9. Derivative Financial Instruments

During the quarter ended July 1, 2012, the Company entered into multiple foreign exchange forward contracts to hedge certain operational exposures resulting from movements in exchange rates in Japanese Yen. The Company’s hedging policy is designed to mitigate the impact of foreign currency exchange rate movements on operating results. Some foreign currency forward contracts were considered to be economic hedges that were not designated as hedging instruments while others were designated as cash flow hedges. Whether designated or undesignated, these forward contracts protect the Company against the variability of forecasted foreign currency cash flows resulting from revenues and net asset or liability positions designated in currencies other than the U.S. dollar and they are not speculative in nature.

Cash Flow Hedges

The Company’s foreign currency forward contracts that were designated as cash flow hedges are carried at fair value and have maturities between three and eight months. These were entered into to protect non-functional currency revenue against variability in cash flows due to foreign currency fluctuations. All hedging relationships are formally documented, and the hedges are designed to offset changes to future cash flows on hedged transactions at inception of the hedge. The maximum original duration of any contract allowable under the Company’s hedging policy is fifteen months. The Company recognizes derivative instruments from hedging activities as either assets or liabilities on the balance sheet and measures them at fair value on a quarterly basis. The Company recorded changes in the intrinsic value of its cash flow hedges in accumulated other comprehensive income in the accompanying Condensed Consolidated Balance Sheets as the forecasted revenue had not yet occurred as of July 1, 2012. Interest charges or “forward points” on the forward contracts were excluded from the assessment of hedge effectiveness and were recorded in interest and other income (expense), net in the accompanying Condensed Consolidated Statements of Operations. When the forecasted revenue is recognized, the Company will reclassify the related gain or loss on the cash flow hedge to revenue. In the event the underlying forecasted revenue does not occur, or it becomes probable that it will not occur, the Company will reclassify the gain or loss on the related cash flow hedge from accumulated other comprehensive income to interest and other income (expense), net in its Condensed Consolidated Statements of Operations at that time. For the quarter ended July 1, 2012, there were no such gains or losses recognized in interest and other income (expense), net.

The Company evaluates hedge effectiveness at the inception of the hedge prospectively as well as retrospectively and records any ineffective portion of the hedging instruments in interest and other income (expense), net in its Condensed Consolidated Statements of Operations. There was no net gain or loss recognized for cash flow hedges due to hedge ineffectiveness for the three months and six months ended July 1, 2012.

At July 1, 2012, the Company had outstanding forward contracts to sell JPY 6,322 million in exchange for $79.6 million. Over the next twelve months, the Company expects to reclassify $0.2 million from accumulated other comprehensive income to earnings as related forecasted revenue transactions occur.

The following table summarizes the derivative-related activity in accumulated other comprehensive income, net of tax:

 

		Six Months Ended July 1, 2012
		(in thousands)
Beginning Balance		$	—
Net increase in fair value of the cash flow hedges			217
Ending Balance		$	217

Non-designated hedges

The Company also hedges net receivables and payables denominated in Japanese Yen with foreign exchange forward contracts to reduce the risk that its earnings and cash flows will be affected by changes in foreign currency exchange rates. These forward contracts are not designated hedges and are carried at fair value with changes in the fair value recorded to interest and other income (expense), net in the accompanying Condensed Consolidated Statements of Income. These forward contracts do not subject the Company to additional material balance sheet risk due to exchange rate movements because gains and losses on these derivatives are intended to offset gains and losses on the monetary assets and liabilities being hedged. As of July 1, 2012 and December 25, 2011, total notional amounts of outstanding contracts were to sell 3,588.0 million Japanese Yen for $45.0 million and 2,595.0 million Japanese Yen for $33.3 million, respectively.

Interest Rate Swap

The Company is currently exposed to the variability of future quarterly interest payments on its Term Loan due to changes in the LIBOR above the floor rate of 1.25 percent. To mitigate this interest rate risk and comply with the hedging requirement in the initial Term Loan agreement, the Company entered into a series of interest rate swaps to manage the interest rate risk associated with its borrowings in the third quarter of 2010. The hedging requirement in the Term Loan agreement was removed when the Term Loan was amended in November 2010. However, the interest rate swaps remained in place as of July 1, 2012.

 

The Company has approximately $232.7 million outstanding under the Term Loan as of July 1, 2012. The swap agreements, have an aggregate notional amount of $250 million and expire on May 17, 2013. Under these agreements, the Company pays the independent swap counterparty a fixed rate of 2.42 percent and, in exchange, the swap counterparty pays the Company an interest rate equal to the floor rate of 2 percent or three-month LIBOR, whichever is higher.

As of November 9, 2010, due to the amendment of the Term Loan, the critical terms of the swaps and the Term Loan were no longer matched. Accordingly, the hedge no longer qualified as a cash flow hedge. As a result, the mark-to-market of the swaps has been reported as a component of interest expense since the fourth quarter of fiscal 2010.

The effect of derivative instruments on the Condensed Consolidated Statements of Operations for the three and six months ended July 1, 2012 and June 26, 2011 was as follows:

 

		Three Months Ended								Six Months Ended
		July 1, 2012				June 26, 2011				July 1, 2012				June 26, 2011
		(in thousands)
Derivatives Designated as Hedging Instruments
Foreign exchange forward contracts
Net unrealized gain recognized in OCI (1)		$	217			$	—			$	217			$	—
Derivatives Not Designated as Hedging Instruments
Net loss recognized in income
Swap interest expense (2)		$	(32	)		$	(750	)		$	(118	)		$	(1,147	)
Foreign exchange forward contracts (3)		$	(2,173	)		$	(347	)		$	(223	)		$	(1,905	)

 

(1)	Net change in the fair value of the effective portion classified in other comprehensive income (OCI)

(2)	Classified in interest expense

(3)	Classified in interest and other income (expense), net

 

The gross fair values of derivative instruments on the Condensed Consolidated Balance Sheets were as follows:

 

		July 1, 2012								December 25, 2011
Balane sheet location		Derivatives designated as hedging instruments				Derivatives not designated as hedging instruments				Derivatives designated as hedging instruments				Derivatives not designated as hedging instruments
						(in thousands)
Prepaid expenses and other current assets
Foreign Currency Forward Contracts		$	196			$	68			$	—			$	20
Other accrued liabilities
Interest rate Swap		$	—			$	1,030			$	—			$	1,011
Other long-term liabilties
Interest rate Swap		$	—			$	—			$	—			$	432

There were no derivatives designated as hedging instruments at December 25, 2011.