.6 $ 302.6 Total stock-based compensation was $438.7 in 2012, $347.6 in 2011, and $302.6 in 2010, representing year-over-year increases of $91.1 and $45.0, respectively. In 2011 and 2010, we capitalized $12.4 and $10.9, respectively, of stock-based compensation to our software development projects. No costs were capitalized in 2012 for software development projects. The increase in total stock-based compensation expenses in 2012 compared with 2011 was primarily due to an increase of $112.4 for new awards issued to our existing employees, as well as an increase of $38.8 for awards made to new employees joining VMware in 2012.

Additionally, total stock-based compensation expense increased by $45.7 in 2012 in connection with our acquisition of Nicira in August 2012. Partially offsetting these increases was a decrease of $96.0 related to grants that became fully vested over the past year.

The increase in stock-based compensation expense in 2011 over 2010 was primarily due to an increase of $74.3 from new awards issued to our existing employees both in the second half of 2010 and the second quarter of 2011, as well as an increase of $32.9 for awards made to new employees joining VMware in 2011. These increases were partially offset by a decrease of $71.7 primarily related to fully vested grants.

Stock-based compensation is recorded to each operating expense category based upon the function of the employee to whom the stock-based compensation relates and fluctuates based upon the value and number of awards granted. Compensation philosophy varies by function, resulting in different weightings of cash incentives versus equity incentives. As a result, functions with larger cash-based components, such as sales commissions, will have comparatively lower stock-based compensation than other functions.

As of December 31, 2012, the total unamortized fair value of our outstanding equity-based awards held by our employees was $945.4, and is expected to be recognized over a weighted-average period of approximately 1.6 years.

Capitalized Software Development Costs, Net Development costs of software to be sold, leased, or otherwise marketed are subject to capitalization beginning when the product's technological feasibility has been established and ending when the product is available for general release. Judgment is required in determining when technological feasibility is established, and as our business, products and go-to-market strategy have evolved, we have continued to evaluate when technological feasibility is established. Following the release of vSphere 5 and the comprehensive suite of cloud infrastructure technologies in the third quarter of 2011, we determined that our go-to-market strategy had changed from single solutions to product suite solutions. As a result of this change in strategy, and the related increased importance of interoperability between our products, the length of time between achieving technological feasibility and general release to customers significantly decreased. We expect our products to be available for general release soon after technological feasibility has been established. Given that we expect the majority of our product offerings to be suites or to have key components that interoperate with our other product offerings, the costs incurred subsequent to achievement of technological feasibility are expected to be immaterial in future periods. In 2012 and the fourth quarter of 2011, all software development costs related to product offerings were expensed as incurred and were included in R&D expenses on the accompanying consolidated statements of income. In 2011 and 2010, we capitalized $86.4 (including $12.4 of stock-based 47-------------------------------------------------------------------------------- Table of Contents compensation) and $71.6 (including $10.9 of stock-based compensation), respectively, of costs for the development of software products. Capitalized software development costs increased by $14.7 in 2011 compared with 2010 primarily due to an increase in costs associated with products that had reached technological feasibility, including vSphere 5. The change in our go-to-market strategy and resulting decrease in the length of time between technological feasibility of our products and the date those products are available for general release to customers did not materially impact the amount of software development costs we capitalized in 2011.

Future changes in our judgment as to when technological feasibility is established, or additional changes in our business, including our go-to-market strategy, could materially impact the amount of costs capitalized. For example, if the length of time between technological feasibility and general availability were to increase in the future, the amount of capitalized costs would likely increase. Additionally, a transition to offering software as a service instead of via a license may also result in an increased level of software capitalization.

In 2012, 2011 and 2010, amortization expense from capitalized software development costs was $70.6, $84.7 and $99.5, respectively. The decrease in amortization of software development costs in 2012 compared with 2011 and 2011 compared with 2010 was primarily due to both the timing of new product releases and the completion of amortization for other product releases, including different versions of vSphere. Amortization expense from capitalized software development costs is included in cost of license revenues on our accompanying consolidated statements of income. In future periods, we expect our amortization expense from capitalized software development costs to decline as these costs are expected to be recorded as R&D expense as incurred given our current go-to-market strategy.

Other Operating Expenses Other operating expenses consist of intangible amortization and employer payroll tax on employee stock transactions, which are recorded to each individual line of operating expense on our accompanying consolidated statements of income.

Additionally, other operating expenses include acquisition-related items, which are recorded in general and administrative expense on our income statement.

Other operating expenses in the years ended 2012, 2011 and 2010 were as follows: For the Year Ended December 31, 2012 2011 2010 Intangible amortization $ 92.0 $ 64.6 $ 34.8 Employer payroll tax on employee stock transactions 13.9 18.4 16.3 Acquisition-related items 3.8 2.3 3.5 Total other operating expenses $ 109.7 $ 85.3 $ 54.6 Other operating expenses increased $24.4 in 2012 from 2011 and $30.7 in 2011 from 2010. The increase in 2012 was primarily due to an increase in intangible amortization of $27.4 resulting from new acquisitions, which was primarily recorded to cost of license revenues on our accompanying consolidated statement of income. The increase was partially offset by a decrease of $4.5 in employer payroll taxes on employee stock transactions, which was attributable to a decrease in the number of awards exercised, sold or vested. The increase in other operating expenses in 2011 was primarily due to additional intangible amortization of $29.8 resulting from new acquisitions, of which $22.3 was recorded to costs of license revenues on our income statement.

Investment Income Investment income increased by $10.4 to $26.6 in 2012 from $16.2 in 2011 and increased by $9.5 to $16.2 in 2011 from $6.6 in 2010. Investment income consists of interest earned on cash, cash equivalents and short-term investment balances partially offset by the amortization of premiums paid on fixed income securities. In both 2012 and 2011 as compared with their respective prior years, investment income increased due to increased balances invested in our fixed income portfolio and higher yields.

Other Income (Expense), Net Other expense, net of $0.7 in 2012 changed by $47.7 compared with other income, net of $47.0 in 2011. Other income, net of $47.0 in 2011 changed by $61.2 from other expense, net of $14.2 in 2010. The changes in 2012 compared with 2011 and in 2011 compared with 2010 were primarily due to a $56.0 gain recognized on the sale of our investment in Terremark Worldwide, Inc. in 2011.

48-------------------------------------------------------------------------------- Table of Contents Income Tax Provision Our effective tax rate was 16.5%, 8.9%, and 14.2% for 2012, 2011, and 2010, respectively. The effective tax rate in 2012 was higher than 2011 primarily due to the federal research credit, which expired at the end of 2011 and was unavailable in 2012. The rate was also negatively impacted by a greater proportion of earnings in the U.S., which are taxed at a higher rate than our earnings in foreign jurisdictions. The effective tax rate in 2011 was lower than 2010 primarily due to a shift in the mix of income before tax from the U.S. to international jurisdictions with lower tax rates compared to the U.S. rate, partially offset by a relative reduction in the benefit from the federal research credit.

In January 2013, the United States Congress retroactively enacted an extension of the federal research credit through December 31, 2013. As a result, we expect that our income tax provision for the first quarter of 2013 will include an estimated discrete tax benefit of approximately $38 reflecting the full year 2012 federal research credit. This estimated amount will be finalized in 2013.

Our 2013 annual estimated effective tax rate will also include the benefit expected for 2013 and accordingly, we expect our 2013 effective tax rate to be lower than the 2012 effective tax rate.

Our rate of taxation in foreign jurisdictions is lower than the U.S. tax rate.

Our international income is primarily earned by our subsidiaries in Ireland, where the statutory tax rate is 12.5%. We do not believe that any recent or currently expected developments in non-U.S. tax jurisdictions are reasonably likely to have a material impact on our effective tax rate. All income earned abroad, except for previously taxed income for U.S. tax purposes, is considered indefinitely reinvested in our foreign operations and no provision for U.S.

taxes has been provided with respect to such income.

As of December 31, 2012, our total cash, cash equivalents, and short-term investments were $4,630.8 of which $2,996.7 were held outside the U.S. Our intent is to indefinitely reinvest our non-U.S. funds in our foreign operations, and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. We plan to meet our U.S. liquidity needs through ongoing cash flows generated from our U.S. operations, external borrowings, or both. We utilize a variety of tax planning strategies in an effort to ensure that our worldwide cash is available in the locations in which it is needed. If management determines these overseas funds are needed for our operations in the U.S., we would be required to accrue U.S. taxes on the related undistributed earnings in the period management determines the earnings will no longer be indefinitely invested outside the U.S. in order to repatriate these funds.

We have been included in the EMC consolidated group for U.S. federal income tax purposes, and expect to continue to be included in such consolidated group for periods in which EMC owns at least 80% of the total voting power and value of our outstanding stock as calculated for U.S. federal income tax purposes. The percentage of voting power and value calculated for U.S. federal income tax purposes may differ from the percentage of outstanding shares beneficially owned by EMC due to the greater voting power of our Class B common stock as compared to our Class A common stock and other factors. Each member of a consolidated group during any part of a consolidated return year is jointly and severally liable for tax on the consolidated return of such year and for any subsequently determined deficiency thereon. Should EMC's ownership fall below 80% of the total voting power or value of our outstanding stock in any period, then we would no longer be included in the EMC consolidated group for U.S. federal income tax purposes, and thus we would no longer be liable in the event that any income tax liability was incurred, but not discharged, by any other member of the EMC consolidated group. Additionally, our U.S. federal income tax would be reported separately from that of the EMC consolidated group.

Although we file a federal consolidated tax return with EMC, we calculate our income tax provision on a stand-alone basis. Our effective tax rate in the periods presented is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax rates. The rate at which the provision for income taxes is calculated differs from the U.S. federal statutory income tax rate primarily due to different tax rates in foreign jurisdictions where income is earned and considered to be indefinitely reinvested.

Our future effective tax rate may be affected by such factors as changes in tax laws, changes in our business, regulations, or rates, changing interpretation of existing laws or regulations, the impact of accounting for stock-based compensation, the impact of accounting for business combinations, changes in our international organization, shifts in the amount of income before tax earned in the U.S. as compared with other regions in the world, and changes in overall levels of income before tax.

Our Relationship with EMC As of December 31, 2012, EMC owned 41,050,000 shares of Class A common stock and all 300,000,000 shares of Class B common stock, representing 79.6% of our total outstanding shares of common stock and 97.2% of the combined voting power of our outstanding common stock.

Pursuant to an ongoing reseller arrangement with EMC, EMC bundles our products and services with EMC's products and sells them to end-users. In the years ended December 31, 2012, 2011 and 2010, we recognized revenues of $160.2, $72.0 and $48.5, respectively, from such contractual arrangement with EMC. As of December 31, 2012 and 2011, $149.5 and $105.6, respectively, of revenues from products and services sold under the reseller arrangement were included in unearned revenues.

49-------------------------------------------------------------------------------- Table of Contents In the years ended December 31, 2012, 2011 and 2010, we recognized professional services revenues of $97.7, $66.2 and $60.6, respectively, from such contractual agreements with EMC. As of December 31, 2012 and 2011, $2.9 and $5.1, respectively, of revenues from professional services to EMC customers were included in unearned revenues.

In the years ended December 31, 2012, 2011 and 2010, we recognized revenues of $9.1, $3.2 and $6.1, respectively, from products and services purchased by EMC for internal use pursuant to our contractual agreements with EMC. As of December 31, 2012 and 2011, $28.4 and $23.4, respectively, of revenues from products and services purchased by EMC for internal use were included in unearned revenues.

We purchased products and services from EMC for $42.2, $24.3 and $18.4 in the years ended December 31, 2012, 2011 and 2010, respectively.

Pursuant to the tax sharing agreement, we have made payments to EMC and EMC has made payments to us. The following table summarizes these payments made between us and EMC during the years ended December 31, 2012, 2011 and 2010: For the Year Ended December 31, 2012 2011 2010 Payments from us to EMC $ - $ 12.1 $ 5.1 Payments from EMC to us 19.3 314.5 2.5 Payments between us and EMC under the tax sharing agreement primarily relate to our portion of federal income taxes on EMC's consolidated tax return. Payments from us to EMC primarily relate to periods for which we had stand-alone federal taxable income, while payments from EMC to us relate to periods for which we had a stand-alone federal taxable loss. The amounts that we either pay to or receive from EMC for our portion of federal income taxes on EMC's consolidated tax return differ from the amounts we would owe on a stand-alone basis and the difference is presented as a component of stockholders' equity. In 2012, the difference between the amount of tax calculated on a stand-alone basis and the amount of tax calculated per the tax sharing agreement was recorded as a decrease in stockholders' equity of $4.4. In 2011 and 2010, the difference between the amount of tax calculated on a stand-alone basis and the amount of tax calculated per the tax sharing agreement was recorded as an increase in stockholders' equity of $7.8 and $6.5, respectively.

In certain geographic regions where we do not have an established legal entity, we contract with EMC subsidiaries for support services and EMC personnel who are managed by us. The costs incurred by EMC on our behalf related to these employees are passed on to us and we are charged a mark-up intended to approximate costs that would have been charged had we contracted for such services with an unrelated third party. These costs are included as expenses in our consolidated statements of income and primarily include salaries, benefits, travel and rent. Additionally, EMC incurs certain administrative costs on our behalf in the U.S. that are also recorded as expenses in our consolidated statements of income. The total cost of the services provided to us by EMC as described above was $106.3, $82.6 and $66.4 in the years ended December 31, 2012, 2011 and 2010, respectively.

In the years ended December 31, 2012, 2011 and 2010, $4.7, $3.9 and $4.1, respectively, of interest expense was recorded related to the note payable to EMC and included in interest expense with EMC on our consolidated statements of income. Our interest expense as a separate, stand-alone company may be higher or lower than the amounts reflected in the consolidated financial statements.

In the second quarter of 2011, we acquired certain assets relating to EMC's Mozy cloud-based data storage and data center services, including certain data center assets and a license to certain intellectual property. EMC retained ownership of the Mozy business and its remaining assets. EMC continues to be responsible to Mozy customers for Mozy products and services and continues to recognize revenue from such products and services. We entered into an operational support agreement with EMC through the end of 2012, pursuant to which we took over responsibility to operate the Mozy service on behalf of EMC. Pursuant to the support agreement, costs incurred by us to support EMC's Mozy services, plus a mark-up intended to approximate third-party costs and a management fee, are reimbursed to us by EMC. On the consolidated statements of income, in the years ended December 31, 2012 and 2011, such amounts were $65.0 and $39.0, respectively. These amounts were recorded as a reduction to the costs we incurred. As of December 31, 2012, the operational support agreement between us and EMC was amended such that we will no longer operate the Mozy service on behalf of EMC. Under the amendment, we will transfer substantially all employees that support Mozy services to EMC and EMC will purchase certain assets from us in relation to transferred employees. The termination of service and related transfer of employees and sale of assets is anticipated to be substantially completed during the first quarter of 2013.

In 2010, we acquired certain software product technology and expertise from EMC's Ionix IT management business for cash consideration of $175.0. EMC retained the Ionix brand and will continue to offer customers the products acquired by us, pursuant to an ongoing reseller agreement between EMC and us.

During the years ended December 31, 2011 and 2010, $14.4 and $10.6, respectively, of contingent amounts were paid to EMC. These payments were recorded as equity transactions and 50-------------------------------------------------------------------------------- Table of Contents were offsets to the initial capital contribution from EMC. As of December 31, 2011, all contingent payments under the agreement had been made.

From time to time, we and EMC enter into agreements to collaborate on technology projects. In the years ended December 31, 2012, 2011 and 2010, we received $6.5, $2.3 and $2.3, respectively, from EMC for EMC's portion of expenses related to such projects.

Effective September 1, 2012, Pat Gelsinger succeeded Paul Maritz as Chief Executive Officer of VMware. Prior to joining us, Pat Gelsinger was the President and Chief Operating Officer of EMC Information Infrastructure Products. Paul Maritz remains a board member of VMware and took on the role of Chief Strategy Officer of EMC. With the exception of a long-term incentive performance award from EMC that Pat Gelsinger agreed to cancel in consideration of a new performance stock unit award from VMware, both Paul Maritz and Pat Gelsinger retained and continue to vest in their respective equity awards that they held as of September 1, 2012. Stock-based compensation related to Pat Gelsinger's EMC awards will be recognized on our consolidated statements of income over the awards' remaining requisite service periods. Stock-based compensation related to Paul Maritz's VMware awards will be recognized as an expense by EMC.

As of December 31, 2012, we had $67.9 net due from EMC, which consisted of $111.5 due from EMC, partially offset by $43.6 due to EMC. As of December 31, 2011, we had $73.8 net due from EMC, which consisted of $101.4 due from EMC, partially offset by $27.6 due to EMC. These amounts resulted from the related party transactions described above. Additionally, we had a net income tax payable due to EMC of $31.9 and $3.3 as of December 31, 2012 and 2011, which were included in accrued expenses and other on our consolidated balance sheets.

Balances due to or from EMC which are unrelated to tax obligations are generally settled in cash within 60 days of each quarter-end. The timing of the tax payments due to and from EMC is governed by the tax sharing agreement with EMC.

In December 2012, we launched the Pivotal Initiative with EMC, pursuant to which both companies plan to commit technology, people and programs.

By nature of EMC's majority ownership of us, the amounts we recorded for our intercompany transactions with EMC may not be considered arm's length with an unrelated third party. Therefore the financial statements included herein may not necessarily reflect our financial condition, results of operations and cash flows had we engaged in such transactions with an unrelated third party during all periods presented. Accordingly, our historical results should not be relied upon as an indicator of our future performance as a stand-alone company.

Liquidity and Capital Resources At December 31, 2012 and 2011, we held cash, cash equivalents, and short-term investments as follows: December 31, 2012 2011 Cash and cash equivalents $ 1,609.3 $ 1,955.8 Short-term investments 3,021.5 2,556.5Total cash, cash equivalents and short-term investments $ 4,630.8 $ 4,512.3 As of December 31, 2012, we held a diversified portfolio of money market funds and fixed income securities totaling $4,194.3. Our fixed income securities were denominated in U.S. Dollars and consisted of highly liquid debt instruments of the U.S. government and its agencies, U.S. municipal obligations, and U.S. and foreign corporate debt securities. We limit the amount of our domestic and international investments with any single issuer and any single financial institution, and also monitor the diversity of the portfolio, thereby diversifying the credit risk. Within our portfolio, we held $40.6 of foreign government and agencies securities, $10.4 of which was deemed sovereign debt, at December 31, 2012. These sovereign debt securities had an average credit rating of AAA and were predominantly from Canada. None of the securities deemed sovereign debt were from Greece, Ireland, Italy, Portugal or Spain.

As of December 31, 2012, our total cash, cash equivalents and short-term investments were $4,630.8, of which $2,996.7 was held outside the U.S. If these overseas funds were needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes on related undistributed earnings to repatriate these funds. However, our intent is to indefinitely reinvest our non-U.S.

earnings in our foreign operations and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations.

We expect to continue to generate positive cash flows from operations in 2013 and to use cash generated by operations as our primary source of liquidity. We believe that existing cash and cash equivalents, together with any cash generated from operations will be sufficient to meet normal operating requirements for at least the next twelve months. While we believe our existing cash and cash equivalents and cash to be generated by operations will be sufficient to meet our normal operating 51-------------------------------------------------------------------------------- Table of Contents requirements, our overall level of cash needs may be impacted by the number and size of acquisitions and investments we consummate and the amount of stock we buy back in 2013. Should we require additional liquidity, we may seek to arrange debt financing or enter into credit facilities.

Our cash flows for 2012, 2011 and 2010 were as follows: For the Year Ended December 31, 2012 2011 2010 Net cash provided by (used in): Operating activities $ 1,897.5 $ 2,025.6 $ 1,174.4 Investing activities (2,034.6 ) (1,611.0 ) (2,261.9 ) Financing activities (209.3 ) (87.9 ) 230.1 Net increase (decrease) in cash and cash equivalents $ (346.4 ) $ 326.7 $ (857.4 ) Operating Activities Cash provided by operating activities is driven by our net income, adjusted for non-cash items and changes in assets and liabilities. Non-cash adjustments include depreciation and amortization, stock-based compensation, excess tax benefits from stock-based compensation and other adjustments.

Cash provided by operating activities decreased by $128.1 to $1,897.5 in the 2012 from $2,025.6 in 2011. The decrease was primarily driven by the timing of tax payments we received from EMC under the tax sharing agreement. Under the tax sharing agreement, EMC is obligated to pay us an amount equal to the tax benefit generated by us and we are obligated to pay EMC an amount equal to the tax expense generated by us that EMC may recognize in a given year on its consolidated tax return. In 2012, we received $19.3 from EMC under the tax sharing agreement, but in 2011 we benefited from the net receipt of $302.3, which included amounts primarily related to refunds received for both the 2011 and 2010 tax years. In future periods, we expect to be in a net payable position to EMC.

In 2012, cash provided by operating activities benefited from increases in cash collections driven by growth in sales to our customers and was negatively impacted by increases in our core operating expenses, primarily due to headcount. In 2012, increases in cash collections from customers outpaced the increases in our core operating expenses. Additionally, the excess tax benefit from stock-based compensation decreased by $86.4 in 2012, which positively impacted our cash provided by operating activities. This change was primarily due to changes in the market value of our stock and the number of equity awards exercised, sold or vested.

Cash provided by operating activities increased by $851.2 to $2,025.6 in 2011 from $1,174.4 in 2010. The increase in operating cash flows for 2011 was primarily the result of an increase in cash collections from customers driven by strong sales volumes. In addition, we benefited from the net receipt of $302.3 from EMC related to income taxes. During 2010, there were no significant amounts collected from or paid to EMC under the tax sharing agreement. The net receipt of $302.3 in 2011 primarily related to refunds received for both the 2011 and 2010 tax years. The increase in cash collections and the benefit from the collection of the income tax receivable was partially offset by increases in our core operating expenses, primarily related to incremental headcount from strategic hiring and business acquisitions.

In evaluating our liquidity internally, we focus on long-term, sustainable growth in free cash flows over trailing twelve months periods, which we consider to be a relevant measure of our long-term progress. We define free cash flows, a non-GAAP financial measure, as net cash provided by operating activities less capital expenditures. See "Non-GAAP Financial Measures" for additional information.

Our free cash flows for 2012, 2011 and 2010 were as follows: For the Year Ended December 31, 2012 2011 2010 Net cash provided by operating activities $ 1,897.5 $ 2,025.6 $ 1,174.4 Capital expenditures (234.5 ) (230.1 ) (131.7 ) Free cash flows $ 1,663.0 $ 1,795.5 $ 1,042.7 Free cash flows decreased by $132.5 or 7% to $1,663.0 for 2012 from $1,795.5 in 2011. The decrease was primarily due to a decrease of $283.0 for net amounts we received from EMC under the tax sharing agreement as described above. This decrease was partially offset by the net benefit received from increased sales and related cash collections that outpaced our growth in operating expenses.

Free cash flows increased by $752.8 or 72% to $1,795.5 for 2011 from $1,042.7 in 2010. The 52-------------------------------------------------------------------------------- Table of Contents increase was primarily due to increased sales and related cash collections that outpaced our growth in operating expenses. Additionally, we benefited from the net receipt of $302.3 from EMC under the tax sharing agreement in 2011.

Investing Activities Cash used in investing activities is generally attributable to the purchase of fixed income securities, business acquisitions, and capital expenditures. Cash provided by investing activities is primarily attributable to the sales or maturities of fixed income securities.

Total fixed income securities of $3,188.7, $2,667.9 and $2,101.9 were purchased in 2012, 2011 and 2010, respectively. All purchases of fixed income securities were classified as cash outflows from investing activities. We classified these investments as short-term investments on our consolidated balance sheets based upon the nature of the security and their availability for use in current operations or for other purposes, such as business acquisitions and strategic investments. These cash outflows were partially offset by cash inflows of $2,782.3, $1,790.8 and $516.3 in 2012, 2011 and 2010, respectively, as a result of the sales and maturities of fixed income securities. Activity in the fixed income portfolio increased each year primarily from increased cash and cash equivalent and short-term investment balances available for investment, including a reallocation of funds from cash equivalents to fixed income securities.

We did not capitalize any development costs for software to be sold, leased, or otherwise marketed in 2012 as compared to $74.0 and $64.1 of costs capitalized in 2011 and 2010, respectively. Following the release of vSphere 5 and the comprehensive suite of cloud infrastructure technologies in the third quarter of 2011, we determined that our go-to-market strategy had changed from single solutions to product suite solutions. As a result of this change in strategy, and the related increased importance of interoperability between our products, the length of time between achieving technological feasibility and general release to customers significantly decreased.

In 2012, 2011 and 2010, we paid $1,344.2, $303.6 and $293.0, respectively, for business acquisitions. The increase in 2012 is primarily related to the acquisition of Nicira which was completed in the third quarter of 2012 and included $1,083.0 of cash consideration. Refer to Note B to the consolidated financial statements for further information. Business acquisitions are an important element of our strategy and we expect to continue to consider additional strategic business acquisitions in the future.

In 2011, we closed an agreement to purchase all of the right, title and interest in a ground lease covering the property and improvements located adjacent to our existing Palo Alto, California campus for $225.0. Based upon the respective fair values, $73.9 of the purchase price was included within additions to property and equipment, and the remaining $151.1 paid and attributed to the intangible assets was separately disclosed within net cash used in investing activities on the consolidated statement of cash flows. Refer to Note G to the consolidated financial statements for further information. Our renovation of the new property will be a multi-year project with capital investment extending into future periods.

In the second quarter of 2011, we sold our investment in Terremark Worldwide, Inc. for $76.0.

Financing Activities Proceeds from the issuance of our Class A common stock from the exercise of stock options and the purchase of shares under the VMware Employee Stock Purchase Plan ("ESPP") were $253.2, $337.6 and $431.3 in 2012, 2011 and 2010, respectively.

In 2012, 2011 and 2010, as part of our share repurchase programs, we repurchased and retired shares of our Class A common stock as shown below (table in millions, except per share amounts): For the Years Ended December 31, 2012 2011 2010 Aggregate purchase price $ 467.5 $ 526.2 $ 338.5 Class A common shares repurchased 5.1 6.0 4.9 Weighted-average price per share $ 91.10 $ 88.37 $ 68.96 From time-to-time, stock repurchases may be made pursuant to the stock repurchase authorizations in open market transactions or privately negotiated transactions as permitted by securities laws and other legal requirements. We are not obligated to purchase any shares under our stock repurchase programs.

The timing of any repurchases and the actual number of shares repurchased will depend on a variety of factors, including our stock price, cash requirements for operations and business combinations, corporate and regulatory requirements and other market and economic conditions. Purchases can be discontinued at any time that we feel that additional purchases are not warranted. As of December 31, 2012, the authorized amount remaining available for repurchase was $467.9. This amount is authorized for repurchases through the end of 2014.

53-------------------------------------------------------------------------------- Table of Contents There were additional cash outflows of $133.1, $123.8 and $86.2 in 2012, 2011 and 2010, respectively, to cover tax withholding obligations in conjunction with the net share settlement upon the vesting of restricted stock units and restricted stock. Additionally, the excess tax benefit from stock-based compensation was $138.1, $224.5 and $223.4 in 2012, 2011 and 2010, respectively, and is shown as a reduction to cash flows from operating activities and an increase to cash flows from financing activities. The year-over-year changes in the repurchase of shares to cover tax withholding obligations and the excess tax benefit from stock-based compensation in 2012 and 2011 were primarily due to changes in the market value of our stock and the number of awards exercised, sold or vested.

Future cash proceeds from issuances of common stock and the excess tax benefit from stock-based compensation and future cash outflows to repurchase our shares to cover tax withholding obligations will depend upon, and could fluctuate significantly from period-to-period based on, the market value of our stock, the number of awards exercised, sold or vested, the tax benefit realized and the tax-affected compensation recognized.

To date, inflation has not had a material impact on our financial results.

Note Payable to EMC As of December 31, 2012, $450.0 remained outstanding on a note payable to EMC, with interest payable quarterly in arrears. In June 2011, we and EMC amended and restated the note to extend the maturity date of the note to April 16, 2015 and to modify the principal amount of the note to reflect the outstanding balance of $450.0. The interest rate continues to reset quarterly and bears an interest rate of the 90-day LIBOR plus 55 basis points.

Non-GAAP Financial Measures Regulation S-K Item 10(e), "Use of Non-GAAP Financial Measures in Commission Filings," defines and prescribes the conditions for use of non-GAAP financial information. Our measures of core operating expenses and free cash flows each meet the definition of a non-GAAP financial measure.

Core Operating Expenses Management uses the non-GAAP measure of core operating expenses to understand and compare operating results across accounting periods, for internal budgeting and forecasting purposes, for short- and long-term operating plans, to calculate bonus payments and to evaluate our financial performance, the performance of our individual functional groups and the ability of operations to generate cash.

Management believes that by excluding certain expenses that are not reflective of our ongoing operating results, core operating expenses reflect our business in a manner that allows for meaningful period-to-period comparisons and analysis of trends in our business.

We define core operating expenses as our total operating expenses excluding the following components, which we believe are not reflective of our ongoing operational expenses. In each case, for the reasons set forth below, management believes that excluding the component provides useful information to investors and others in understanding and evaluating our operating results and future prospects in the same manner as management, in comparing financial results across accounting periods and to those of peer companies and to better understand the long-term performance of our core business.

• Stock-based compensation. Stock-based compensation is generally fixed at the time the stock-based instrument is granted and amortized over a period of several years. Although stock-based compensation is an important aspect of the compensation of our employees and executives, the expense for the fair value of the stock-based instruments we utilize may bear little resemblance to the actual value realized upon the vesting or future exercise of the related stock-based awards. Furthermore, unlike cash compensation, the value of stock options is determined using a complex formula that incorporates factors, such as market volatility, that are beyond our control. Additionally, in order to establish the fair value of performance-based stock awards, which are also an element of our ongoing stock-based compensation, we are required to apply judgment to estimate the probability of the extent to which performance objectives will be achieved.

• Amortization and capitalization of software development costs. Capitalized software development costs encompass capitalization of development costs and the subsequent amortization of the capitalized costs over the useful life of the product. Amortization and capitalization of software development costs can vary significantly depending upon the timing of products reaching technological feasibility and being made generally available. We did not capitalize software development costs related to product offerings during 2012. In future periods, we expect our amortization expense from previously capitalized software development costs to steadily decline as previously capitalized software development costs become fully amortized. For additional information, see "Results of Operations - Capitalized Software Development Costs, Net" above.

• Other expenses. Other expenses excluded are amortization of acquired intangible assets, employer payroll taxes on employee stock transactions and other acquisition-related items. Regarding the amortization of acquired intangible 54-------------------------------------------------------------------------------- Table of Contents assets, we generally allocate a portion of the purchase price of an acquisition to intangible assets, such as intellectual property, which is subject to amortization. The amount of employer payroll taxes on stock-based compensation is dependent on our stock price and other factors that are beyond our control and do not correlate to the operation of the business. Additionally, the amount of an acquisition's purchase price allocated to intangible assets and the term of its related amortization can vary significantly and are unique to each acquisition. Acquisition-related items include direct costs of acquisitions, such as transaction fees, which vary significantly and are unique to each acquisition. We also do not acquire businesses on a predictable cycle.

Free cash flows In evaluating our liquidity internally, we focus on long-term, sustainable growth in free cash flows over trailing twelve month periods, which we consider to be a relevant measure of our long-term progress. In 2012, we changed our methodology for calculating free cash flows, which is reflected in the amounts presented for all periods, to be defined as GAAP operating cash flows less capital expenditures. We include the impact from capital expenditures on property and equipment because these expenditures are also considered to be a necessary component of our operations and therefore part of our core operating expenses. Management uses free cash flows as a measure of financial progress in our business, as it balances operating results, cash management and capital efficiency. We believe that free cash flows provides useful information to investors and others as it allows for meaningful period-to-period comparisons of our operating cash flows for analysis of trends in our business. Additionally, we believe that it provides investors and others with an important perspective on the amount of cash that we may choose to use for strategic acquisitions and investments, the repurchase of shares, operations and other capital expenditures.

Limitations on the use of Non-GAAP financial measures A limitation of our non-GAAP financial measures of core operating expenses and free cash flows is that they do not have uniform definitions. Our definitions will likely differ from the definitions used by other companies, including peer companies, and therefore comparability may be limited. Thus, our non-GAAP measures of core operating expenses and free cash flows should be considered in addition to, not as a substitute for, or in isolation from, measures prepared in accordance with GAAP. Additionally, in the case of stock-based compensation, if we did not pay out a portion of compensation in the form of stock-based compensation and related employer payroll taxes, the cash salary expense included in costs of revenues and operating expenses would be higher which would affect our cash position. Further, the non-GAAP measure of core operating expenses has certain limitations because it does not reflect all items of income and expense that affect our operations and are reflected in the GAAP measure of total operating expenses.

We compensate for these limitations by reconciling core operating expenses to the most comparable GAAP financial measure. Management encourages investors and others to review our financial information in its entirety, not to rely on any single financial measure and to view our non-GAAP financial measures in conjunction with the most comparable GAAP financial measures.

See "Results of Operations-Operating Expenses" for a reconciliation of the non-GAAP financial measure of core operating expenses to the most comparable GAAP measure, "total operating expenses," for the years ended December 31, 2012, 2011, and 2010.

See "Liquidity and Capital Resources" for a reconciliation of free cash flows to the most comparable GAAP measure, "net cash provided by operating activities," for the years ended December 31, 2012, 2011 and 2010.

Off-Balance Sheet Arrangements, Contractual Obligations, Contingent Liabilities and Commitments Guarantees and Indemnification Obligations We enter into agreements in the ordinary course of business with, among others, customers, distributors, resellers, system vendors and systems integrators. Most of these agreements require us to indemnify the other party against third-party claims alleging that one of our products infringes or misappropriates a patent, copyright, trademark, trade secret or other intellectual property right. Certain of these agreements require us to indemnify the other party against certain claims relating to property damage, personal injury, or the acts or omissions by us and our employees, agents or representatives.

We have agreements with certain vendors, financial institutions, lessors and service providers pursuant to which we have agreed to indemnify the other party for specified matters, such as acts and omissions by us and our employees, agents, or representatives.

We have procurement or license agreements with respect to technology that we have obtained the right to use in our products and agreements. Under some of these agreements, we have agreed to indemnify the supplier for certain claims that may be brought against such party with respect to our acts or omissions relating to the supplied products or technologies.

We have agreed to indemnify our directors and executive officers, to the extent legally permissible, against all liabilities reasonably incurred in connection with any action in which such individual may be involved by reason of such individual being 55-------------------------------------------------------------------------------- Table of Contents or having been a director or officer. Our by-laws and charter also provide for indemnification of our directors and officers to the extent legally permissible, against all liabilities reasonably incurred in connection with any action in which such individual may be involved by reason of such individual being or having been a director or executive officer. We also indemnify certain employees who provide service with respect to employee benefits plans, including the members of the Administrative Committee of the VMware 401(k) Plan, and employees who serve as directors or officers of our subsidiaries.

In connection with certain acquisitions, we have agreed to indemnify the former directors and officers of the acquired company in accordance with the acquired company's by-laws and charter in effect immediately prior to the acquisition or in accordance with indemnification or similar agreements entered into by the acquired company and such persons. We typically purchase a "tail" directors' and officers' insurance policy, which should enable us to recover a portion of any future indemnification obligations related to the former officers and directors of an acquired company.

It is not possible to determine the maximum potential amount under these indemnification agreements due to our limited history with prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Historically, payments made by us under these agreements have not had a material effect on our consolidated financial position, results of operations or cash flows.

Contractual Obligations We have various contractual obligations impacting our liquidity. The following represents our contractual obligations as of December 31, 2012: Payments Due by Period Less than More than Total 1 year 1-3 years 3-5 years 5 years Note payable to EMC(1) $ 450.0 $ - $ 450.0 $ - $ - Operating leases(2) 757.1 54.6 90.0 65.3 547.2 Other agreements(3) 67.1 17.7 25.6 7.1 16.7 Sub-Total 1,274.2 72.3 565.6 72.4 563.9 Uncertain tax positions(4) 156.0 Total $ 1,430.2 (1) The note is due and payable in full on April 16, 2015; however, we can pay down the note at an earlier date in full or in part at our election.

(2) Our operating leases are primarily for office space and land around the world.

(3) Consisting of various contractual agreements, which include commitments on the lease for our Washington data center facility.

(4) As of December 31, 2012, we had $156.0 of non-current net unrecognized tax benefits. We are not able to provide a reasonably reliable estimate of the timing of future payments relating to these obligations.

Critical Accounting Policies Our consolidated financial statements are based on the selection and application of accounting principles generally accepted in the United States of America that require us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and any such differences may be material to our financial statements. We believe that the critical accounting policies set forth below may involve a higher degree of judgment and complexity in their application than our other significant accounting policies and represent the critical accounting policies used in the preparation of our financial statements. If different assumptions or conditions were to prevail, the results could be materially different from our reported results. Our significant accounting policies are presented within Note A, "Overview and Basis of Presentation," to our consolidated financial statements appearing in this Annual Report on Form 10-K.

Revenue Recognition We derive revenues from the licensing of software and related services. We recognize revenues when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectibility is probable. Determining whether and when some of these criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of revenue we report.

56-------------------------------------------------------------------------------- Table of Contents We recognize license revenues from the sale of software licenses when risk of loss transfers, which is generally upon electronic shipment. We primarily license our software under perpetual licenses through our channel of distributors, resellers, system vendors, systems integrators and our direct sales force. To the extent we offer product promotions and the promotional products are not yet available and VSOE of fair value cannot be established, the revenue for the entire order is deferred until such time as all product obligations have been fulfilled. We defer revenues relating to products that have shipped into our channel until our products are sold through to the next tier of the channel. We estimate and record reserves for products that are not sold through the channel based on historical trends and relevant current information. For software sold by system vendors that is bundled with their hardware, unless we have a separate license agreement which governs the transaction, revenue is recognized in arrears upon the receipt of binding royalty reports. The accuracy of our reserves depends on our ability to estimate the product sold through the channels and could have a significant impact on the timing and amount of revenue we report.

We offer rebates to certain channel partners, which are recognized as a reduction of revenue at the time the related product sale is recognized. When rebates are based on the set percentage of actual sales, we recognize the costs of the rebates as a reduction of revenue when the underlying revenue is recognized. In cases where rebates are earned if a cumulative level of sales is achieved, we recognize the cost of the rebates as a reduction of revenue proportionally for each sale that is required to achieve the target. The estimated reserves for channel rebates and sales incentives are based on channel partners' actual performance against the terms and conditions of the programs, historical trends and the value of the rebates. The accuracy of these reserves for these rebates and sales incentives depends on our ability to estimate these items and could have a significant impact on the timing and amount of revenue we report.

With limited exceptions, VMware's return policy does not allow product returns for a refund. Certain distributors and resellers may rotate stock when new versions of a product are released. We estimate future product returns at the time of sale. Our estimate is based on historical return rates, levels of inventory held by distributors and resellers and other relevant factors. The accuracy of these reserves depends on our ability to estimate sales returns and stock rotation among other criteria. If we were to change any of these assumptions or judgments, it could cause a material increase or decrease in the amount of revenue that we report in a particular period. Returns have not been material to date and have been in line with our expectations.

Our services revenues consist of software maintenance, professional services and software as a service subscriptions. Software as a service subscriptions were not material in any period presented. We recognize software maintenance revenues ratably over the contract period. Typically, our software maintenance contract periods range from one to five years. Professional services include design, implementation and training. Professional services are not considered essential to the functionality of our products because services do not alter the product capabilities and may be performed by customers or other vendors. Professional services engagements performed for a fixed fee, for which we are able to make reasonably dependable estimates of progress toward completion are recognized on a proportional performance basis based on hours and direct expenses incurred.

Professional services engagements that are on a time and materials basis are recognized based upon hours incurred. Revenues on all other professional services engagements are recognized upon completion. Software as a service revenues are recognized ratably over the subscription period. If we were to change any of these assumptions or judgments regarding our services revenues, it could cause a material increase or decrease in the amount of revenue that we report in a particular period.

Our software products are typically sold with software maintenance services.

VSOE of fair value for software maintenance services is established by the rates charged in stand-alone sales of software maintenance contracts. Our software products may also be sold with professional services. VSOE of fair value for professional services is based upon the standard rates we charge for such services when sold separately. The revenues allocated to the software license included in multiple-element contracts represent the residual amount of the contract after the fair value of the other elements has been determined.

Our multiple element arrangements typically fall into one or more of the following categories: • Arrangements including undelivered elements for which VSOE of fair value has been established. Revenue for those undelivered items is recognized ratably over the service period, or as the services are delivered. Revenue allocated to the delivered elements is recognized upfront; • Arrangements including specified product elements for which VSOE of fair value cannot be established. The entire arrangement fee is deferred until either VSOE of fair value is established or the specified products are delivered; • Arrangements including undelivered elements without VSOE of fair value that are not essential to the functionality of the delivered products where all of the undelivered elements are delivered ratably over time. Revenue for the entire arrangement fee is recognized ratably, once the services have commenced, over the longest delivery period; • Arrangements including undelivered elements without VSOE of fair value that are not essential to the functionality of the delivered products where one or more of the elements are not delivered ratably over time. The entire arrangement fee is deferred until VSOE of fair value is established or only elements that are delivered ratably over time remain. At 57-------------------------------------------------------------------------------- Table of Contents such time, a pro-rated share of revenue is recognized immediately with any remaining fee recognized ratably over the longest remaining ratable delivery period.

Customers under software maintenance agreements are entitled to receive updates and upgrades on a when-and-if-available basis, as well as various types of technical support based on the level of support purchased. In the event specific features or functionalities, entitlements or the release number of an upgrade have been announced but not delivered, and customers will receive that upgrade as part of a current software maintenance contract, a specified upgrade is deemed created. As a result of the specified upgrade, product revenues are deferred on purchases made after the announcement date until delivery of the upgrade for those purchases that include the current version of the product subject to the announcement. The amount and elements to be deferred are dependent on whether the company has established VSOE of fair value for the upgrade. VSOE of fair value of these upgrades is established based upon the price set by management. We have a history of selling such upgrades on a stand-alone basis. We are required to exercise judgment in determining whether VSOE exists for each undelivered element based on whether our pricing for these elements is sufficiently consistent with the sale of these elements on a stand-alone basis. Our determination of VSOE is based on an analysis of the sales of our products, primarily maintenance and professional services on a stand-alone basis. However, judgment is required in assessing whether fluctuations in sales prices represent anomalies or whether the product pricing is changing on a more consistent basis. This determination could cause a material increase or decrease in the amount of revenue that we report in a particular period.

For multiple-element arrangements that contain software and non-software elements such as our software as a service subscription offerings, we allocate revenue to software or software-related elements as a group and any non-software elements separately based on the selling price hierarchy. We determine the relative selling price for each deliverable using VSOE of selling price, if it exists, or third-party evidence ("TPE") of selling price. If neither VSOE nor TPE of selling price exist for a deliverable, we use our best estimate of selling price ("BESP") for that deliverable. Once revenue is allocated to software or software-related elements as a group, it follows historic software accounting guidance. Revenue is then recognized when the basic revenue recognition criteria are met for each element.

The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine BESP by considering our overall pricing objectives and market conditions. At this time, we use BESP to determine the relative selling price of our license elements and software as a service elements based upon rates charged in both multi-element and stand-alone arrangements. If we modify our pricing practices in the future, this could result in changes in relative selling prices.

Additionally, as our go-to-market strategies evolve, we may modify our pricing practices in the future, which could result in changes in relative selling prices, including both VSOE and BESP.

Asset Valuation Asset valuation includes assessing the recorded value of certain assets, including accounts receivable, other intangible assets and goodwill. We use a variety of factors to assess valuation, depending upon the asset. Accounts receivable are evaluated based upon the creditworthiness of our customers, historical experience, the age of the receivable and current market and economic conditions. Should current market and economic conditions deteriorate, our actual bad debt expense could exceed our estimate. Whenever indicators of potential impairment are present, our analysis of potential impairment involves judgment in grouping our intangible assets based on the expected period during which the assets will be utilized, forecasted cash flows, changes in technology and customer demand. Changes in judgments on any of these factors could materially impact the value of the asset. As we operate our business in one operating segment and one reporting unit, our goodwill is assessed at the consolidated level for impairment in the fourth quarter of each year or more frequently if events or changes in circumstances indicate that the asset might be impaired. The assessment is performed by comparing the market value of our reporting unit to its carrying value.

Accounting for Income Taxes In calculating our income tax expense, management judgment is necessary to make certain estimates and judgments for financial statement purposes that affect the recognition of tax assets and liabilities.

In order for us to realize our deferred tax assets, we must be able to generate sufficient taxable income in those jurisdictions where the deferred tax assets are located. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We consider future market growth, forecasted earnings, future taxable income, and prudent and feasible tax planning strategies in determining the need for a valuation allowance. In the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to earnings in the period in which we make such determination. Likewise, if we later determine that it is more likely than not that the net deferred tax assets would be realized, we would reverse the applicable portion of the previously provided valuation allowance.

58-------------------------------------------------------------------------------- Table of Contents We calculate our current and deferred tax provision based on estimates and assumptions that could differ from the actual results reflected in income tax returns filed during the subsequent year. Adjustments based on filed returns are generally recorded in the period when the tax returns are filed.

The amount of income tax we pay is subject to audits by federal, state and foreign tax authorities, which may result in proposed assessments. Our estimate of the potential outcome for any uncertain tax issue is highly judgmental. We believe that we have adequately provided for any reasonably foreseeable outcome related to these matters. However, our future results may include favorable or unfavorable adjustments to our estimated tax liabilities in the period the assessments are made or resolved, audits are closed or when statutes of limitation on potential assessments expire. Additionally, the jurisdictions in which our earnings or deductions are realized may differ from our current estimates. As a result, our effective tax rate may fluctuate significantly on a quarterly basis.

We do not provide for a U.S. income tax liability on undistributed earnings of our foreign subsidiaries. The earnings of non-U.S. subsidiaries, which reflect full provision for non-U.S. income taxes, are indefinitely reinvested in non-U.S. operations or will be remitted substantially free of additional tax. If these overseas funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes on related undistributed earnings to repatriate these funds. However, our intent is to indefinitely reinvest our non-U.S. earnings in our foreign operations and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. We will meet our U.S. liquidity needs through ongoing cash flows generated from our U.S.

operations, external borrowings, or both. We utilize a variety of tax planning strategies in an effort to ensure that our worldwide cash is available in locations in which it is needed.

Income taxes are calculated on a separate tax return basis, although we are included in the consolidated tax return of EMC. The difference between the income taxes payable that is calculated on a separate return basis and the amount actually paid to EMC pursuant to our tax sharing agreement with EMC is presented as a component of additional paid-in capital.

Capitalized Software Development Costs Development costs of software to be sold, leased, or otherwise marketed are subject to capitalization beginning when the product's technological feasibility has been established and ending when the product is available for general release. Judgment is required in determining when technological feasibility is established and as our business, products and go-to-market strategy have evolved, we have continued to evaluate when technological feasibility is established. Following the release of vSphere 5 and the comprehensive suite of cloud infrastructure technologies in the third quarter of 2011, we determined that VMware's go-to-market strategy had changed from single solutions to product suite solutions. As a result of this, and the related increased importance of interoperability between our products, the length of time between achieving technological feasibility and general release to customers significantly decreased. For future releases, we expect our products to be available for general release soon after technological feasibility has been established. Given that we expect the majority of our product offerings to be suites or to have key components that interoperate with our other product offerings, the costs incurred subsequent to achievement of technological feasibility are expected to be immaterial in future periods. In 2012, all software development costs were expensed as incurred.

Our R&D expenses and amounts that we have capitalized as software development costs may not be comparable to our peer companies due to differences in judgment as to when technological feasibility has been reached or differences in judgment regarding when the product is available for general release. Additionally, future changes in our judgment as to when technological feasibility is established, or additional changes in our business, including our go-to-market strategy, could materially impact the amount of costs capitalized. For example, if the length of time between technological feasibility and general availability was to increase again in the future, the amount of capitalized costs would likely increase. Additionally, a transition to offering software as a service instead of via a license may also result in an increased level of software capitalization.

Generally accepted accounting principles require annual amortization expense of capitalized software development costs to be the greater of the amounts computed using the ratio of current gross revenue to a product's total current and anticipated revenues, or the straight-line method over the product's remaining estimated economic life. To date, we have amortized these costs using the straight-line method as it is the greater of the two amounts. The costs are amortized over 18 to 24 months, which represent the product's estimated economic life. The ongoing assessment of the recoverability of these costs requires considerable judgment by management with respect to certain external factors such as anticipated future revenue, estimated economic life, and changes in software and hardware technologies. Material differences in amortization amounts could occur as a result of changes in the periods over which we actually generate revenues or the amounts of revenues generated.

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