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TMCNet:  DIGI INTERNATIONAL INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

[November 21, 2012]

DIGI INTERNATIONAL INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) Our management's discussion and analysis should be read in conjunction with our financial statements and other information in this Annual Report on Form 10-K for the fiscal year ended September 30, 2012.



OVERVIEW We are a leading provider of machine to machine (M2M) networking solutions that enable the connection, monitoring and control of local or remote physical assets by electronic means. These networking products and solutions can connect communication hardware to a physical asset and convey information about the asset's status and performance which can be sent to a computer system and used to improve or automate one or more processes. As wireless communications become more and more prevalent, increasingly these products and solutions are deployed via wireless networks. Our hardware products have been the historical foundation of our business. In 2009, we introduced a cloud-based internet platform (iDigi®) which our customers can utilize to monitor and control electronic devices. Our iDigi® Device Cloud provides customers with a platform to securely aggregate and to host data transmitted by remote electronic devices and to connect enterprise applications to these devices. We also assist customers by providing application development and hosting services as well as consulting and integration services. These applications and services ease the deployment of M2M communications solutions. Our wireless product design and development services offered by our Spectrum Design Services subsidiary provides customers turn-key wireless networking products that can use a wide range of wireless technology platforms. Our products are deployed by a wide range of businesses and institutions as any business that utilizes a significant number of devices in the conduct of their business may realize benefits from M2M networking.

We have a single operating and reporting segment. Our revenues consist of products that are in non-embedded and embedded product categories. Non-embedded products are connected externally to a device or larger system to provide wired or wireless network connectivity or port expansion. Embedded products are used by a product developer to build an electronic device in which the product provides processing power, wired Ethernet, or wireless network connectivity to that device. The products included in the non-embedded product category include cellular products, wireless communication adapters, console and serial servers, USB connected products and serial cards. The products included in the embedded product category include modules, single-board computers, chips, software and development tools, iDigi® services, software applications and related services, custom hardware design services and satellite communication products.

We utilize many financial, operational, and other metrics to evaluate our financial condition and financial performance. Below we highlight the fiscal 2012 metrics that we feel are most important in these evaluations: • Net Sales were approximately $191 Million. Our net sales were $190.6 million in fiscal 2012, and decreased by $13.6 million, or 6.7%, compared to net sales of approximately $204.2 million in fiscal 2011. The majority of the decrease was attributable to wired product net sales which decreased by $11.7 million from fiscal 2012 to fiscal 2011.

• Gross Margin was 52.7%. Our gross margin increased as a percentage of net sales to 52.7% in fiscal 2012 from 52.2% in fiscal 2011. The increase primarily resulted from a reduction in the amortization of purchased and core technology as certain intangibles were fully amortized, reduced costs through the restructuring of European operations and cost reduction initiatives for the production of our products. These impacts were partially offset by increased costs to operate the iDigi® Device Cloud and increased expenses associated with mitigating the effects of flooding in Thailand in October 2011 which impacted a significant contract manufacturer.

• Net Income was $7.6 Million and Earnings Per Diluted Share were $0.29. Our net income was $7.6 million in fiscal 2012, a decrease of $3.4 million, or 30.9%, compared to net income of $11.0 million in fiscal 2011. Earnings per diluted share were $0.29 in fiscal 2012 compared to $0.43 in fiscal 2011.

•Earnings Before Taxes, Interest, Depreciation and Amortization (EBITDA). We believe that the presentation of EBITDA as a percentage of net sales, which is a non-GAAP financial measure, is useful because it provides a reliable and consistent approach to measuring our performance from year to year and in assessing our performance against that of other companies. We also believe this information helps compare operating results and corporate performance exclusive of the impact of our capital structure and the method by which assets were acquired. EBITDA is also used as an internal metric for executive compensation, as well as incentive compensation for the rest of the employee base, and it is monitored quarterly for these purposes. Our EBITDA were $18.4 million, or 9.7% of net sales in fiscal 2012 compared to $25.5 million, or 12.5% of net sales in fiscal 2011. Below is a table reconciling net income to EBITDA (in thousands): 24-------------------------------------------------------------------------------- Table of Contents ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Year ended September 30, 2012 2011 Net income $ 7,615 $ 11,019 Interest income, net (266 ) (165 ) Income tax provision 3,282 5,496 Depreciation and amortization 7,815 9,177 Earnings before interest, taxes, depreciation and amortization $ 18,446 $ 25,527 • Our Balance Sheet and Cash from Operations Remained Strong. Our current ratio was 9.5 to 1 at September 30, 2012 compared to 8.3 to 1 at September 30, 2011. Cash and cash equivalents and marketable securities increased $12.4 million to $118.6 million at September 30, 2012, from $106.2 million at September 30, 2011. On July 25, 2012 our Board of Directors authorized a new program to repurchase up to $20.0 million of our common stock (see Note 12 to our Consolidated Financial Statements).

We accomplished a number of key initiatives in fiscal 2012 and also faced significant challenges relative to our business.

Accomplishments • We continued to generate strong, positive cash flows even as revenues fell short of expectations. We believe our strong cash position provides a solid foundation for growing our business.

• We announced important strategic relationships with Freescale and Wind River that we believe will advance our business to become the leading M2M solutions provider. Each relationship will provide connectivity to our iDigi® Device Cloud in products that use Freescale, via our relationship with Wind River, Intel technology, respectively. This will allow developers and OEMs to build connected products and cloud enabled services more rapidly. We believe that these types of relationships signal the beginning of a market strategy that will promote sales of broader M2M solutions that include hardware, cloud-based software services and professional services.

• We restructured our sales organization and invested in solution sales capabilities to more aggressively sell broader-based M2M solutions. As a result of this restructuring, we eliminated employment positions in our work force and hired new employees or re-assigned existing employees into newly created positions (see Note 9 to our Consolidated Financial Statements).

Challenges • During fiscal 2011 we completed sales on many significant customer projects. During fiscal 2012 we were unable to close on a similar level of project-based sales opportunities. This issue was most pronounced in North America and Europe.

• The global economic environment, most notably in Europe, continued to be volatile in fiscal 2012. This also adversely impacted our financial results.

• We experienced an unexpected decline in sales of our Rabbit products during fiscal 2012 and now believe this product line is maturing one to two years earlier than anticipated.

• Flooding at a Thailand based contract manufacturer in October 2011 disrupted our business temporarily. While this did not impact our revenues or margins materially, it did have some negative impact on our expenses within cost of goods sold.

25-------------------------------------------------------------------------------- Table of Contents ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) CONSOLIDATED RESULTS OF OPERATIONS The following table sets forth selected information derived from our Consolidated Statements of Operations, expressed as a percentage of net sales and as a percentage of change from year-to-year for the years indicated.

($ in thousands) Year ended September 30, % Increase (decrease) 2012 compared 2011 compared 2012 2011 2010 to 2011 to 2010 Net sales $ 190,558 100.0 % $ 204,160 100.0 % $ 182,548 100.0 % (6.7 )% 11.8 % Cost of sales (exclusive of amortization of purchased and core technology shown separately below) 88,445 46.4 94,702 46.4 86,266 47.3 (6.6 ) 9.8 Amortization of purchased and core technology 1,776 0.9 2,870 1.4 4,073 2.2 (38.1 ) (29.5 ) Gross profit 100,337 52.7 106,588 52.2 92,209 50.5 (5.9 ) 15.6 Operating expenses: Sales and marketing 39,242 20.6 39,549 19.4 37,010 20.3 (0.8 ) 6.9 Research and development 30,767 16.2 31,642 15.5 27,825 15.2 (2.8 ) 13.7 General and administrative 18,188 9.5 18,206 8.9 17,889 9.8 (0.1 ) 1.8 Restructuring 1,259 0.7 154 0.1 (468 ) (0.3 ) 717.5 (132.9 ) Total operating expenses 89,456 47.0 89,551 43.9 82,256 45.0 (0.1 ) 8.9 Operating income 10,881 5.7 17,037 8.3 9,953 5.5 (36.1 ) 71.2 Other income (expense), net 16 - (522 ) (0.2 ) 566 0.3 (103.1 ) (192.2 ) Income before income taxes 10,897 5.7 16,515 8.1 10,519 5.8 (34.0 ) 57.0 Income tax provision 3,282 1.7 5,496 2.7 1,578 0.9 (40.3 ) 248.3 Net income $ 7,615 4.0 % $ 11,019 5.4 % $ 8,941 4.9 % (30.9 )% 23.2 % NET SALES Net sales were $190.6 million in fiscal 2012 compared to $204.2 million in fiscal 2011, a decrease of $13.6 million or 6.7%. The decrease primarily was due to a lower than anticipated closure rate of large new customer projects, most notably in North America and EMEA, and unfavorable economic conditions, most notably in Europe. In addition, our Rabbit-branded product line matured and net sales began to decline one to two years earlier than anticipated. We believe that our serial servers, Rabbit-branded modules, chips and USB products are mature products and we expect that net sales of these products will continue to decrease in the future. We did not experience a material change in revenue due to pricing during fiscal 2012.

Net sales were $204.2 million in fiscal 2011 compared to $182.5 million in fiscal 2010, an increase of $21.7 million or 11.8%, primarily due to a $26.6 million increase in the net sales of modules, cellular products, engineering design services, serial servers, chips and iDigi® services. This was partially offset by a $4.9 million decrease in net sales of serial cards, USB devices, wireless communication adapters and satellite-related products. The increase in net sales in fiscal 2011 compared to fiscal 2010 is primarily driven by increased unit volume as a result of increased customer sales, many of which were wireless. We did not experience a material change in revenue due to pricing during fiscal 2011.

Fluctuation in foreign currency rates compared to the prior year's rates had an unfavorable impact on net sales of $1.4 million in fiscal 2012. In fiscal 2011 we had a favorable impact on net sales of $0.9 million and in fiscal 2010 we had an unfavorable impact of $0.3 million.

26 -------------------------------------------------------------------------------- Table of Contents ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Net Sales by Non-Embedded and Embedded Product Categories The following summarizes our net sales by non-embedded and embedded product categories: Net Sales % of Net Sales ($ in millions) 2012 2011 2010 2012 2011 2010 Non-embedded $ 95.6 $ 108.5 $ 91.2 50.2 % 53.1 % 55.0 % Embedded 95.0 95.7 74.7 49.8 % 46.9 % 45.0 % Total net sales $ 190.6 $ 204.2 $ 165.9 100.0 % 100.0 % 100.0 % Non-embedded products Non-embedded products net sales decreased $12.9 million, or 11.8%, in fiscal 2012 compared to fiscal 2011. The decrease was mostly due to a reduction in net sales of cellular products, serial servers, wireless communication adapters and USB products. We believe that the serial servers and USB products are in the mature phase of their product life cycle and we expect the net sales of these products to continue to decrease in the future.

Non-embedded products net sales increased $8.4 million, or 8.3%, in fiscal 2011 compared to fiscal 2010 due primarily to increases in cellular products and serial servers. This was partially offset by decreases in sales of serial cards, wireless communication adapters and USB connected products. USB connected product net sales decreased due to softening of the retail sector for retail point-of-sale related USB applications in fiscal 2011. Increased sales to customers in the medical and fleet industries contributed to the increase in fiscal 2011 compared to fiscal 2010.

Embedded products Embedded products net sales decreased $0.7 million, or 0.8%, in fiscal 2012 compared to fiscal 2011. The decrease was primarily due to a reduction in net sales of Rabbit-branded modules, chips and engineering design services. This was offset partially by increased net sales of Digi-branded modules, iDigi® services and satellite-related products. We believe that the Rabbit-branded products and chips are in the mature phase of their product life cycle and we expect the net sales of these products to continue to decrease in the future.

Embedded products net sales increased $13.3 million, or 16.2%, in fiscal 2011 compared to fiscal 2010 due mostly to increases of net sales of modules, engineering design services and chips. Increased sales to customers in the medical industry contributed to the increase in fiscal 2011 compared to fiscal 2010.

Net Sales by Wireless and Wired Product Categories The following table presents our revenue by wireless and wired categories: Net Sales % of Net Sales ($ in millions) 2012 2011 2010 2012 2011 2010 Wireless $ 82.8 $ 84.7 $ 66.4 43.4 % 41.5 % 36.3 % Wired 107.8 119.5 116.1 56.6 % 58.5 % 63.7 % Total net sales $ 190.6 $ 204.2 $ 182.5 100.0 % 100.0 % 100.0 % Wireless product net sales decreased by 2.3% in fiscal 2012 compared to fiscal 2011 and increased 27.6% in fiscal 2011 compared to fiscal 2010. Despite this decrease, wireless product net sales as a percentage of our total net sales increased in fiscal 2012. We believe this is because of our continued investment and focus on wireless M2M products and solutions. As is the trend with respect to the use of telecommunications generally, we anticipate that our sales of wireless products will continue to increase as a percentage of net sales.

27 -------------------------------------------------------------------------------- Table of Contents ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Net Sales by Geographic Location Our net sales by geographic location of our customers is as follows: Net Sales % of Net Sales ($ in millions) 2012 2011 2010 2012 2011 2010 North America $ 112.4 $ 118.7 $ 107.3 59.0 % 58.1 % 58.8 % Europe, Middle East & Africa 47.0 52.1 47.7 24.7 % 25.5 % 26.2 % Asian countries 24.9 27.0 22.7 13.0 % 13.2 % 12.4 % Latin America 6.3 6.4 4.8 3.3 % 3.2 % 2.6 % Total net sales $ 190.6 $ 204.2 $ 182.5 100.0 % 100.0 % 100.0 % North America net sales in fiscal 2012 decreased $6.3 million, or 5.3%, due to lower net sales of non-embedded products of $8.2 million. This was offset partially by an increase in net sales of embedded products of $1.9 million. The decrease in net sales in fiscal 2012 compared to the prior year largely was due to a lower than anticipated closure rate on large projects. North America net sales in fiscal 2011 increased $11.4 million, or 10.5%, due to an increase of $6.3 million in net sales of embedded products. The North American sales for fiscal 2011 increased over the prior fiscal year primarily as a result of large project based sales, many of which were for wireless products.

EMEA net sales decreased $5.1 million, or 9.8%, in fiscal 2012 from fiscal 2011.

This primarily was due to poor economic conditions in the EMEA market, a lower than anticipated closure rate on large projects and the weakening of the Euro.

Net sales in EMEA increased $4.4 million, or 9.3%, in fiscal 2011 over fiscal 2010 mostly due to large project-based sales. The strengthening of the Euro and British Pound contributed $0.7 million to the increase in fiscal 2011 compared to fiscal 2010.

Asian countries revenue decreased $2.1 million, or 7.8%, in fiscal 2012 from fiscal 2011 mostly related to net sales of non-embedded products. Net sales in Asian countries increased by $4.3 million, or 18.5%, in fiscal 2011 compared to fiscal 2010 mostly related to net sales of RF modules in the embedded product grouping.

Latin America revenue decreased slightly by $0.1 million, or 2.6%, in fiscal 2012 from fiscal 2011. Latin America revenue increased by $1.6 million, or 35.3%, in fiscal 2011 compared to fiscal 2010 primarily due to non-embedded cellular products.

Net Sales by Distribution Channel The following table presents our revenue by distribution channel: Net Sales % of Net Sales ($ in millions) 2012 2011 2010 2012 2011 2010 Direct/OEM channel $ 73.6 $ 73.3 $ 66.2 38.6 % 35.9 % 36.3 % Distributors channel 117.0 130.9 116.3 61.4 % 64.1 % 63.7 % Total net sales $ 190.6 $ 204.2 $ 182.5 100.0 % 100.0 % 100.0 % During fiscal 2012, net sales by our distributors decreased by $13.9 million, or 10.6% compared to net sales in fiscal 2011. Net sales in fiscal 2012 in our Direct/OEM channel increased by $0.3 million, or 0.3% compared to the prior fiscal year. The decrease in net sales in the Distributors channel compared to the Direct/OEM channels was due to lower net sales of mature non-embedded products, lower than anticipated closure rate on large projects, and foreign currency impacts.

Net sales in our Direct/OEM channel increased $7.1 million, or 10.8% compared to net sales in fiscal 2010. During fiscal 2011, net sales by our distributors increased by $14.6 million, or 12.4% compared to net sales in fiscal 2010.

Increased customer sales to targeted industries contributed to the increase in net sales by both our distributors and our Direct/OEM channel. International sales growth also contributed to the increase by our distributors.

28 -------------------------------------------------------------------------------- Table of Contents ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) GROSS PROFIT 2012 Compared to 2011 Gross profit was $100.3 million and $106.6 million in fiscal 2012 and 2011, respectively, a decrease of $6.3 million, or 5.9%. The gross margin for fiscal 2012 was 52.7% compared to 52.2% in fiscal 2011, an increase of 0.5 percentage points. The increase primarily resulted from a reduction in the amortization of purchased and core technology as certain intangibles were fully amortized, reduced costs through the restructuring of European operations and cost reduction initiatives for the production of our products. Amortization of purchased and core technology was $1.8 million or 0.9% of net sales in fiscal 2012 as compared to $2.9 million or 1.4% of net sales in fiscal 2011. These aggregated impacts were partially offset by increased costs to operate the iDigi® Device Cloud and increased expenses associated with mitigating the effects of flooding in Thailand in October 2011 which impacted a significant contract manufacturer.

2011 Compared to 2010 Gross profit was $106.6 million and $92.2 million in fiscal 2011 and 2010, respectively, an increase of $14.4 million, or 15.6%. The gross margin for fiscal 2011 was 52.2% compared to 50.5% in fiscal 2010. Gross margin increased 1.7 percentage points primarily due to product cost reduction initiatives that allowed us to reduce the cost of our products and increase gross profit through purchasing and manufacturing efficiencies during the fiscal year. Favorable customer and product mix, as well as a decrease in the amortization of purchased and core technology as certain intangibles were fully amortized, also contributed to the increase in gross profit during fiscal 2011. Amortization of purchased and core technology was $2.9 million or 1.4% of net sales in fiscal 2011 as compared to $4.1 million or 2.2% of net sales in fiscal 2010.

OPERATING EXPENSES 2012 Compared to 2011 Operating expenses were essentially flat at $89.5 million in fiscal 2012 and $89.6 million in fiscal 2011. Below is a summary of our operating expenses by function.

Sales and marketing expenses were $39.2 million in fiscal 2012, a decrease of $0.4 million or 0.8%, compared to $39.6 million in fiscal 2011. Commission expense decreased by $0.6 million, partially offset by a $0.2 million increase in other compensation-related expenses.

Research and development expenses were $30.8 million in fiscal 2012, a decrease of $0.8 million or 2.8%, compared to $31.6 million in fiscal 2011. Compensation expenses were reduced by $1.1 million resulting primarily from lower incentive compensation payouts compared to the prior fiscal year, as well as lower headcount. In addition, professional services decreased by $0.3 million compared to the prior fiscal year. This was partially offset by an increase of $0.6 million in other miscellaneous research and development expenses.

General and administrative expenses were $18.2 million in both fiscal 2012 and 2011. General and administrative expenses decreased by $0.6 million in amortization expense as certain intangible assets are now fully amortized.

Compensation-related expenses decreased by $0.4 million due to a decrease in headcount and lower incentive compensation payouts. This was offset by increases of $0.4 million in bad debt expense, $0.3 million in professional fees and $0.3 million in other general and administrative expenses.

Restructuring expenses were $1.3 million in fiscal 2012, an increase of $1.1 million, compared to $0.2 million in fiscal 2011. During fiscal 2012, we recorded $1.0 million related to our 2012 restructuring that was announced on April 26, 2012. In addition, we recorded an additional $0.3 million related to the Breisach, Germany restructuring announced on July 21, 2011. In fiscal 2011 we recorded $0.2 million related to the above mentioned restructuring for Breisach, Germany. For further information on restructuring, see Note 9 to our Consolidated Financial Statements.

2011 Compared to 2010 Operating expenses were $89.6 million in fiscal 2011, an increase of $7.3 million or 8.9%, compared to $82.3 million in fiscal 2010. Below is a summary of our operating expenses by function.

29 -------------------------------------------------------------------------------- Table of Contents ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Sales and marketing expenses were $39.6 million in fiscal 2011, an increase of $2.6 million or 6.9%, compared to $37.0 million in fiscal 2010. Sales and marketing expenses increased by $2.0 million for compensation-related expenses due to increased headcount and full reinstatement of our non-sales incentive program and $0.6 million for outside services, travel and entertainment and miscellaneous other sales and marketing expenses.

Research and development expenses were $31.6 million in fiscal 2011, an increase of $3.8 million or 13.7%, compared to $27.8 million in fiscal 2010. Research and development expenses increased by $2.6 million for compensation-related expenses due to increased headcount and full reinstatement of our non-sales incentive program, $0.8 million for other research and development expenses mostly related to the investment in our iDigi® cloud-based platform and $0.4 million for professional services and contract labor.

General and administrative expenses were $18.2 million in fiscal 2011, an increase of $0.3 million or 1.8%, compared to $17.9 million in fiscal 2010. The increase in general and administrative expenses was due to increases of $1.3 million for compensation-related expenses mostly related to a full reinstatement of our non-sales incentive program and $0.2 million related to a litigation settlement discussed in Notes 16 and 18 to our Consolidated Financial Statements. This partially was offset by a reduction of $1.2 million in professional fees related to internal investigation and remediation actions we took related to the U.S. Foreign Corrupt Practices Act incurred in fiscal 2010.

Restructuring expenses were $0.2 million in fiscal 2011, and increase of $0.6 million, compared to a net reversal of restructuring expenses of $0.4 million in fiscal 2010. During fiscal 2011, we recorded $0.2 million related to the Breisach, Germany restructuring announced on July 21, 2011. In fiscal 2010 we reversed $0.5 million of restructuring expenses related to the closing of an engineering facility in Long Beach, California, and the relocation and consolidation of the manufacturing facility in Davis, California that was announced on April 23, 2009, which was partially offset by an additional charge relating to this restructuring of $0.1 million for an additional six months of continued medical benefits as a result of new health care legislation passed in December 2009.

OTHER (EXPENSE) INCOME, NET 2012 Compared to 2011 Total other income, net was minimal in fiscal 2012 and $0.5 million in fiscal 2011, a decrease of $0.5 million. This decrease was mostly due to a reduction of $0.3 million in foreign currency net transaction losses in fiscal 2012 as compared to fiscal 2011. Also during fiscal 2012 we recorded a gain on the sale of an investment of $0.1 million and recorded an additional $0.1 million in interest income. Our average investment balance increased from $85.9 million in fiscal 2011 to $94.4 million in fiscal 2012, but our interest income remained the same as the prior fiscal year since we earned an average interest rate of 0.3% in both fiscal 2012 and fiscal 2011.

2011 Compared to 2010 Other (expense) income, net was $0.5 million of expense in fiscal 2011, a decrease of $1.1 million compared to $0.6 million of income in fiscal 2010. The majority of this was due to $0.7 million of foreign currency net transaction losses in fiscal 2011 compared to foreign currency net transaction gains of $0.3 million in fiscal 2010. We realized interest income on marketable securities and cash and cash equivalents of $0.3 million in fiscal 2011 compared to $0.4 million in fiscal 2010. Our average investment balance increased from $69.0 million in fiscal 2010 to $85.9 million in fiscal 2011, but our interest income was less than in the prior fiscal year since we earned an average interest rate of 0.3% in fiscal 2011 compared to 0.5% in fiscal 2010.

INCOME TAXES Our effective income tax rate was 30.1%, 33.3% and 15.0% for fiscal years 2012, 2011 and 2010, respectively. Our effective tax rate will vary based on a variety of factors, including overall profitability, the geographical mix of income before taxes and related statutory tax rate in each jurisdiction, and discrete events, such as settlements of audits.

During fiscal 2012, we recorded a discrete tax benefit of $1.5 million, related to additional research and development tax credits identified for fiscal years ended September 30, 2009, 2010 and 2011, reversal of tax reserves for closure of various jurisdictions' tax matters and tax rate reductions in foreign jurisdictions. These discrete tax benefits reduced our effective tax rate by 14 percentage points for the twelve month period ended September 30, 2012 to 30.1%. During fiscal 2012, the income tax provision before discrete tax benefits was higher than the statutory rate primarily due to an increase in certain reserves for unrecognized tax benefits, an adjustment for foreign income taxed at the U.S. rate, and a reduction in domestic tax benefits 30 -------------------------------------------------------------------------------- Table of Contents ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) compared to a year ago.

During fiscal 2011, we recorded a discrete tax benefit of $0.7 million. This benefit primarily resulted from the reversal of tax reserves from various jurisdictions, primarily foreign, related to the expiration of the statutes of limitations. It also resulted from the enactment of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extending the research and development tax credit that allowed us to record tax credits earned during the last three quarters of fiscal 2010 in the first quarter of fiscal 2011. This benefit reduced our effective tax rate by 4 percentage points for the twelve month period ended September 30, 2011 to 33.3%.

During fiscal 2010, we reversed $2.3 million in income tax reserves associated primarily with the closing of prior tax years through statute expiration and the conclusion of a federal tax audit. While the statutes of limitations have not expired, U.S. federal income tax returns for the periods ended September 30, 2007 and September 30, 2008 have been audited by and settled with the Internal Revenue Service. The aforementioned income tax benefits resulting from the reversal of income tax reserves and other discrete tax benefits reduced the effective tax rate by 22 percentage points in fiscal 2010.

INFLATION Management believes that during fiscal years 2012, 2011 and 2010, inflation has not had a material effect on our operations or on our consolidated financial position.

LIQUIDITY AND CAPITAL RESOURCES We have financed our operations principally with funds generated from operations. We held cash, cash equivalents and short-term marketable securities of $118.6 million, $106.2 million and $87.6 million at September 30, 2012, 2011 and 2010, respectively. Our working capital was $155.4 million, $142.7 million and $122.1 million at September 30, 2012, 2011 and 2010, respectively. Absent a disruption in our business, we expect our working capital to continue to increase.

Consolidated Statements of Cash Flows Highlights: Year ended September 30, ($ in thousands) 2012 2011 2010 Operating activities $ 15,127 $ 21,839 $ 16,095 Investing activities (10,954 ) (22,399 ) (15,167 ) Financing activities 2,311 4,639 2,604 Effect of exchange rate changes on cash and cash equivalents (922 ) (338 ) (1,023 ) Net increase in cash and cash equivalents $ 5,562 $ 3,741 $ 2,509 Net cash provided by operating activities was $15.1 million during fiscal 2012 compared to $21.8 million during fiscal 2011, a net decrease of $6.7 million.

This net decrease is due to the following: a decrease in net income of $3.4 million, deferred income tax benefit of $1.2 million, depreciation and amortization of $1.4 million and an increase in net working capital of $2.3 million. This was partially offset by net increases related to restructuring of $1.1 million and other non-cash items of $0.5 million. Changes in working capital decreased cash flows primarily due to decreases of $5.1 million for accrued expenses, partially offset by an increase of $2.8 million related to income taxes.

Net cash provided by operating activities was $21.8 million during fiscal 2011 compared to $16.1 million in fiscal 2010, a net increase of $5.7 million. This net increase was due to an increase in net income of $2.1 million, deferred income taxes of $2.4 million, inventory obsolescence of $1.1 million, net increases in working capital of $1.0 million and other non-cash items of $0.4 million. This was offset by net decreases in amortization expense of $1.3 million. Changes in working capital increased cash flows by $1.0 million due to a $3.8 million increase in accounts receivable as the increase in accounts receivable in fiscal 2011 was less than the increase in fiscal 2010 and a $1.5 million increase in inventories as inventories have declined in fiscal 2011.

This was offset by a $2.7 million net decrease in accounts payable and $1.6 million in other assets and accrued expenses.

Net cash used by investing activities was $11.0 million in fiscal 2012 as compared to $22.4 million in fiscal 2011. Our net purchases of marketable securities were $9.5 million less in fiscal 2012 as compared to fiscal 2011. We spent $3.0 million for the final deferred payment related to the Spectrum acquisition in fiscal 2011. This was partially offset by a decrease of $1.2 million related to additional purchases of capital expenditures in fiscal 2012 compared to fiscal 2011.

31 -------------------------------------------------------------------------------- Table of Contents ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Net cash used in investing activities was $22.4 million in fiscal 2011 as compared to $15.2 million in fiscal 2010, a net increase of $7.2 million. We used an additional $7.4 million of cash for net purchases of marketable securities in fiscal 2011 compared to fiscal 2010, partially offset by $0.2 million fewer capital expenditures in fiscal 2011 as compared to fiscal 2010.

Net cash provided by financing activities was $2.3 million in fiscal 2012 as compared $4.6 million in fiscal 2011, a net decrease of $2.3 million, resulting primarily from fewer exercises of stock options. Net cash provided by financing activities was $4.6 million in fiscal 2011 as compared to $2.6 million in fiscal 2010, an increase of $2.0 million, resulting from additional exercises of stock options and employee stock purchase plan transactions.

We expect positive cash flows from operations and believe that our current cash, cash equivalents and marketable securities balances, cash generated from operations and our ability to secure debt and/or equity financing will be sufficient to fund our business operations and capital expenditures for the next twelve months and beyond. On July 25, 2012 our Board of Directors authorized a new program to repurchase up to $20.0 million of our common stock. This repurchase authorization expires on September 30, 2013.

At September 30, 2012, our total cash and cash equivalents and marketable securities balance was $118.6 million This balance includes approximately $28.7 million of cash and cash equivalents held by our controlled foreign subsidiaries of which $22.0 million represents accumulated undistributed foreign earnings.

Although we have no current need to do so, if we change our unremitted assertion to repatriate additional undistributed foreign earnings for cash requirements in the United States, we would have to accrue applicable taxes. The amount of any taxes and the application of any tax credits would be determined based on the income tax laws at the time of such repatriation. Under current tax laws, we estimate the unrecognized deferred tax liability to be in the range of $2.5 million to $3.5 million and could have a material impact on our current consolidated balance sheet, results of operations and cash flows.

The following summarizes our contractual obligations at September 30, 2012: Payments due by fiscal period ($ in thousands) Total Less than 1 year 1-3 years 3-5 years Thereafter Operating leases $ 5,844 $ 2,390 $ 2,737 $ 716 $ 1 The operating lease agreements included above primarily relate to office space.

The table above does not include possible payments for uncertain tax positions.

Our reserve for uncertain tax positions, including accrued interest and penalties, was $3.3 million as of September 30, 2012. Due to the nature of the underlying liabilities and the extended time often needed to resolve income tax uncertainties, we cannot make reliable estimates of the amount or timing of future cash payments that may be required to settle these liabilities.

The above table also does not include those obligations for royalties under a license agreement as these royalties are calculated based on future sales of licensed products identified in the settlement agreement and we cannot make reliable estimates of the amount of cash payments.

FOREIGN CURRENCY We are exposed to foreign currency risk associated with certain sales transactions being denominated in Euros, British Pounds, Japanese Yen and Indian Rupees and foreign currency translation risk as the financial position and operating results of our foreign subsidiaries are translated into U.S. Dollars for consolidation. We have not implemented a formal hedging strategy to reduce foreign currency risk.

During 2012, we had approximately $78.2 million of net sales related to foreign customers including export sales, of which $23.4 million was denominated in foreign currency, predominantly the Euro and British Pound. During both 2011 and 2010, we had approximately $85.5 million and $75.2 million, respectively, of net sales to foreign customers including export sales, of which $28.8 million and $27.6 million, respectively, were denominated in foreign currency, predominantly the Euro and British Pound. In future periods, we expect a significant portion of sales will continue to be made in Euros and British Pounds.

32 -------------------------------------------------------------------------------- Table of Contents ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) RECENT ACCOUNTING DEVELOPMENTS In August 2012, the U.S. Securities and Exchange Commission (the "SEC") adopted a rule mandated by the Dodd-Frank Act to require companies to publicly disclose their use of conflict minerals that originated in the Democratic Republic of the Congo or an adjoining country. The final rule applies to a company that uses minerals including tantalum, tin, gold or tungsten. The final rule requires companies to provide disclosure on a new form filed with the SEC, with the first specialized disclosure report due on May 31, 2014, for the 2013 calendar year, and annually on May 31 each year thereafter. We are currently evaluating the impact of adoption.

In July 2012, the Financial Accounting Standards Board ("FASB") issued ASU 2012-02, "Intangibles - Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment." The FASB amended its guidance on testing of indefinite-lived intangible assets for impairment. Under the amended guidance, companies may perform a qualitative assessment to determine whether further impairment testing is necessary, similar to the amended goodwill impairment testing guidance noted below. The guidance for indefinite-lived intangible assets is effective for annual and interim tests performed for fiscal years beginning after September 15, 2012, with an option for early adoption. We will adopt ASU 2012-02 effective for our fiscal year beginning October 1, 2012 and do not expect this pronouncement to have a material effect on our consolidated financial statements.

In September 2011, the FASB issued Accounting Standards Update ("ASU") No.

2011-08, "Intangibles-Goodwill and Other (Topic 350) Testing Goodwill for Impairment". This guidance provides an update on how an entity tests goodwill for impairment. This revised guidance allows companies an option to make a qualitative evaluation about the likelihood of goodwill impairment. Under the revised guidance, a company is permitted to first assess qualitative factors to determine whether goodwill impairment exists prior to performing analysis comparing the fair value of a reporting unit to its carrying amount. If, based on the qualitative assessment, a company concludes it is more likely than not that the fair value of the reporting unit exceeds its carrying value, then quantitative testing for impairment is not necessary. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. We, however, adopted this update early so it was effective for our fiscal year beginning October 1, 2011 (see Note 7 to the Condensed Consolidated Financial Statements). This guidance had no impact on our consolidated financial statements.

In June 2011, the FASB issued ASU No. 2011-05, "Comprehensive Income (Topic 220): Presentation of Comprehensive Income". This guidance eliminates the option to report other comprehensive income and its components in the consolidated statement of stockholders' equity. Rather it requires that all non-owner changes in stockholders' equity be presented in either a single continuous statement of comprehensive income or in two separate but consecutive statements. This guidance also requires us to present on the face of the financial statements any reclassification adjustments for items that are reclassified from other comprehensive income to net income. The guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. We will adopt this guidance beginning with our fiscal quarter ending December 31, 2012. The adoption of this guidance is not expected to have any effect on our consolidated financial position or results of operations, as it will only impact how certain information related to other comprehensive income is presented in our consolidated financial statements. In December 2011, FASB issued ASU No. 2011-12 which amends this guidance and defers only the presentation of reclassification of items out of accumulated comprehensive income. No other requirements of ASU No. 2011-05 are affected by this deferral.

In May 2011, the FASB issued ASU No. 2011-04, "Fair Value Measurements (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs". This guidance updates many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements to ensure consistency between U.S. GAAP and International Financial Reporting Standards ("IFRS"). This guidance is to be applied prospectively and is effective during interim and annual periods beginning after December 15, 2011. We adopted this guidance beginning with our fiscal quarter ending March 31, 2012. This guidance had no impact on our consolidated financial statements.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, the disclosure of contingent assets and liabilities and the values of purchased assets and assumed liabilities in acquisitions. We base our estimates on historical experience and various 33 -------------------------------------------------------------------------------- Table of Contents ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

We believe the following critical accounting policies impact our more significant judgments and estimates used in the preparation of our consolidated financial statements.

REVENUE RECOGNITION Our revenues are derived primarily from the sale of embedded and non-embedded hardware products to our distributors and Direct/OEM customers, and to a small extent from the sale of professional and engineering services, fees associated with technical support, training, software licenses and royalties. We recognize product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, collectability is reasonably assured and there are no post-delivery obligations other than warranty.

Under these criteria, product revenue is generally is recognized upon shipment of product to customers, including Direct/OEM and distributors. Sales to authorized domestic distributors and Direct/OEMs are made with certain rights of return and price adjustment provisions. Estimated reserves for future returns and pricing adjustments are established by us based on an analysis of historical patterns of returns and price adjustments as well as an analysis of authorized returns compared to received returns, current on-hand inventory at distributors, and distribution sales for the current period. Estimated reserves for future returns and price adjustments are charged against revenues in the same period as the corresponding sales are recorded. Material differences between the historical trends used to determine estimated reserves and actual returns and pricing adjustments could result in a material change to our consolidated results of operations or financial position. We have applied consistent methodologies for estimating reserves for future returns and pricing adjustments for all years presented. The reserve for future returns and pricing adjustments was $1.4 million at September 30, 2012 and $1.3 million at September 30, 2011.

Our non-product revenue represented 4.5%, 4.5% and 3.3% of net sales in fiscal 2012, 2011 and 2010, respectively. The majority of the non-product revenue was from professional and engineering services and represented 4.1%, 4.2% and 2.9% of net sales in fiscal 2012, 2011 and 2010, respectively. We also had revenue from cloud-based services, post-contract customer support, fees associated with technical support, training, royalties and the sale of software licenses. Our software development tools and development boards often include multiple elements, including hardware, software licenses, post-contract customer support, limited training and basic hardware design review. Our customers purchase these products and services during their product development process in which they use the tools to build network connectivity into the devices they are manufacturing.

Revenue for professional and engineering services and training is recognized upon performance. Revenue from software licenses is recognized when earned.

Revenues from contracts with multiple element arrangements are recognized as each element is earned based on the relative fair value of each element provided the delivered elements have value to customers on a standalone basis. Amounts allocated to each element are based on its vendor specific objective evidence, such as the sales price for the product or service when it is sold separately.

Revenue from cloud-based services is earned in two ways. First, web-based management fees are considered to be earned on a monthly basis consistent with a monthly contractual commitment. Second, transaction fees that are billed to the customer at the larger of the minimum price or the number of transactions times the stated fee and are considered earned as the transactions occur.

CASH EQUIVALENTS AND MARKETABLE SECURITIES We regularly monitor and evaluate the realizable value of our marketable securities. When assessing marketable securities for other-than-temporary declines in value, we consider several factors. These factors include: how significant the decline in value is as a percentage of the original cost, how long the market value of the investment has been less than its original cost, the underlying factors contributing to a decline in the prices of securities in a single asset class, the performance of the issuer's stock price in relation to the stock price of its competitors within the industry, expected market volatility, analyst recommendations, the views of external investment managers, any news or financial information that has been released specific to the investee and the outlook for the overall industry in which the issuer operates.

If events and circumstances indicate that a decline in the value of these securities has occurred and is other-than-temporary, we would record a charge to other income (expense).

ACCOUNTS RECEIVABLE AND ALLOWANCE FOR DOUBTFUL ACCOUNTS We maintain an allowance for doubtful accounts, which reflects the estimate of losses that may result from the inability of some of our customers to make required payments. The estimate for the allowance for doubtful accounts is based on known 34 -------------------------------------------------------------------------------- Table of Contents ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) circumstances regarding collectability of customer accounts and historical collections experience. If the financial condition of one or more of our customers were to deteriorate, resulting in an inability to make payments, additional allowances may be required. Material differences between the historical trends used to estimate the allowance for doubtful accounts and actual collection experience could result in a material change to our consolidated results of operations or financial position. The allowance for doubtful accounts was $0.3 million at both September 30, 2012 and September 30, 2011.

INVENTORIES Inventories are stated at the lower of cost or fair market value, with cost determined using the first-in, first-out method. We reduce the carrying value of our inventories for estimated excess and obsolete inventories equal to the difference between the cost of inventory and its estimated realizable value based upon assumptions about future product demand and market conditions. Once the new cost basis is established, the value is not increased with any changes in circumstances that would indicate an increase in value after the remeasurement. If actual product demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required that could result in a material change to our consolidated results of operations or financial position. We have applied consistent methodologies for the net realizable value of inventories.

GOODWILL Goodwill represents the excess of cost over the fair value of identifiable assets acquired. Goodwill is tested for impairment on an annual basis as of June 30, or more frequently if events or circumstances occur which could indicate impairment. As of June 30, 2012, our market capitalization was $264.3 million compared to our carrying value of $265.7 million. Our market capitalization plus our estimated control premium of 40% resulted in a fair value in excess of our carrying value by a margin of 39% and therefore no impairment was indicated. At September 30, 2012, our market capitalization was $263.3 million compared to our carrying value of $270.9 million. Since there were no triggering events through September 30, 2012, and our market capitalization plus our estimated control premium of 40% resulted in a fair value in excess of our carrying value by a margin of 36%, no impairment was indicated.

The control premium used in our annual goodwill assessment at June 30, 2012 and our further evaluation of goodwill at September 30, 2012 was based on a recent control premium study as of June 30, 2012, resulting in a range of control premium of 30% to 45%. We concluded that a 40% control premium best represented the amount an investor would pay, over and above market capitalization, in order to obtain a controlling interest given the economic conditions at that time.

INCOME TAXES We operate in multiple tax jurisdictions both in the U.S. and outside of the U.S. Accordingly, we must determine the appropriate allocation of income to each of these jurisdictions. This determination requires us to make several estimates and assumptions. Tax audits associated with the allocation of this income, and other complex issues, may require an extended period of time to resolve and could result in adjustments to our income tax balances that are material to our consolidated financial position and results of operations and could affect our cash flows for potential cash outflows.

We have unrecognized tax benefits of $3.3 million classified as a long-term liability. We expect that it is reasonably possible that the total amounts of unrecognized tax benefits will decrease approximately between $0.3 million to $0.4 million over the next 12 months due to the expiration of statue of limitations. The total amount of unrecognized tax benefits that if recognized would affect our effective tax rate is $2.7 million. We recognize interest and penalties related to income tax matters in income tax expense.

WARRANTIES In general, we warrant our products to be free from defects in material and workmanship under normal use and service. The warranty periods generally range from one to five years. We typically have the option to repair or replace products we deem defective due to material or workmanship. Estimated warranty costs are accrued in the period that the related revenue is recognized based upon an estimated average per unit repair or replacement cost applied to the estimated number of units under warranty. These estimates are based upon historical warranty incidents and are evaluated on an ongoing basis to ensure the adequacy of the warranty accrual. The product warranty accrual was $1.0 million and $0.9 million at September 30, 2012 and September 30, 2011, respectively.

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