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PROCERA NETWORKS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following unaudited discussion and analysis of financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on March 11, 2014. As used in this Quarterly Report on Form 10-Q, references to the "Company," "we," "us," "our" or similar terms include Procera Networks, Inc. and its consolidated subsidiaries. Cautionary Note Regarding Forward-Looking Statements Our disclosure and analysis in this Quarterly Report on Form 10-Q contain certain "forward-looking statements," as such term is defined in Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. These statements set forth anticipated results based on management's plans and assumptions. From time to time, we also provide forward-looking statements in other materials we release to the public as well as oral forward-looking statements. Such statements give our current expectations or forecasts of future events; they do not relate strictly to historical or current facts. We have attempted to identify such statements by using words such as "anticipate," "estimate," "expect," "project," "intend," "plan," "believe," "will," "could," "initial," "future," "may," "predict," "potential," "should" and similar expressions in connection with any discussion of future events or future operating or financial performance or strategies. Such forward-looking statements include, but are not limited to, statements regarding: ? trends related to and management's expectations regarding future results of operations, required capital expenditures, revenues from existing and new products and sales channels, and cash flows, including but not limited to those statements set forth below in this Item 2; ? sales efforts, expenses, interest rates, foreign exchange rates and the outcome of contingencies, such as legal proceedings; ? our services, including the development and deployment of products and services and strategies to expand our targeted customer base and broaden our sales channels; ? the operation of our Company with respect to the development of products and services; ? our liquidity and financial resources, including anticipated capital expenditures, funding of capital expenditures and anticipated levels of indebtedness; and ? our expectations regarding our financial results for fiscal year 2014 and subsequent periods. We cannot guarantee that any forward-looking statement will be realized. Achievement of future results is subject to risks, uncertainties and potentially inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from past results and those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements. We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. We also provide cautionary discussion of risks and uncertainties related to our businesses which are identified under the caption "Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q. We believe these factors, individually or in the aggregate, as well as general risks and uncertainties such as those relating to general economic conditions and demand for our products and services, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties. 23-------------------------------------------------------------------------------- Index Overview We are a leading provider of Internet Intelligence solutions designed for network operators worldwide. Our solutions are focused on enhancing the subscriber experience in fixed, mobile and enterprise broadband networks. Our PacketLogic solutions are targeted towards service providers, and enable operators to gain insights and take action to deliver personalized services with a high quality of experience. Telecom and network equipment vendors use our Network Application Visibility Library, or NAVL, solutions to enhance their products by adding application intelligence to their portfolio. We believe that the intelligence our products provide about users and their usage enables our network operator customers to make better business decisions that result in greater profitability and to deliver a better broadband experience. Our network operator customers include service provider customers and enterprises. Our service provider customers include mobile service providers and broadband service providers, which include cable multiple system operators and internet service providers. Our enterprise customers include educational institutions, commercial enterprises and government and municipal agencies. We sell our products directly to network operators through partners, value added resellers and system integrators, and to other network solution suppliers for incorporation into their network solutions. Our Internet Intelligent products are classified as part of the high-growth Deep Packet Inspection, or DPI, market for mobile packet and broadband core products. The market for DPI products was $1.4 billion in 2013 and is expected to grow to $2.9 billion in 2018, a 2013 to 2018 compounded annual growth rate of 14%. Our bundled products containing hardware and software elements deliver a solution that is a key element of the mobile packet and broadband core ecosystems. Our technology is transitioning to a software-focused solution as the trends in Network Function Virtualization, or NFV, and Software Defined Networking, or SDN, take hold in the service provider network core. Our solutions are often integrated with additional elements in the mobile packet and broadband core, including policy management and charging functions, and are compliant with the widely adopted 3rd Generation Partnership Program standard. In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, network operators are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers. We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products, and the drive for NFV will open up new opportunities for our solutions. Our embedded solutions enable network solutions suppliers to more quickly add Internet Intelligence to their platforms, since our NAVL products have been designed to be highly portable among many platforms and processors. NAVL eliminates the need for network solutions providers to research and develop their own DPI technology, saving significant time and resources while enabling them to more effectively compete in their market space. We have recently announced several new development initiatives that are designed to expand our product offerings and our addressable market. These initiatives include: (1) RAN Perspectives, a Radio Access Network awareness solution, to gain device and location intelligence that will compete with a new set of probe and Customer Experience Assurance solutions, (2) Video Perspectives, a new Video Intelligence offering that will compete with Big Data solutions, and (3) Network Function Virtualization versions of our PacketLogic products that will change our business model to shift more towards software sales rather than hardware with embedded software. We believe that these new initiatives, if successful, will increase our addressable market opportunity to include portions of the Telco Big Data and Customer Experience Assurance markets, where the breadth of our product offerings will provide a broader view of the subscriber experience than current offerings in those markets. Our products are marketed under the PacketLogic and NAVL brand names. We have a broad spectrum of products delivering intelligence at the access, edge and core layers of the network. Our products are designed to offer maximum flexibility to our customers and enable differentiated services and revenue-enhancing applications, all while delivering a high quality of service for subscribers. 24-------------------------------------------------------------------------------- Index We face competition from suppliers of standalone and integrated Intelligence Policy Enforcement, or IPE, and DPI products, including Allot Communications Ltd., Blue Coat Systems, Brocade Communications Systems, Cisco Systems, Inc., Citrix Systems (acquired Bytemobile), Ericsson, F5 Networks, Huawei Technologies Company, Qosmos, SAIC (acquired Cloudshield Technologies), Sandvine Corporation, and Tektronix (acquired Arbor Networks). Some of our competitors supply platform products with different degrees of DPI functionality, such as switch/routers, routers, session border controllers and voice-over Internet protocol, or VoIP, switches. In addition, we face competition from large integrators that package third-party IPE solutions into their products, including Alcatel-Lucent and Nokia Siemens. It is possible that these companies will develop their own IPE solutions or strategically acquire existing competitor IPE vendors in the future. Some of our competitors are also our customers. Most of our competitors are larger and more established enterprises with substantially greater financial and other resources. Some competitors may be willing to reduce prices and accept lower profit margins to compete with us. As a result of such competition, we could lose market share and sales, or be forced to reduce our prices to meet competition. However, we do not believe there is a dominant supplier in our market. Based on our belief in the superiority of our technology, we believe that we have an opportunity to increase our market share and benefit from what we believe will be growth in the DPI market. On January 9, 2013, we completed our acquisition of Vineyard Networks Inc., or Vineyard, a privately held developer of Layer 7 DPI and application classification technology located in Kelowna, Canada. Vineyard's integrated DPI and application classification technology provides enterprise and service provider networking infrastructure vendors with these capabilities through its integrated software suite, primarily through a variety of subscription-based original equipment manufacturer and partner license agreements. This acquisition complements our hardware and application software-based IPE and DPI solutions. We are headquartered in Fremont, California, and we have key operating entities in Kelowna, Canada and Varberg, Sweden, as well as a geographically dispersed sales force. We sell our products through our direct sales force, resellers, distributors, systems integrators and other equipment manufacturers in the Americas, Asia Pacific, Europe and the Middle East. Critical Accounting Estimates The discussion and analysis of our financial condition and results of operations are based upon financial statements that have been prepared in accordance with United States generally accepted accounting principles, or GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates. We base our estimates on historical experience and on assumptions that are believed to be reasonable. These estimates and assumptions provide a 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 under different assumptions or conditions, and these differences may be material. We believe the following critical accounting policies reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements: ? Revenue Recognition; ? Valuation of Long-Lived Assets and Goodwill; ? Inventory Valuation; ? Stock-Based Compensation; and ? Accounting for Income Taxes. These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on March 11, 2014. 25-------------------------------------------------------------------------------- Index Results of Operations Comparison of Three and Nine Months Ended September 30, 2014 and 2013 Revenue Revenue for the three and nine months ended September 30, 2014 and 2013 was as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change Net product revenue $ 11,164 $ 16,301 (32 )% $ 35,792 $ 40,328 (11 )% Net support revenue 4,945 5,032 (2 )% 15,466 13,015 19 % Total revenue $ 16,109 $ 21,333 (24 )% $ 51,258 $ 53,343 (4 )% Our revenue is derived from two sources: (1) product revenue, which includes sales of our hardware appliances bundled with software licenses, separate software licenses and software upgrades; and (2) service revenue, which consists primarily of software maintenance and customer support revenue and secondarily of professional services. Maintenance and customer support revenue is recognized over the support period, which is typically 12 months. Our product revenues tend to vary seasonally and are typically higher in the second half of the year as compared to the first half of the year. Product revenue for the three and nine months ended September 30, 2014 was $11.2 million and $35.8 million, respectively, which represents a decrease of 32% and 11%, respectively, compared to the three and nine months ended September 30, 2013. The decreases were driven by fewer large product orders primarily from Tier 1 customers in North America as compared to the prior periods. Support revenue for the three months ended September 30, 2014 was $4.9 million, a decrease of 2%, compared to the three months ended September 30, 2013. The decrease in support revenue for the three months ended September 30, 2014 was due to a $0.2 million decrease in professional service revenue due to fewer project completions, offset by a $0.1 million increase in support service revenue. Support revenue for the nine months ended September 30, 2014 was $15.5 million, an increase of 19% compared to the nine months ended September 30, 2013. The increase in support revenue for the nine months ended September 30, 2014 was due to a $2.3 million increase in support revenue and a $0.1 million increase in professional service revenue. The increase in support revenue in the three and nine months ended September 30, 2014 reflected the continued expansion of the installed base of our product to which we have sold ongoing support services. Total support revenue will fluctuate over time depending on the number of new customers, support renewals from continuing customers, and completed professional service projects during the period. By region, sales to customers located in Europe, the Middle East and Africa, or EMEA, as a percentage of revenue were 57% and 47% for the three and nine months ended September 30, 2014, respectively, compared to 46% and 36% for the three and nine months ended September 30, 2013, respectively. See Note 13 - "Segment Information" of the Notes to Condensed Consolidated Financial Statements for additional details. For the three months ended September 30, 2014, one customer represented 37% of net revenue, with no other single customer accounting for more than 10% of net revenue. For the nine months ended September 30, 2014, one customer represented 11% of net revenue with no other single customer accounting for more than 10% of net revenue.For the three months ended September 30, 2013, revenue from two customers represented 33% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue. For the nine months ended September 30, 2013, revenue from Shaw Communications, Inc. represented 13% of net revenue, and two other customers represented 13% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue. 26-------------------------------------------------------------------------------- Index For the year ending December 31, 2014, we expect total revenue to approximate the total revenue for the year ended December 31, 2013. Cost of Sales Cost of sales includes material costs and direct labor for products sold, amortization of acquired developed technology, costs expected to be incurred for warranty, adjustments to inventory values, including the write-down of slow moving or obsolete inventory, and costs for support and professional services personnel. The following table presents the breakdown of cost of sales by category for the three and nine months ended September 30, 2014 and 2013 (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change Product costs $ 4,774 $ 10,080 (53 )% $ 17,645 $ 22,451 (21 )% Percent of net product revenue 43 % 62 % 49 % 56 % Support costs 1,118 896 25 % 3,269 2,442 34 % Percent of net support revenue 23 % 18 % 21 % 19 % Total cost of sales $ 5,892 $ 10,976 (46 )% $ 20,914 $ 24,893 (16 )% Percent of total net revenue 37 % 51 % 41 % 47 % Total cost of sales in the three and nine months ended September 30, 2014 decreased by $5.1 million and $4.0 million, respectively, compared to the three and nine months ended September 30, 2013, due to lower material costs associated with a decrease in product sales, offset by higher employee-related costs from an increase in customer support and professional services headcount. Cost of sales as a percentage of revenue decreased by 14 percentage points and 6 percentage points for the three and nine months ended September 30, 2014, respectively, compared to the same period in the prior year. The decrease as a percentage of revenue for the three and nine month comparable periods was primarily due to a product mix shift within product revenue to appliances from chassis based product sales. Appliance product sales tend to yield a greater margin compared with chassis based product sales. Stock-based compensation recorded to cost of sales in each of the three and nine months ended September 30, 2014 and 2013 was $0.1 million and $0.3 million, respectively. Gross Profit Gross profit for the three and nine months ended September 30, 2014 and 2013 was as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change Gross profit $ 10,217 $ 10,357 (1) % $ 30,344 $ 28,450 7 % Percent of total net % % % % revenue 63 49 59 53 Gross profit for the three months ended September 30, 2014 decreased by $0.1 million as compared to the three months ended September 30, 2013. The decrease in gross profit was driven by lower overall revenue. Gross profit for the nine months ended September 30, 2014 increased by $1.9 million as compared to the nine months ended September 30, 2013 due to higher support and professional services revenue. Our gross profit margin for the three and nine months ended September 30, 2014 increased by 14 and 6 percentage points compared to the same period in the prior year, respectively, to 63% and 59%, respectively. The increase in gross profit margin for the three and nine months ended September 30, 2014 was due to support revenue representing a higher proportion of total revenue and higher margins earned on product sales. Support revenue tends to have a greater gross profit margin compared with product sales. The higher margins earned on product sales reflect a product mix shift to appliances from chassis based product sales. Appliance product sales tend to yield a greater margin compared with chassis based product sales. 27-------------------------------------------------------------------------------- Index On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangible assets and cost reduction efforts, the gross margin for the three and nine months ended September 30, 2014 was 66% and 62%, respectively, as compared to 50% and 55% for the three and nine months ended September 30, 2013, respectively. The increase in non-GAAP gross profit margin for the three and nine months ended September 30, 2014 was primarily due to support revenue representing a higher proportion of total revenue and higher margins earned on product sales. (See page 33 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.) Our gross margin rate in any given period is impacted by the revenue and product mix in that period, and we expect variability in our gross margin rate to continue in the future. We expect our gross profit margin to be a higher percentage of total net revenue in the year ending December 31, 2014 as compared to the year ended December 31, 2013. Operating Expenses Operating expenses for the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change Research and development $ 4,096 $ 3,945 4 % $ 12,360 $ 12,532 (1 )% Sales and marketing 6,497 7,322 (11 )% 20,425 21,293 (4 )% General and administrative 2,760 2,510 10 % 8,311 9,498 (12 )% Impairment of goodwill and purchased intangible assets 12,380 - n/a 12,380 - n/a Total $ 25,733 $ 13,777 87 % $ 53,476 $ 43,323 23 % Our total operating expenses for the three and nine months ended September 30, 2014 increased compared to the three and nine months ended September 30, 2013 as a result of impairment charges of $12.4 million associated with NAVL goodwill and purchased intangible assets. Excluding these charges, total operating expenses for the three and nine months ended September 30, 2014 decreased $0.4 million and $2.2 million, respectively, from the prior year periods. The decrease was primarily due to a decrease in amortization of deferred compensation costs associated with retention agreements with Vineyard's three founders, which were $0.1 million in the nine months ended September 30, 2014 as these costs became fully amortized, compared to $1.5 million and $4.3 million in the three and nine months ended September 30, 2013, respectively. The decrease in the nine months ended September 30, 2014 also reflected the absence of acquisition related costs, which were $1.6 million in the nine months ended September 30, 2013. These reductions were partially offset by increases in the three and nine months ended September 30, 2014 of product development costs for our next generation PacketLogic products, severance and related costs associated with cost reduction efforts and higher compensation costs associated with additional investment in sales and business development and research and development personnel. On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangible assets, cost reduction efforts, impairment of goodwill and intangible assets, deferred compensation and business development expenses, operating expenses in the three and nine months ended September 30, 2014 were $11.7 million and $36.5 million, respectively, compared to $11.2 million and $33.5 million for the three and nine months ended September 30, 2013, respectively. The increase in operating expenses on a non-GAAP basis for the three and nine months ended September 30, 2014 reflected investment in sales and business development personnel and in product development and quality. (See page 33 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.) 28-------------------------------------------------------------------------------- Index We took certain cost reduction steps in the three and nine months ended September 30, 2014 to contain spending in order to improve our profitability. These steps consisted of a reduction in workforce, which resulted in severance and other employee-related costs of $0.3 million and $1.0 million in the three and nine months ended September 30, 2014, respectively, and also included steps to reduce spending on outside professionals. In total, we anticipate that new employee and contractor hiring in fiscal year 2014 will be substantially reduced compared with the hiring activity in fiscal year 2013; therefore, we expect our headcount will be similar or will increase somewhat from that reported for the year ended December 31, 2013. Research and Development Research and development expenses include costs associated with personnel focused on the development or improvement of our products, prototype materials, initial product certifications, testing equipment and software costs. Research and development costs include sustaining and enhancement efforts for products already released and development costs associated with planned new products. Research and development expenses for the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change Research and development $ 4,096 $ 3,945 4 % $ 12,360 $ 12,532 (1 )% As a percentage of net revenue 25 % 18 % 24 % 23 % Research and development expenses for the three months ended September 30, 2014 increased by $0.2 million as compared to the three months ended September 30, 2013 primarily due to increases in product development costs of $0.7 million, compensation costs associated with increased headcount of $0.1 million, stock compensation of $0.1 million, and depreciation expense of $0.1 million, offset by the reduction of amortization of deferred compensation costs of $0.8 million. Deferred compensation was fully amortized in the first quarter of 2014. Research and development expenses for the nine months ended September 30, 2014 decreased by $0.2 million from the comparable prior year period. The decrease resulted primarily from a reduction in amortization of deferred compensation costs of $2.2 million, offset by increased product development costs of $0.9 million, compensation costs associated with increased headcount of $0.5 million, stock compensation expense of $0.1 million, depreciation expense of $0.3 million and severance and related costs of $0.2 million. On a non-GAAP basis, after adjusting for stock-based compensation, cost reduction efforts and deferred compensation, research and development expenses for the three and nine months ended September 30, 2014 were $3.8 million and $11.1 million, respectively, as compared to $3.0 million and $9.4 million for the three and nine months ended September 30, 2013, respectively. The increase resulted primarily from higher product development costs and compensation costs associated with additional personnel as we continue to expand our research and development group to develop the next generation PacketLogic solutions and other new product initiatives. (See page 33 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.) 29-------------------------------------------------------------------------------- Index Sales and Marketing Sales and marketing expenses primarily include personnel costs, sales commissions and marketing expenses, such as trade shows, channel development and literature. Sales and marketing expenses for the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change ($ in thousands) ($ in thousands) Sales and marketing $ 6,497 $ 7,322 (11 )% $ 20,425 $ 21,293 (4 )% As a percentage of net revenue 40 % 34 % 40 % 40 % Sales and marketing expenses for the three and nine months ended September 30, 2014 decreased by $0.8 million and $0.9 million, respectively, compared to the three and nine months ended September 30, 2013. The decreases in the three and nine months ended September 30, 2014 were primarily a result of a reduction in the amortization of deferred compensation costs of $0.7 million and $2.1 million, respectively, and lower sales commissions of $0.5 million and $0.1 million, respectively, associated with the lower levels of revenue. These reductions were partially offset by severance and related costs of $0.3 million and $0.5 million in the three and nine months ended September 30, 2014, respectively, and an increase in compensation and related costs associated with the hiring of additional sales and marketing personnel in the EMEA region of $0.1 million and $0.6 million, respectively. On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangible assets, cost reduction efforts and deferred compensation, sales and marketing expenses for the three months ended September 30, 2014 were $5.6 million as compared to $6.1 million for the three months ended September 30, 2013. The $0.5 million decrease was mainly due to a $0.4 million decrease in sales commissions from lower quarterly revenues in the three months ended September 30, 2014. Non-GAAP sales and marketing expenses for the nine months ended September 30, 2014 were $18.3 million as compared to $17.5 million for the nine months ended September 30, 2013. The increase of $0.8 million was primarily due to compensation costs associated with higher headcount. (See page 33 for a reconciliation of this non-GAAP measure to the most comparable GAAP financial measure and other important information.) General and Administrative General and administrative expenses consist primarily of personnel and facilities costs related to our executive and finance functions and fees for professional services. Professional services include costs for legal advice and services, accounting and tax professionals, independent auditors and investor relations. General and administrative expenses for the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change ($ in thousands) ($ in thousands) General and administrative $ 2,760 $ 2,510 10 % $ 8,311 $ 9,498 (12 )% As a percentage of net revenue 17 % 12 % 16 % 18 % General and administrative expenses for the three months ended September 30, 2014 increased by $0.3 million compared to the three months ended September 30, 2013. The increase was mainly due to a $0.2 million increase in legal and professional service costs. General and administrative expenses for the nine months ended September 30, 2014 decreased by $1.2 million compared to the nine months ended September 30, 2013. The decrease resulted from the reduction of business development costs of $1.6 million related to accounting and investment banking fees, partially offset by an increase in rent expense of $0.4 million and compensation-related expenses of $0.3 million associated with higher headcount. 30-------------------------------------------------------------------------------- Index On a non-GAAP basis, after adjusting for stock-based compensation, cost reduction efforts and business development costs, general and administrative expenses for the three and nine months ended September 30, 2014 were $2.3 million and $7.1 million, respectively, as compared to $2.1 million and $6.6 million for the three and nine months ended September 30, 2013, respectively. The increase in the three and nine months ended September 30, 2014 was mainly due to an increase in compensation costs associated with higher headcount. (See page 33 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.) Impairment of Goodwill and Purchased Intangible Assets During the third quarter of fiscal year 2014, we considered the effect of the economic environment in which our NAVL reporting unit markets our products and determined that sufficient indicators existed requiring us to perform an interim impairment review of the NAVL reporting unit goodwill and long-lived assets. The indicators consisted primarily of: (1) decelerating revenue growth during the third quarter of fiscal year 2014 and a decline in forecasted revenue in future quarters, and (2) lower than anticipated total addressable market for NAVL products. As a result, we performed impairment reviews of our NAVL goodwill and long-lived assets within the NAVL reporting unit. The reviews were performed at the NAVL reporting unit level. Based on our reviews, we recorded total impairment charges of $12.4 million; $10.8 million to write down the value of NAVL goodwill to zero, and $0.7 and $0.8 million to write down the carrying values of NAVL developed technology and customer relationship intangible assets, respectively, to their current estimated fair values. See Note 6 - "Goodwill and Intangible Assets" of the Notes to Condensed Consolidated Financial Statements for additional details. Interest and Other Income (Expense), Net Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change ($ in thousands) ($ in thousands) Interest and other income (expense), net $ (356 ) $ 232 (253 )% $ (245 ) $ 203 (221 )% Interest and other income (expense), net decreased in the three and nine months ended September 30, 2014 compared to the three and nine months ended September 30, 2013. The decrease in the three and nine months ended September 30, 2014 was mainly due to an increase in foreign currency losses. Benefit from Income Taxes Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 Change 2014 2013 Change ($ in thousands) ($ in thousands) Income tax benefit $ (160 ) $ (205 ) (22 )% $ (281 ) $ (1,688 ) (83 )% We are subject to taxation primarily in the U.S., Australia, Canada, Japan, Singapore and Sweden, as well as in a number of U.S. states, including California. The benefit for income tax in the three months ended September 30, 2014 was largely comprised of the reversal of the US deferred tax liability related to the impairment of goodwill. The reduction in the tax benefit for the nine months ended September 30, 2014 relates to the valuation allowance placed on the Canadian net deferred tax asset which has the effect of limiting the tax benefit. The tax benefits were offset by state taxes, foreign withholding taxes and earnings taxed in foreign jurisdictions. 31-------------------------------------------------------------------------------- Index We have established a valuation allowance for substantially all of our deferred tax assets. We calculated the valuation allowance in accordance with the provisions of Accounting Standards Codification, or ASC, Topic 740, which requires that a valuation allowance be established or maintained when it is "more likely than not" that all or a portion of deferred tax assets will not be realized. We will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal. Important Information Regarding non-GAAP Financial Measures In this Quarterly Report on Form 10-Q, we include non-GAAP financial measures. Our management believes that certain non-GAAP financial measures provide investors with additional useful information and regularly uses these supplemental non-GAAP financial measures internally to understand and manage our business and forecast future periods. In addition, our management believes that these non-GAAP financial measures, when taken together with the corresponding GAAP measures, provide incremental insight into the underlying factors and trends affecting both our performance and our cash-generating potential. Our non-GAAP financial measures include adjustments for stock-based compensation expenses; business development expenses; cost reduction efforts; acquisition-related intangible asset and deferred compensation amortization; and income tax effects. We have excluded the effect of stock-based compensation, the cost of outside professional services for negotiating and performing legal, accounting and tax due diligence for potential mergers and acquisitions, expenses connected with cost reduction efforts, acquisition-related intangible asset and deferred compensation amortization, impairment of goodwill and intangible assets and income tax effects from our non-GAAP gross profit, operating expenses and net income measures. Stock-based compensation, which represents the estimated fair value of stock options, restricted stock and restricted stock units granted to employees, is excluded since grant activities vary significantly from quarter to quarter in both quantity and fair value. In addition, although stock-based compensation will recur in future periods, excluding this expense allows us to better compare core operating results with those of our competitors who also generally exclude stock-based compensation from their core operating results and who may have different granting patterns and types of equity awards and who may use different option valuation assumptions than we do. Business development expenses are necessary as part of certain growth strategies, such as through mergers and acquisitions, and will occur when such transactions are pursued. We have excluded these expenses because they can vary materially from period-to-period and transaction-to-transaction and expenses associated with these business development activities are not considered a key measure of our operating performance. Cost reduction efforts occur with shifts in objectives and evolving requirements of the business and can result in fluctuating expenses connected with reducing employment in certain areas. We have excluded these expenses because they can vary significantly from period-to-period and are not considered a key measure of our operating performance. Acquisition-related intangible assets and deferred compensation amortization and income tax effects represent non-cash charges and benefits that result from the accounting for acquisitions. We have excluded these items because, in any period, they may not directly correlate to the underlying performance of our business and can vary materially from period-to-period and transaction-to-transaction. In addition, we exclude these acquisition-related costs and benefits when evaluating our current operating performance. Our non-GAAP financial measures may not reflect the full economic impact of our activities. Further, these non-GAAP financial measures may be unique to us as they may differ from non-GAAP financial measures used by other companies, including our competitors. As such, this presentation of non-GAAP financial measures may not enhance the comparability of our results to the results of other companies. Therefore, these non-GAAP financial measures are limited in their usefulness and investors are cautioned not to place undue reliance on our non-GAAP financial measures. In addition, investors are cautioned that these non-GAAP financial measures are not intended to be considered in isolation and should be read in conjunction with our consolidated financial statements prepared in accordance with GAAP. 32-------------------------------------------------------------------------------- Index A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measure, net loss, is as follows: Three Months Ended Nine Months Ended Sept 30, Sept 30, Sept 30, Sept 30, 2014 2013 2014 2013 Sales: Product sales $ 11,164 $ 16,301 $ 35,792 $ 40,328 Support sales 4,945 5,032 15,466 13,015 Total net sales 16,109 21,333 51,258 53,343 Cost of sales: Product cost of sales, GAAP 4,774 10,080 17,645 22,451 Non-GAAP adjustments: Stock-based compensation (1) (7 ) (19 ) (29 ) (58 ) Amortization of intangibles (2) (264 ) (275 ) (793 ) (819 ) Cost reduction efforts (3) - - (237 ) - Product cost of sales, non-GAAP 4,503 9,786 16,586 21,574 Support cost of sales, GAAP 1,118 896 3,269 2,442 Non-GAAP adjustments: Stock-based compensation (1) (85 ) (82 ) (253 ) (223 ) Support cost of sales, non-GAAP 1,033 814 3,016 2,219 Total cost of sales, non-GAAP 5,536 10,600 19,602 23,793 Gross profit, non-GAAP 10,573 10,733 31,656 29,550 Operating expenses: Research and development, GAAP 4,096 3,945 12,360 12,532 Non-GAAP adjustments: Stock-based compensation (1) (314 ) (218 ) (998 ) (933 ) Cost reduction efforts (3) - - (206 ) - Deferred compensation (5) - (753 ) (65 ) (2,193 ) Research and development, non-GAAP 3,782 2,974 11,091 9,406 Sales and marketing, GAAP 6,497 7,322 20,425 21,293 Non-GAAP adjustments: Stock-based compensation (1) (443 ) (385 ) (1,249 ) (1,348 ) Amortization of intangibles (2) (114 ) (117 ) (342 ) (353 ) Cost reduction efforts (3) (327 ) - (515 ) - Deferred compensation (5) - (716 ) - (2,086 ) Sales and marketing, non-GAAP 5,613 6,104 18,319 17,506 General and administrative, GAAP 2,760 2,510 8,311 9,498 Non-GAAP adjustments: Stock-based compensation (1) (429 ) (365 ) (1,200 ) (1,252 ) Cost reduction efforts (3) - - (27 ) - Business development expenses (6) - - - (1,616 ) General and administrative, non-GAAP 2,331 2,145 7,084 6,630 Impairment of goodwill and purchased intangible assets 12,380 - 12,380 - Non-GAAP adjustments: Impairment of goodwill and purchased intangible assets (4) (12,380 ) - (12,380 ) - Impairment of goodwill and purchased intangible assets, non-GAAP - - - - Total operating expenses, non-GAAP 11,726 11,223 36,494 33,542 Loss from operations, non-GAAP (1,153 ) (490 ) (4,838 ) (3,992 ) Interest and other income (expense), net (356 ) 232 (245 ) 203 Income tax benefit (160 ) (205 ) (281 ) (1,688 ) Non-GAAP adjustment (7) 192 136 578 1,550 Income tax provision, non-GAAP 32 (69 ) 297 (138 ) Non-GAAP net loss $ (1,541 ) $ (189 ) $ (5,380 ) $ (3,651 ) Net loss per share - diluted $ (0.08 ) $ (0.01 ) $ (0.26 ) $ (0.18 ) Shares used in computing diluted net loss per share: Diluted 20,500 20,031 20,395 20,007 Reconciliation of net loss: U.S. GAAP as reported $ (15,712 ) $ (2,983 ) $ (23,096 ) $ (12,982 ) Non-GAAP adjustments: Stock-based compensation (1) 1,278 1,069 3,729 3,814 Amortization of intangibles (2) 378 392 1,135 1,172 Cost reduction efforts (3) 327 - 985 - Impairment of goodwill and purchased intangible assets (4) 12,380 - 12,380 - Deferred compensation (5) - 1,469 65 4,279 Business development expenses (6) - - - 1,616 Income tax provision, non-GAAP (7) (192 ) (136 ) (578 ) (1,550 ) As adjusted $ (1,541 ) $ (189 ) $ (5,380 ) $ (3,651 ) Reconciliation of diluted net loss per share: U.S. GAAP as reported $ (0.77 ) $ (0.15 ) $ (1.13 ) $ (0.65 ) Non-GAAP adjustments: Stock-based compensation (1) 0.06 0.05 0.18 0.19 Amortization of intangibles (2) 0.02 0.02 0.06 0.06 Cost reduction efforts (3) 0.02 - 0.04 - Impairment of goodwill and purchased intangible assets (4) 0.60 - 0.61 - Deferred compensation (5) - 0.08 - 0.22 Business development expenses (6) - - - 0.08 Income tax provision, non-GAAP (7) (0.01 ) (0.01 ) (0.02 ) (0.08 ) As adjusted $ (0.08 ) $ (0.01 ) $ (0.26 ) $ (0.18 ) Shares used in computing diluted net loss per share: 20,500 20,031 20,395 20,007 33-------------------------------------------------------------------------------- Index (1) Stock-based compensation expense is calculated in accordance with the fair value recognition provisions of ASC Topic 718. (2) Amortization expense associated with intangible assets acquired in the Vineyard acquisition. (3) Severance and other employee-related costs in connection with our cost-reduction efforts. (4) Impairment charges to write-down the carrying value of goodwill and purchased intangible assets associated with the Vineyard acquisition as a result of lower than anticipated total addressable market and revenue growth of our NAVL products. See Note 6 - "Goodwill and Intangible Assets" of the Notes to Condensed Consolidated Financial Statements for additional details. (5) Amortization of amounts paid under retention agreements with Vineyard's three founders. These amounts were paid during the first quarter of fiscal year 2014, after one year of continuous employment with us. See Note 5 - "Acquisitions" in the Notes to Condensed Consolidated Financial Statements for additional details. (6) Includes the cost of outside professional services for negotiating and performing legal, accounting and tax due diligence for potential mergers and acquisitions and other significant partnership arrangements. (7) Income tax benefit associated with the following Vineyard acquisition-related items: reversal of Vineyard's pre-existing income tax valuation allowance upon acquisition, amortization of acquired intangible assets, Canadian valuation allowance and book to tax differences on deferred revenue. 34-------------------------------------------------------------------------------- Index Liquidity and Capital Resources Cash, Cash Equivalents and Investments The following table summarizes the changes in our cash balance for the periods indicated: Nine Months Ended September 30, 2014 2013 (in thousands) Net cash used in operating activities $ (2,495 ) $ (10,751 ) Net cash provided by (used in) investing activities (74,711 ) 57,142 Net cash provided by (used in) financing activities 352 (69 ) Effect of exchange rate changes on cash and cash equivalents 328 (117 ) Net increase (decrease) in cash and cash equivalents $ (76,526 ) $ 46,205 During the nine months ended September 30, 2014, cash used in operating activities was $2.5 million as compared to $10.8 million of cash used in operating activities for the nine months ended September 30, 2013. Cash used in operating activities during the nine months ended September 30, 2014 primarily consisted of net working capital sources of cash of $1.1 million and non-cash charges of $19.5 million, offset by our net loss of $23.1 million. As compared to the nine months ended September 30, 2013, working capital sources of cash for the nine months ended September 30, 2014 mainly consisted of a decrease in accounts receivable of $4.5 million due to strong collections, a reduction in inventory of $1.8 million due to improved inventory management, and a $0.6 million increase in deferred revenues due to increased deferred term license revenue. As compared to the nine months ended September 30, 2013, working capital uses of cash for the nine months ended September 30, 2014 consisted primarily of a decrease in accounts payable of $3.4 million associated with payments on inventory purchases and an increase in prepaid expenses and other current assets of $1.7 million. Non-cash charges for the nine months ended September 30, 2014 consisted primarily of impairment of goodwill and purchased intangible assets of $12.4 million, depreciation expense of $1.7 million, amortization of intangible assets of $1.1 million, stock-based compensation of $3.7 million and amortization of premium on investments of $0.5 million, offset by changes in deferred taxes of $0.5 million. Net cash used in investing activities of $74.7 million during the nine months ended September 30, 2014 consisted of purchases of short-term investments of $111.4 million and equipment purchases primarily of lab and testing equipment for use in research and development of $2.3 million, offset by proceeds from sales of short-term investments of $24.2 million and maturities of short-term investments of $14.8 million. Net cash provided by financing activities of $0.3 million during the nine months ended September 30, 2014 consisted of proceeds from the exercise of employee stock options. Our cash, cash equivalents and short-term investments at September 30, 2014 consisted of bank deposits with third party financial institutions, money market funds, U.S. treasury and agency securities, commercial paper and corporate bonds. Our investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relationship to our investment guidelines and market conditions. Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase. Short-term investments have a remaining maturity of greater than three months at the date of purchase and the portfolio of short-term investments has a weighted average maturity of less than one year. All investments are classified as available for sale. In January 2013, we acquired Vineyard in Kelowna, Canada. The aggregate total consideration of $20.9 million consisted of $9.8 million in cash and 825,060 shares of our common stock. In addition to the purchase consideration, we recorded deferred compensation of $5.9 million, consisting of $2.7 million in cash consideration and $3.2 million in our common stock, related to retention agreements with Vineyard's three founders, which was disbursed from the escrow account in January 2014 after one year of continuous employment with us. Based on our current cash, cash equivalents and short-term investment balances, and anticipated cash flow from operations, we believe that our working capital will be sufficient to meet the cash needs of our business for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of growth, the expansion of our sales and marketing activities, development of additional channel partners and sales territories, the infrastructure costs associated with supporting a growing business and greater installed base of customers, introduction of new products, enhancement of existing products and the continued acceptance of our products. We may also enter into arrangements that require investment such as entering into complementary businesses, service expansion, technology partnerships or acquisitions. 35-------------------------------------------------------------------------------- Index Off-Balance Sheet Arrangements As of September 30, 2014, we had no off-balance sheet items as described by Item 303(a)(4) of Regulation S-K. We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments or other contingent arrangements that expose us to material continuing risks, contingent liabilities or any other obligations under a variable interest in an unconsolidated entity that provides us with financing, liquidity, market risk or credit risk support. Contractual Obligations We lease facility space under non-cancelable operating leases in California, Canada and Sweden that extend through 2024. The details of these contractual obligations are further explained in Note 11 - "Commitments and Contingencies" of the Notes to Condensed Consolidated Financial Statements. We use third-party suppliers to assemble and test our hardware products. In order to reduce manufacturing lead-times and ensure an adequate supply of inventories, our agreements with some of these suppliers allow them to procure long lead-time component inventory based on rolling production forecasts provided by us. We may be contractually obligated to purchase long lead-time component inventory procured by certain suppliers in accordance with our forecasts. In addition, we issue purchase orders to our third-party suppliers that may not be cancelable at any time. As of September 30, 2014, we had open non-cancelable purchase orders amounting to $7.7 million, primarily with our third-party suppliers. In addition, in October 2014, we issued a purchase order to one of our main hardware suppliers for $7.9 million. If certain shipment date milestones are not met, we may reduce the number of committed hardware orders. In March 2014, we entered into a lease agreement with B.C. Ltd, as landlord, relating to office space located in Kelowna, British Columbia. Tenant improvements were completed near the end of October 2014, and we are in the process of moving our Canadian offices to this new location. We accrued a liability of $0.6 million associated with the construction of the leasehold improvements beginning in the leasehold construction period of May 2014 to September 2014. Payments to reduce the liability will begin in November 2014. 36-------------------------------------------------------------------------------- Index |