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CYAN INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion contains forward-looking statements, including, without limitation, our expectations and statements regarding our outlook and future revenues, expenses, results of operations, liquidity, plans, strategies and objectives of management and any assumptions underlying any of the foregoing. Our actual results may differ significantly from those projected in the forward-looking statements. Our forward-looking statements and factors that might cause future actual results to differ materially from our recent results or those projected in the forward-looking statements include, but are not limited to, those discussed in the sections entitled "Forward Looking Information" and "Risk Factors" of this Form 10-Q. Except as required by law, we assume no obligation to update the forward-looking statements or our risk factors for any reason. Overview We have pioneered innovative, carrier-grade networking solutions that transform disparate and inefficient legacy networks into open, high-performance networks. Our solutions include high-capacity, multi-layer switching and transport platforms as well as a carrier-grade software-defined networking platform and applications. Our solutions enable network operators to virtualize their networks, accelerate service delivery and increase scalability and performance, while reducing costs. We have designed our solutions to provide a variety of existing and emerging premium applications, including business Ethernet, wireless backhaul, broadband backhaul and cloud connectivity. Our comprehensive solutions including include the Z-Series family of high-capacity, multi-layer switching and transport platforms, our Blue Planet SDN and NFV (network functions virtualization) orchestration platform and applications, and a range of professional services. Our Z-Series family of products has been designed to support the multiple concurrent technologies used in regional and metro networks, including both Ethernet-based services as well as optical services. Our Z-Series platforms are architected to transport traffic over the most efficient network layer, utilizing both electrical and optical domains, enabling network operators to maximize network capacity at the lowest cost per bit. Our solutions are designed to support a variety of use cases from traffic aggregation at the network edge to multi-terabit switching optimized for handoff at the network core. The second element of our solution is our Blue Planet platform that we introduced in December 2012. Our Blue Planet platform is a carrier-grade SDN and NFV solution purpose-built to address network operator requirements. Blue Planet is the latest implementation of our network virtualization and management software that we first introduced in 2009 to work in combination with our high-capacity, multi-layer switching and transport platforms. Now, Blue Planet is designed to simplify the development, deployment and orchestration of scalable communication, business applications, and virtual resources over high-performance multi-vendor networks. Blue Planet is designed to enable our customers to make more efficient use of existing network assets, cost-effectively expand network capacity and significantly accelerate the delivery of premium, revenue-generating services to their customers. By deploying Blue Planet, our customers can also provide their subscribers with network-as-a-service, or NaaS, allowing for real-time tailoring and customization of their network architecture and services to meet their end-customers' specific needs. Beyond that, Blue Planet is designed to instantiate virtual resources (such as cloud services or virtual network functions) in data center and cloud environments and connect those resources with the underlying network to create a new class of revenue-generating services for our customers. We were founded in October 2006 to simplify network operations and accelerate innovation through a centralized, open, multi-vendor, software orchestration model. We launched our first Z-Series platform in September 2009. Since then, we have led emerging, carrier-grade SDN initiatives in the industry through our development of open, multi-vendor and multi-layer network and virtual resource planning, management, and verification software. In April 2010, we launched one of the first multi-layer network management solutions. In December 2012, we launched Blue Planet, our carrier-grade SDN and NFV orchestration platform that is designed to allow network operators of all types to virtualize their networks and simplify the development, deployment and orchestration of scalable communications and business applications over both high-performance networks and virtual infrastructure. Our customers include service providers, hyperscale web 2.0 content providers, data center operators, large enterprises, and other private network operators. We target our customers through our direct sales force and through channel partners. Our solutions have been deployed primarily across North America as well as in Asia and Europe. For the years ended December 31, 2013, 2012 and 2011 our largest customer, Windstream Corporation, or Windstream, represented approximately 39%, 45% and 37% of our total revenue. In the first quarter of 2014, four customers, none of which were Windstream, each represented greater than 10% of total revenue for the period. In the second quarter of 2014, Windstream represented 28% of total revenue and no other single customer accounted for 10% or more of revenue. In the third quarter of 2014, Windstream represented 21% of total revenue and two other customers accounted for 10% or more of revenue. Given the episodic nature of capital expenditures associated with network deployments, we may continue to derive a substantial amount of our revenue from a limited number of customers in any particular future period. Unless and until we 20 -------------------------------------------------------------------------------- substantially diversify our customer base, we may continue to experience significant volatility in our quarterly results, and may not be able to maintain or grow our revenues. In recent periods, sales to Windstream have been highly volatile from quarter to quarter. Sales to Windstream declined from $19.0 million, or 50% of total revenue, in the third quarter of 2013 to $2.3 million, or 11% of total revenue, in the fourth quarter of 2013 and to $1.1 million, or 6% of total revenue, in the first quarter of 2014. The unanticipated 88% decline in revenue from Windstream from the third to the fourth quarters of 2013 resulted in our overall revenue in the fourth quarter being substantially lower than anticipated. In the second quarter of 2014, sales to Windstream increased to $6.7 million or 28% of total revenue. In the third quarter of 2014, sales to Windstream decreased to $5.6 million or 21% of total revenue. While we expect our sales to Windstream for the full year of 2014 to be significantly lower than in recent years, and for our sales to Windstream to be volatile, potentially highly volatile, from quarter to quarter, we nonetheless anticipate that a significant portion of our revenue in 2014 and beyond will continue to depend on sales to Windstream. In July 2014 Windstream announced that it was spinning-off certain network and real estate assets into a separate entity. It is unclear whether this development will impact our business with Windstream. If our sales to Windstream do not continue to remain significantly above the levels experienced in the fourth quarter of 2013 and first quarter of 2014, our revenue and results of operations would be adversely affected. In addition, approximately 20% and 7% of our revenue for the three months ended September 30, 2014 and 2013 and approximately 17% and 12% of our revenue for the nine months ended September 30, 2014 and 2013 was attributable to Independent Operating Companies, or IOCs, and other telecommunications network providers that used government-supported loan programs or grants to fund purchases from us. A significant portion of the government stimulus related revenue recognized in 2014 represented deferred revenue recognized upon customer acceptance of products provided under transactions entered into in previous years. Changes to or elimination of similar government programs have occurred in the past and are likely to occur in the future, especially given the current U.S. federal government fiscal issues. To the extent that any of our customers have received grants or loans under government stimulus programs, but no longer have access to such assistance, they may substantially reduce or curtail future purchases of our solutions. Approximately 26% and 13% of our revenue for the three months ended September 30, 2014 and 2013 and approximately 23% and 7% of our revenue for the nine months ended September 30, 2014 and 2013 was attributable to customers located outside the United States. We expect international revenue to increase in dollar amount over the longer term and to fluctuate as a percent of total revenue from quarter to quarter depending on the level of domestic revenue. Our customers have historically purchased our solutions using a pay-as-you-grow approach that begins with a targeted product purchase to address specific services or portions of their networks and expands over time to additional product purchases as they experience the benefits of our solutions. The sales cycle for a new customer deployment, from the time of prospect qualification to the completion of the first sale, may span multiple quarters. Typically, after we have completed an initial customer deployment, we experience much shorter sales cycles. We utilize a mixed sales channel approach, complementing our direct sales force with a channel distribution strategy, particularly in international markets. We expect to generate a substantial portion of our international sales through this network of channel partners in future periods. We intend to continue to deepen our engagement with our current channel partners and establish relationships with new channel partners to target our existing core markets. We also intend to target additional customer verticals, including large data center networks, governments, cable MSOs and enterprises that build and operate large, private networks. We outsource the manufacturing of our Z-Series platforms. Our outsourced manufacturing model allows us to scale our business without the significant capital investment and ongoing expenses required to establish and maintain manufacturing operations. Our Z-Series platforms leverage industry standard components, and we work closely with our contract manufacturer and key suppliers to manage the procurement, quality and cost of these components. Because our contract manufacturer manages procurement of many of the key components in our Z-Series platforms and has substantially greater purchasing power than we would on our own, our outsourced manufacturing model is also designed to help us effectively manage our inventory of raw materials and finished goods such that we are able to meet forecasted demand on a timely basis and at the same time mitigating our excess and obsolete inventory risk. There can be no assurance, however, that we will have sufficient inventory to meet forecasted demand or that we will not purchase and later have to write-down or write-off excess or obsolete inventory. We believe that our technological advantages will continue to support our growth and demand for our solutions. However, our business may be affected by future challenging economic conditions, decreased availability of capital for 21 -------------------------------------------------------------------------------- network infrastructure projects, as well as whether the market for Blue Planet develops. In addition, capital spending in our industry is cyclical and sporadic, can change on short notice and can fluctuate in response to outside factors such as the availability of government stimulus assistance. As a result, changes in spending behavior in any given quarter or during any economic downturn can reduce our revenue. Spending on network construction, maintenance, expansion and upgrades is also affected by seasonality, delays in the purchasing cycles and reductions in budgets of network operators. Finally, we may face direct and indirect risks as a result of our planned international expansion, including expenses of doing business in multiple jurisdictions, differing regulatory environments, foreign currency fluctuations and varying collection practices. We require a significant amount of cash resources to operate our business. We used approximately $35.2 million of cash, cash equivalents and marketable securities in the nine months ended September 30, 2014 including $30.4 million used in operating activities. We ended the quarter with cash, cash equivalents and marketable securities of $28.9 million. Our liquidity is affected by many factors including, among others, fluctuations in revenue, gross profits and operating expenses, as well as changes in operating assets and liabilities. At forecasted levels of revenue, expenses and capital expenditures, we believe that our existing cash, cash equivalents and marketable securities, together with our cash collections will be sufficient to meet our projected operating and capital expenditure requirements through the first quarter of 2015. However, further softening in the demand for our products and services may result in higher than anticipated losses in the future and lower our cash balances at a faster rate. We are exploring options to raise additional funds through public or private equity or debt financing to extend that period. Should additional funding not be available, or should funding only be available on unfavorable terms, we would be required to make changes to our operating expenses and capital expenditures to extend that period or would likely need to significantly reduce our business activities which could adversely affect our ability to compete effectively in the markets in which we participate which could, in turn, adversely affect our results of operations. If we issue equity securities in order to raise additional funds, substantial dilution to existing stockholders may occur. If we raise cash through additional indebtedness, we may be subject to additional contractual restrictions on our business. Components of Operating ResultsRevenue We generate revenue primarily from the sales of our Z-Series platforms and licenses to our Blue Planet software-defined networking solutions and various professional service fees. Cyan Z-Series Our Z-Series hardware is a family of high-capacity, multi-layer switching and transport platforms. Each Z-Series platform is comprised of a chassis that supports a variety of interchangeable Z-Series line cards to provide a wide range of network applications. Our customers make an initial purchase of chassis and line cards to address their particular network deployment needs, then typically make subsequent purchases of line cards and/or larger chassis as the capacity and service needs of their networks evolve. The majority of our revenue is generated from sales of our Z-Series platforms. We generally recognize product revenue at the time of shipment provided that all other revenue recognition criteria have been met. Cyan Blue Planet In December 2012, we expanded our network virtualization and management software offerings with the commercial launch of Blue Planet. Blue Planet is the latest implementation of the network virtualization and management software that we first introduced in 2009 to work in combination with our Z-Series platforms. This software has evolved to become a multi-vendor network orchestration platform supporting the deployment of both virtual and physical resources in carrier-grade networks. Blue Planet is available to customers regardless of whether they have deployed our Z-Series platforms in their networks. Customers may purchase Blue Planet using standard configurations to address common network needs or may customize their implementations by pairing the Blue Planet orchestration layer with their own selection of applications and element adapters. We offer Blue Planet on a variety of licensing models. Where we license Blue Planet on a term or on a software-as-a-service (SaaS) basis, we invoice customers for the entire contract amount at the start of the contract term. This leads to the majority of the invoiced amounts being treated as deferred revenue that will be recognized ratably over the term of the contract. We occasionally license software to customers on a perpetual basis with on-going support and maintenance services. Revenue from software that functions together with the tangible hardware elements necessary to deliver the tangible products' essential functionality is generally recognized upon shipment assuming all other revenue recognition criteria are met. Revenue from application software and related software elements which are not considered essential to the functionality of hardware is accounted for in accordance with software industry guidance, and therefore is recognized ratably over the longest 22 -------------------------------------------------------------------------------- service period for post-contract customer support and professional services as we have not established VSOE for software or the related software elements. CyNOC Professional Services Our CyNOC offering is a network operations center (NOC) service through which we monitor, and, in some cases, manage our customers' multi-vendor networks. Additionally, a number of our customers which maintain their own internal NOC leverage our services as a backup NOC. These services are typically sold to our customers for a one-year term at the time of the initial product sale and renewed on an annual basis thereafter. The revenue is recognized ratably over the one year term. Maintenance, Support, Training and Other Professional Services We offer professional services, including our CySupport and CyService offerings, to provide a variety of customer service products and support through our technical support engineers as well as through our growing network of authorized and certified channel partners. These services are sold to our customers at the time of the initial product sale, typically for one-year terms that customers may choose to renew for successive annual or multi-year periods. These services are invoiced separately at the time of the initial product sale and recognized ratably over the year term. We also provide training and other professional services to our end-customers, including services related to the implementation, use, functionality and ongoing maintenance of our products. These services are invoiced separately when the services are delivered and recognized as services are performed. Deferred Revenue Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue as of the period end, pending completion of the revenue recognition process. Our deferred revenue was $7.5 million and $19.1 million as of September 30, 2014 and December 31, 2013. As of December 31, 2013, the majority of our deferred revenue consists of amounts related to sales of our Z-Series platforms, principally to Independent Operating Companies, or IOCs, and other telecommunications network providers that used government-supported loan programs or grants to fund purchases from us, and primarily represents amounts related to shipped and billed hardware awaiting acceptance. As a result of decreased government stimulus programs for telecommunications infrastructure and the recognition in 2014 of deferred revenue from these transactions entered into in previous years, the deferred revenue balance related to such sales has declined during the nine months ended September 30, 2014. The remaining deferred revenue balance consists primarily of term license, support and maintenance revenue that is recognized ratably over the contractual service period. In most cases, we expect to invoice our customers for the entire contract amount at the start of the Blue Planet license term, which will lead to the majority of these invoiced amounts being treated as deferred revenue and recognized ratably over the term of the contract. As a result, over the longer term, we expect that the proportion of our deferred revenue relating to Blue Planet will increase relative to Z-Series related deferred revenue. Costs of Revenue Cost of revenue primarily consists of manufacturing costs of our products payable to our contract manufacturer. Our cost of revenue also includes third-party manufacturing and supply chain logistics costs, provisions for excess and obsolete inventory, warranty, hosting costs, certain allocated costs for facilities, depreciation and other expenses associated with logistics and quality control. Additionally, it includes salaries, benefits and stock-based compensation for personnel directly involved with manufacturing, installation, maintenance and support services. Gross Margin Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including product mix sold, large initial deployments as well as other factors including adjustments to warranty accrual, inventory obsolescence charges and the level of revenue experienced in any particular period. Large initial deployments typically involve a lower margin product mix, as initial deployments are generally comprised of thinly configured chassis. As our customers expand their networks after the initial deployments, they typically purchase additional higher-margin line cards. In the longer term, we expect Blue Planet revenue to represent a greater percent of overall revenue which will contribute to increases in gross margin. Our gross margins have in the past, and can be expected in the future to fluctuate from period-to-period. Operating Expenses 23 -------------------------------------------------------------------------------- Operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Personnel-related costs, including stock-based compensation, commission and bonus, are the most significant component of each of these expense categories. The increase in employees is the most significant driver behind the increase in operating expenses for the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. The timing and number of additional hires has and could materially affect our operating expenses, both in absolute dollars and as a percentage of revenue, in any particular period. Research and Development. Research and development expense consists primarily of personnel and consultant costs. Research and development expense also includes costs for prototypes, product certification, travel, depreciation, recruiting and allocated costs for certain facilities. Sales and Marketing. Sales and marketing expense consists primarily of personnel costs including commission costs. We expense commission costs as incurred. Sales and marketing expense also includes the costs of trade shows, marketing programs, promotional materials, demonstration equipment, travel, depreciation, recruiting and allocated costs for certain facilities. General and Administrative. General and administrative expense consists of personnel costs, professional services costs as well as allocated costs for certain facilities costs. General and administrative personnel include our executive, finance, human resources, IT and legal organizations. Professional services consist primarily of legal, auditing, accounting, and other consulting costs. Stock-Based Compensation Stock-based compensation expense was $2.7 million and $2.2 million for the three months ended September 30, 2014 and 2013. Stock-based compensation expense was $7.9 million and $5.1 million for the nine months ended September 30, 2014 and 2013. We expect to continue to incur significant stock-based compensation expense because we expect stock-based compensation to continue to play an important part in the overall compensation structure for our employees. Stock-based compensation included in the statements of operations data above was as follows (in thousands): Three Months Ended September 30, Nine months Ended September 30, 2014 2013 2014 2013 Cost of revenue $ 96 $ 61 $ 269 $ 121 Research and development 955 773 2,891 1,684 Sales and marketing 1,008 571 2,763 1,444 General and administrative 600 793 2,018 1,851 Total stock-based compensation $ 2,659 $ 2,198 $ 7,941 $ 5,100 Interest Expense Interest expense consists of interest on our notes payable as well as amortization of loan fees. Our loan facility consists of a revolving loan facility and a term loan facility governed by a Loan and Security Agreement with Silicon Valley Bank (SVB). Under the revolving loan facility, we may, from time to time, borrow up to $10.0 million due December 2014 at a floating annual interest rate equal to the greater of 3.25% or the prime rate. Under the term loan facility we may, from time to time, borrow up to $5.0 million due 48 months following an advance at an annual interest rate equal to the prime rate plus 0.5%, which floated through March 31, 2013 and is fixed thereafter. Borrowings under the loan facility are secured by a first-priority security interest in our assets, excluding our intellectual property and certain other assets. Borrowings under the loan facility are subject to our compliance with certain negative and affirmative covenants, including financial covenants, covenants relating to our ability to incur other indebtedness, our maintenance of depository accounts with SVB, our selling assets or entering into change of control transactions, liens on our assets and our ability to pay dividends to our stockholders. As of September 30, 2014 we had $3.8 million as term loans and no revolving loans outstanding under the agreement, and were in compliance with all covenants. Other Income (Expense), Net For periods prior to our initial public offering (IPO), other income (expense), net consists primarily of the change in fair value of our preferred stock warrant liability offset in part by interest income. Prior to the closing of our IPO in the second 24 -------------------------------------------------------------------------------- quarter of 2013, we re-measured the fair value of the preferred stock warrants at each balance sheet date. The fair value of the outstanding warrants was classified within current liabilities on the consolidated balance sheets, and any changes in fair value were recognized as a component of other income (expenses), net in the consolidated statements of operations. Upon the closing of the IPO, the preferred stock warrant liability was reclassified from current liabilities to additional paid-in capital. We performed the final re-measurement of the warrant in May 2013 in connection with completion of the IPO. For periods subsequent to our IPO, other income (expense), net consists primarily of interest income on our cash and marketable securities as well as foreign currency gains and losses. Provision for Income Taxes Our effective tax rate for the three and nine months ended September 30, 2014 and 2013 was less than one percent. Our effective tax rate for the three and nine months ended September 30, 2014 is consistent with the effective tax rate during the same periods of the prior year. The primary difference between the effective tax rate and the federal statutory tax rate relates to the valuation allowance on the Company's net deferred tax assets, foreign tax rate differences and permanent differences for non-deductible stock-based compensation expense. We record a valuation allowance to reduce our deferred tax assets to the amount we believe is more likely than not to be realized. Our corporate structure includes legal entities located in jurisdictions with income tax rates lower than the U.S. statutory tax rate. Our intercompany arrangements allocate income to such entities in accordance with arm's-length principles and commensurate with functions performed, risks assumed and ownership of corporate assets. This includes the manner in which we develop and use our intellectual property as well as the transfer pricing of intercompany transactions. We are subject to income tax audit in the US as well as numerous state and foreign jurisdictions. We recognize the tax benefit of an uncertain tax position only if it is more-likely-than-not that the position is sustainable upon examination by the taxing authority based on the technical merits. The tax benefit recognized is measured as the largest amount of benefit which is greater than 50 percent likely to be realized upon settlement with the taxing authority. We recognize interest accrued and penalties related to unrecognized tax benefits in the income tax provision. Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP). These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that these estimates and judgments are made. To the extent there are material differences between these estimates and actual results, our condensed consolidated financial statements could be adversely affected. The accounting policies that reflect our more significant estimates, judgments and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following: revenue recognition, lease receivables, inventory valuation, warranty, income taxes and stock-based compensation. Please refer to Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Form 10-K for a more complete discussion of our critical accounting policies and estimates including revenue recognition, lease receivables, inventory valuation, warranty, income taxes and stock-based compensation. Our critical accounting policies have been discussed with the Audit Committee of the Board of Directors. Events in 2014 required us to make additions to the accounting policies for stock-based compensation and liquidity as disclosed in the notes to condensed consolidated financial statements. There have been no other changes in the significant accounting policies as described in the audited consolidated financial statements for 2013 included in the Annual Report. 25 -------------------------------------------------------------------------------- Results of Operations Revenue Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 (dollars in thousands) (dollars in thousands) Revenue $ 26,599 $ 37,694 $ 70,029 $ 95,699 Revenue decreased by $11.1 million or 29%, and $25.7 million or 27%, for the three and nine months ended September 30, 2014 from the three and nine months ended September 30, 2013. The declines were primarily due to substantial decreases in revenue from our largest customer and our inability to offset those declines with increases in revenue from other customers. Our largest customer represented 21% and 50% of revenue for the three months ended September 30, 2014 and 2013, respectively and represented 19% and 45% of revenue for the nine months ended September 30, 2014 and 2013, respectively. Approximately 26% and 13% of our revenue for the three months ended September 30, 2014 and 2013 and approximately 23% and 7% of our revenue for the nine months ended September 30, 2014 and 2013 was attributable to customers located outside the United States. International revenue has increased across these periods as we have begun to see momentum in both customer engagement and market penetration translate into increased revenue from our international customers. We expect international revenue to increase in dollar amount over the longer term and to fluctuate as a percent of total revenue from quarter to quarter depending on the level of domestic revenue. Cost of Revenue, Gross Profit and Gross Margin Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 (dollars in thousands) (dollars in thousands)Cost of revenue $ 15,684 $ 22,605 $ 41,567 $ 55,943 Gross profit $ 10,915 $ 15,089 $ 28,462 $ 39,756 Gross margin 41.0 % 40.0 % 40.6 % 41.5 % Cost of revenue decreased by $6.9 million or 31%, and $14.4 million or 26% for the three and nine months ended September 30, 2014 from the three and nine months ended September 30, 2013 corresponding to the decreased revenue. Gross profit decreased by $4.2 million or 28%, and 11.3 million or 28%, for the three and nine months ended September 30, 2014 from the three and nine months ended September 30, 2013, corresponding to the decreased revenue. Gross margin increased by 1.0%, from 40.0% to 41.0%, for the three months ended September 30, 2014 compared to the prior year period. The increase in gross margin is due to an increase in customer contribution margin. Gross margin decreased by 0.9%, from 41.5% to 40.6% for the nine months ended September 30, 2014 compared to the prior period primarily due to fixed manufacturing operations expenses, which are relatively flat between periods despite lower revenue in 2014. We anticipate our gross margins to fluctuate from quarter to quarter depending on the product mix sold, large initial deployments as well as other factors including provisions for warranty, inventory excess and obsolescence charges and the level of revenue experienced in any particular period. Research and Development Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 (dollars in thousands) (dollars in thousands)Research and development $ 8,856 $ 9,220 $ 27,948 $ 24,617 Percent of total revenue 33.3 % 24.5 % 39.9 % 25.7 % Research and development expense decreased by $0.4 million, or 4%, from the three months ended September 30, 2013 to the three months ended September 30, 2014. The decrease were primarily due to a decrease of $0.2 million in professional fees and product certification charges and a $0.2 million decrease in expenses for prototypes and lab supplies due to timing of the Company's engineering cycle. 26 -------------------------------------------------------------------------------- Research and development expense increased by $3.3 million, or 14%, from the nine months ended September 30, 2013 to the nine months ended September 30, 2014. These increases were primarily due to increases in personnel-related costs of $2.8 million, including $1.2 million increase in stock-based compensation, resulting from an increase in research and development personnel of five from September 30, 2013 to September 30, 2014 representing an increase of 4% in research and development personnel. Additional components of the increase include increased depreciation of $0.6 million. In the near term, we expect our research and development expenses to be somewhat lower and to fluctuate somewhat from quarter to quarter as a percent of revenue. Sales and Marketing Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 (dollars in thousands) (dollars in thousands) Sales and marketing $ 10,515 $ 10,518 $ 32,875 $ 29,356 Percent of total revenue 39.5 % 27.9 % 46.9 % 30.7 % Sales and marketing expense were flat from the three months ended September 30, 2013 to the three months ended September 30, 2014. Sales and marketing expenses increased by $3.5 million, or 12%, from the nine months ended September 30, 2013 to the nine months ended September 30, 2014. The increase for the nine months ended September 30, 2014 were primarily due to increases in personnel-related expenses of $4.5 million, including a $1.3 million increase in stock-based compensation, due to the expansion of our sales force. We increased our sales and marketing headcount by 8 from September 30, 2013 to September 30, 2014 representing an increase of 7% in sales and marketing personnel. The increase in personnel costs were partially offset by decreases in consulting and professional fees. In the near term, we expect our sales and marketing expenses to be somewhat lower and fluctuate somewhat from quarter to quarter as a percent of revenue. General and Administrative Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 (dollars in thousands) (dollars in thousands)General and administrative $ 3,531 $ 3,895 $ 11,805 $ 9,853 Percent of total revenue 13.3 % 10.3 % 16.9 % 10.3 % General and administrative expense decreased by $0.4 million, or 9%, from the three months ended September 30, 2013 to the three months ended September 30, 2014. The decrease was primarily due to decreases in personnel related expenses of $0.4 million, including $0.2 million decrease in stock based compensation. General and administrative expense increased by $2.0 million, or 20%, from the nine months ended September 30, 2013 to the nine months ended September 30, 2014. The increase was primarily due to a $1.2 million increase in accounting, legal, and outside services expenses required to support our public company reporting obligations. Additional components of the increase included personnel-related expenses of $0.5 million including a $0.2 million increase in stock-based compensation. We expect our general and administrative expenses to be somewhat lower and fluctuate somewhat from quarter to quarter as a percent of revenue. Interest Expense Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 (dollars in thousands) (dollars in thousands)Interest expense $ (45 ) $ (55 ) $ (134 ) $ (317 ) Interest expense for the three and nine months ended September 30, 2014 relates to obligations under our term loan. Interest expense for the three and nine months ended September 30, 2013 relates to obligations under our term loan and 27 -------------------------------------------------------------------------------- revolving loan. As of September 30, 2014 and December 31, 2013 the Company had $3.8 million and $5.0 million as term loans and no revolving loans outstanding. Other Income (Expense), Net Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 (dollars in thousands) (dollars in thousands) Interest Income $ 48 $ 17 $ 152 $ 24 Preferred stock warrant liabilities - - - (2,602 ) Foreign currency gain (loss) 389 (4 ) 245 (17 ) Other (29 ) - (100 ) - Other Income (expense), net $ 408 $ 13 $ 297 $ (2,595 ) Other income (expense), net increased to $0.4 million during the quarter ended September 30, 2014, up from $13 thousand in the same quarter in 2013. For the nine month period ended September 30, we reported other income of $0.3 million in 2014 compared to an other expense of $2.6 million in 2013. The difference for the nine months ended was primarily due to the absence in the 2014 period of charges associated with the previously outstanding preferred stock warrants as well as a $0.2 million gain on foreign currency in the nine months ended September 30, 2014. Upon completion of the IPO in May 2013, the preferred stock warrant liability was reclassified to additional paid-in capital. The increase in the three months ended September 30, 2014 was due a $0.4 million gain from foreign currency transactions. Liquidity and Capital Resources We require a significant amount of cash resources to operate our business. We used approximately $35.2 million of cash, cash equivalents and marketable securities in the nine months ended September 30, 2014 including $30.4 million used in operating activities. We ended the quarter with cash, cash equivalents and marketable securities of $28.9 million. Our liquidity is affected by many factors including, among others, fluctuations in revenue, gross profits and operating expenses, as well as changes in operating assets and liabilities. At forecasted levels of revenue, expenses and capital expenditures, we believe that our existing cash, cash equivalents and marketable securities, together with our cash collections will be sufficient to meet our projected operating and capital expenditure requirements through the first quarter of 2015. However, further softening in the demand for our products and services may result in higher than anticipated losses in the future and lower our cash balances at a faster rate. We are exploring options to raise additional funds through public or private equity or debt financing to extend that period. Should additional funding not be available, or should funding only be available on unfavorable terms, we would be required to make changes to our operating expense levels and capital expenditures to extend that period and would likely need to significantly reduce our business activities which could adversely affect our ability to compete effectively in the markets in which we participate which could, in turn, adversely affect our results of operations. If we issue equity securities in order to raise additional funds, substantial dilution to existing stockholders may occur. If we raise cash through additional indebtedness, we may be subject to additional contractual restrictions on our business. Cash and cash equivalents consist of cash and money market funds. Marketable securities, which were held as available for sale at September 30, 2014, consist of U.S. treasury securities, U.S. government-sponsored agency securities, commercial paper, corporate bonds and municipal bonds. The fair value of marketable securities is determined as the exit price in the principal market in which we would transact. The fair value of our marketable securities has not materially fluctuated from amortized cost. Generally, our marketable securities have contractual maturity dates up to two years from our date of purchase and active markets for these securities exist. We classify our available-for-sale marketable securities as short-term marketable securities in our consolidated balance sheet based on management's intention to have the funds available for use in operations or strategic investments rather than actual maturity dates. During the year ended December 31, 2013 we provided lease arrangements for one qualified end-user customer. We classify these arrangements as lease receivables, which represent sales-type leases resulting from the sale of our products. Lease receivables consist of arrangements with this customer and generally have three-year terms. As of September 30, 2014 and December 31, 2013 we had zero and $0.6 million of lease receivables. In the three months ended March 31, 2014 this lease receivable was paid off by the customer for cash proceeds of $0.6 million. Pursuant to this, the Company retained no substantial risk of default by the lessee nor provided any guarantee of residual value of the underlying leased equipment, except 28 -------------------------------------------------------------------------------- for standard product warranty which is provided in the normal course of business. Consequently, the Company has met the requirements for derecognition of the related lease receivables. From our inception through our initial public offering in May 2013, we financed our operations and capital expenditures primarily through private sales of redeemable convertible preferred stock for aggregate net proceeds of $98.1 million, as well as through a commercial credit facility and capital leases. In May 2013 we completed our initial public offering, generating net proceeds of $87.2 million. On December 21, 2012, we entered into a Loan and Security Agreement with Silicon Valley Bank. The agreement provides a revolving loan facility of up to $10.0 million and a term loan facility of up to $5.0 million, for a total loan facility of up to $15.0 million. Loans drawn under the Loan and Security Agreement will be used for working capital and general corporate purposes. As of September 30, 2014 and December 31, 2013 we had $3.8 million and $5.0 million as term loans outstanding. Revolving loans bear interest at a floating rate equal to the greater of (i) 3.25% or (ii) the prime rate (3.25% as of September 30, 2014). For the first 12 months following each term loan advance, each term loan advance bears interest at a floating rate equal to the prime rate, plus 0.50%. On the date following such 12 month period and thereafter, each term loan advance bears interest at a fixed rate equal to the prime rate on the date following such 12 month period, plus 0.50%. 29--------------------------------------------------------------------------------The following table summarizes our cash flows (in thousands): Nine months ended Nine months ended September 30, 2014 September 30, 2013 Net cash used in operations $ (30,369 ) $ (19,265 ) Net cash provided by (used in) investing activities 12,564 (28,590 ) Net cash provided by (used in) financing activities (1,359 ) 80,994 Effect of exchange rates on cash (363 ) 8 Net increase (decrease) in cash and cash equivalents $ (19,527 ) $ 33,147 Operating Activities In the nine months ended September 30, 2014 we used cash in operations of $30.4 million. Cash used in operations resulted from a net loss of $44.2 million, which was partially offset by $7.9 million in non-cash stock-based compensation and $2.7 million of depreciation and amortization as well as a $8.3 million decrease in our inventory balance as we were successful in our efforts to better utilize our inventory to fulfill our sales volume in the second and third quarter of 2014. This was offset by a decrease in deferred revenue of $11.6 million, partially offset by a decrease in deferred costs of $7.4 million. The decreases in deferred revenue and deferred costs primarily relate to acceptance being received from customers with contracts under federal broadband stimulus programs. We used cash in operations of $19.3 million for the nine months ended September 30, 2013, primarily as a result of a net loss of $27.0 million which was partially offset by $5.1 million of stock-based compensation, $2.6 million related to the revaluation of preferred stock warrants and $2.0 million in non-cash depreciation and amortization. In addition, we experienced increases in a majority of our working capital accounts, primarily due to significant increases in our operations as a result of growth in the business. Lease receivables increased by $9.8 million due to lease arrangements provided to one qualified end-user customer. This was offset by an increase in deferred revenue of $3.4 million, partially offset by an increase in deferred costs of $1.0 million related to such deferred revenue. The increases in deferred revenue and deferred costs primarily relate to shipped and billed hardware awaiting formal acceptance from customers with contracts under federal broadband stimulus programs. In addition, accounts payable and accrued liabilities increased approximately $5.7 million, primarily as a result of significant inventory purchases and timing of payments of invoices from our contract manufacturer. Additionally, accrued compensation increased by $2.0 million as we increased total headcount. Investing Activities Cash provided by investing activities primarily relates to purchases, maturities and sales of marketable securities as well as capital expenditures, such as purchases of lab equipment, tooling and computer hardware to support our business. Cash provided by investing activities in the nine months ended September 30, 2014 was $12.6 million and primarily related to $15.7 million net proceeds from the purchase, maturity and sale of marketable securities, partially offset by capital expenditures of $3.1 million. Marketable securities consist of U.S. treasury securities, U.S. government-sponsored agency securities, commercial paper, corporate bonds and municipal bonds. Generally, our marketable securities have maturity dates up to two years from our date of purchase, and active markets for these securities exist. We used $28.6 million in cash for investing activities in the nine months ended September 30, 2013, primarily related to the purchase of marketable securities of $23.7 million as well as capital expenditures of $4.4 million. Financing Activities Cash used in financing activities for the nine months ended September 30, 2014 was $1.4 million. This included $1.2 million in repayments of borrowings under our term loan and $0.6 million of taxes paid related to net-share settlement of restricted stock units. These were partially offset by $0.5 million in proceeds from the exercise of stock options. Cash provided by financing activities for the nine months ended September 30, 2013, was $81.0 million. In May 2013, we completed our initial public offering which generated aggregate net proceeds of $87.4 million, net of underwriting discounts and commissions and offering costs. This was partially offset by the repayment of $7.6 million outstanding under our revolving loan facility. Additionally, we received $1.2 million proceeds from the exercise of stock options and preferred stock warrants during the nine months ended September 30, 2013. 30 -------------------------------------------------------------------------------- Guaranties, Warranties and Indemnifications We generally offer hardware warranties on our products for one to eight years based on a tiered structure as determined by the type of customer. In accordance with the Financial Accounting Standards Board's, or FASB's, Accounting Standards Codification, or ASC 450-20, Loss Contingencies, we record an accrual for expected warranty based on historical experience. We record a provision for estimated future warranty work in cost of goods sold upon recognition of revenue and we review the resulting accrual regularly and periodically adjust it to reflect changes in warranty estimates. From time to time, we enter into certain types of contracts that contingently require us to indemnify various parties against claims from third parties. These contracts primarily relate to (i) certain real estate leases, under which we may be required to indemnify property owners for environmental and other liabilities, and other claims arising from our use of the applicable premises; (ii) certain agreements with our officers, directors, and employees, under which we be required to indemnify such persons for liabilities arising out of their relationship with us; (iii) contracts under which we may be required to indemnify customers against third-party claims that our product infringes a patent, copyright, or other intellectual property right; and (iv) procurement or license agreements, under which we may be required to indemnify licensors or vendors for certain claims that may be brought against us arising from our acts or omissions with respect to the supplied products or technology. Generally, a maximum obligation under these contracts is not explicitly stated. Because the obligated amounts associated with these types of agreements are not explicitly stated, the overall maximum amount of the obligation cannot be reasonably estimated. Historically, we have not been required to make any payments under these obligations, and no liabilities have been recorded for these obligations in our consolidated balance sheets. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements as defined in Item 303 of SEC Regulation S-K and we do not have any holdings in variable interest entities. Contractual Obligations and Commitments In July, 2013 we entered into a commercial building lease agreement for additional space in Petaluma, California. The July 2013 lease has a 10 year term, estimated to commence in the first quarter of 2015 and provides for the lease by the Company of 20,005 square feet, going to 38,778 square feet in 2015. Base rent is initially set at $46,012 per month and increases to $91,904 per month when the additional space is occupied. Total base rent payable over the ten year lease period is $11.5 million. We have an option to extend the term of the lease for an additional five year period. Item 3. Quantitative and Qualitative Disclosures About Market Risk We are exposed to market risks in the ordinary course of our business, primarily related to interest rate, inflation and foreign currency risks. We also are exposed to risks relating to changes in the general economic conditions that affect our business. To reduce certain of these risks, we monitor the financial condition of our customers and manage our contract manufacturer and suppliers. In addition, our investment strategy has been to invest in cash, cash equivalents and marketable securities. To date, we have not used derivative instruments to mitigate any market risk exposures. We have not used, nor do we intend to use, derivatives for trading or speculative purposes. We do not believe that these risks have been material to date. We are exposed to market risk related to changes in interest rates. We had cash and cash equivalents of $13.0 million at September 30, 2014. Cash and cash equivalents consist of cash and money market funds. Additionally, we had marketable securities of $15.9 million at September 30, 2014. Marketable securities consist of U.S treasury securities, U.S. government-sponsored agency securities, municipal bonds, corporate bonds and commercial paper. The primary objectives of our investment activities are the preservation of capital, the fulfillment of liquidity needs and the fiduciary control of cash, cash equivalents and marketable securities. We do not enter into marketable securities for trading or speculative purposes. Our marketable securities are exposed to market risk due to a fluctuation in interest rates, which may affect our interest income and the fair market value of our marketable securities. In addition, as of September 30, 2014 we had $3.8 million as term loans outstanding under our Loan and Security Agreement with SVB. Due to the short-term nature of our marketable securities portfolio and our outstanding loan amount, we believe that only dramatic fluctuations in interest rates would have a material effect on us. As a result, we do not expect our operating results or cash flows to be materially affected by a sudden change in market interest rates. We do not believe that inflation has had a material effect on our business, financial condition or results of operations. However, if our costs, in particular salaries and manufacturing costs were to become subject to significant inflationary 31 -------------------------------------------------------------------------------- pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, operating results and financial condition. Historically, as our operations and sales, including all of our manufacturing, have been primarily in the United States, we have not faced any significant foreign currency risk. As our international operations grow, our risks associated with fluctuation in currency rates will become greater, and we will continue to reassess our approach to managing this risk. In addition, currency fluctuations or a weakening U.S. dollar can increase the costs of our international expansion efforts. Our risks are somewhat mitigated by the fact that all our foreign sales to date have been denominated in U.S. dollars. Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures Our management has evaluated, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act) as of September 30, 2014. Based on their evaluation as of September 30, 2014 our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective at the reasonable assurance level to ensure that the information required to be disclosed by us on this Form 10-Q was (i) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and regulations and (ii) accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. Changes in Internal Control Over Financial Reporting Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during our most recently completed fiscal quarter. Based on that evaluation, our principal executive officer and principal financial officer concluded that there has not been any material change in our internal control over financial reporting during the quarter covered by this report that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. |