[August 15, 2011] DIALOGIC INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Tweet (Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis should be read in conjunction with our Condensed Consolidated Financial Statements and Notes thereto included in Part 1, Item 1 of this Quarterly Report on Form 10-Q and our Consolidated Financial Statements and Notes thereto for the year ended December 31, 2010, in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 31, 2011. The discussion in this Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, including, but not limited to, statements of our future financial operating results, future expectations concerning cash and cash equivalents available to us, our business strategy, including whether we can successfully develop new products and the degree to which these gain market acceptance, revenue estimations, plans, objectives, expectations and intentions. In some cases, you can identify forward-looking statements by terms such as "anticipates," "believes," "could," "estimates," "expects," "intends," "may," "plans," "potential," "predicts," "projects," "should," "will," "would" and similar expressions intended to identify forward-looking statements. Forward-looking statements reflect our current views with respect to future events are based on assumptions and are subject to risks, uncertainties and other important factors. Our actual results could differ materially from those discussed here. See "Risk Factors" in Item 1A of Part II for factors that could cause future results to differ materially from any results expressed or implied by these forward-looking statements. Given these risks, uncertainties and other important factors, you should not place undue reliance on these forward-looking statements, which speak only as of the date hereof. Except as required by law, we assume no obligation to update any forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in any forward-looking statements, even if new information becomes available in the future. Overview Dialogic Inc. ("Dialogic" or "Company") is a leading provider of communications platforms and technology that enable developers and service providers to build and deploy innovative applications without concern for the complexities of the communication medium or network. The Company provides reliable, cost-effective and secure communications solutions that enable enterprises and service providers to shift to Internet Protocol ("IP") based communications while still maintaining existing Time Division Multiplexing ("TDM") networks. Additionally, the Company provides multimedia engines for video, voice, conferencing and facsimile solutions. Enterprises rely on the Company's innovative IP, transitional hybrid and flexible TDM boards, software and gateway products to enable the integration of new IP technologies into existing communications networks. Representative applications that are enabled by the Company's technology include: Unified Communications/Unified Messaging, Short Message Service ("SMS")/Video SMS, Mobile Video Messaging, Voicemail/Videomail, interactive voice response and interactive voice and video response solutions, and Audio and Video Conferencing. The Company also provides voice infrastructure solutions for established and emerging wireline and wireless service providers. Service providers use the Company's products to transport, convert and manage data and voice traffic over both TDM and IP networks while enabling Voice Over Internet Protocol and other multimedia services. The Company sells into the enterprise and service provider communications market both directly and indirectly through distribution partners such as telecommunications equipment vendors, value added resellers ("VARs") and other channel partners. Business Combination with Dialogic Corporation On October 1, 2010, we completed our business combination with Dialogic Corporation, a British Columbia Corporation, in accordance with the terms of an acquisition agreement dated May 12, 2010, or the Acquisition Agreement. Pursuant to the Acquisition Agreement, we acquired all of Dialogic Corporation's outstanding common and preferred shares in exchange for an aggregate of approximately 22.1 million shares of our common stock, after giving effect to the stock split described below and, accordingly Dialogic Corporation became our wholly-owned subsidiary. All outstanding options to purchase Dialogic Corporation common shares were cancelled and new options to purchase our common stock were granted. Each option to purchase Dialogic Corporation common shares became an option to acquire that number of shares of our common stock equal to the product obtained by multiplying the number of shares in the capital of Dialogic Corporation subject to the option by 0.9, rounded down to the nearest whole share of our common stock. Each option to purchase our common shares has a purchase price per share of our common stock equal to the exercise price per share (in U.S. dollars) for the Dialogic Corporation option immediately prior to October 1, 2010 divided by 0.9, rounded up to the nearest whole cent. After taking into account the issuance of stock options to purchase our common stock in exchange for Dialogic Corporation options, as of October 1, 2010, the former Dialogic Corporation shareholders and option holders held approximately 70% and our existing stockholders held approximately 30% of our outstanding securities. As of October 1, 2010, there were approximately 31 million shares of our common stock issued and outstanding, after taking into account the effect of the one-for-five reverse stock split approved by the our stockholders on September 30, 2010 and effected on October 1, 2010. As of October 1, 2010, we changed our name from Veraz Networks, Inc. to Dialogic Inc. and on October 4, 2010, our common stock began trading on The NASDAQ Global Market under the symbol "DLGC". Our business combination with Dialogic Corporation was accounted for as a reverse acquisition under the purchase method of accounting whereby Dialogic Corporation was considered the accounting acquirer in accordance with U.S. generally accepted accounting principles or U.S. GAAP. 27-------------------------------------------------------------------------------- Table of Contents All common stock share and per share data presented have been retroactively restated to give effect to the reverse stock split. Also, all common stock and per share data reflects the legal capital of the former Veraz Networks, Inc. retroactively adjusted for the exchange ratios in the Acquisition Agreement to reflect the number of shares received in the business combination. Critical Accounting Policies and Estimates Management's discussion and analysis of our financial position and results of operations is based upon the consolidated financial statements, which have been prepared in accordance with U.S. GAAP pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. We base our estimates on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. If actual results differ significantly from management's estimates and projections, there could be a material effect on our financial statements. The accounting policies that we believe are the most critical to aid in fully understanding and evaluating our reported financial results, and which required the most subjective judgment by us, are the following: • Revenue Recognition; • Accounts Receivable and Allowance for Doubtful Accounts; • Inventory Reserves; • Impairment of Long-Lived Assets and Goodwill; • Stock-Based Compensation; • Accounting for Income Taxes; and • Business Combinations. Revenue Recognition Revenue derived from the sale of products and services is recognized when all of the following criteria are met: (i) Persuasive evidence of an arrangement exists-Our customary practice is to have a written contract, which is signed by both thecustomer and us, or a purchase order or other written or electronic order documentation for those customers who have previously negotiated a standard arrangement with us. (ii) Delivery has occurred-Delivery of hardware and software products generally occurs at the point of shipment when title and risk of loss have passed to the customer. However, some arrangements require evidence of customer acceptance of the hardware and software products that have been sold. In such cases, delivery of the software, hardware and services is not considered to have occurred until evidence of acceptance is received from the customer or we have completed our contractual requirements. Revenue from sales of standalone services, including training courses, is recognized when the services are completed. In certain arrangements involving subsequent sales of hardware and software products to expand a customers' networks, the revenue recognition on these arrangements, after the initial arrangement has been accepted, typically occurs at the point of shipment since we have historically experienced successful implementations of these expansions. (iii) The fee is fixed or determinable-We sell its products through our direct sales force and channel partners. In certain cases where the sales price cannot be reliably determined due to frequent sales price reductions, or when sales are made to distributors under agreements allowing price protection and/or right of return and when returns cannot be estimated, the related fee is considered to be not fixed or determinable and revenue is deferred until such pricereduction or return rights cease. Arrangement fees are generally due within one year or less from date of acceptance, or the date of delivery if no acceptance. Some arrangements may have payment terms extending beyond these customary payment terms and therefore the arrangement fees may be considered not to be fixed or determinable. For multiple element arrangements with payment terms that are considered not to be fixed or determinable, revenue is recognized as payments become due, based on relative selling price, after delivery and acceptance of the software, hardware, and services, and assuming all other revenue recognition criteria are satisfied. For arrangements with contingent revenue provisions (a portion of the relative selling price of a delivered item is contingent upon the delivery of additional items or meeting other specified performance conditions), revenue recognized on delivered items is limited to the non-contingent amount. We defer the cost of inventory when products have been shipped, but have not yet been installed or accepted, and expense those costs in full in the same period that the 28-------------------------------------------------------------------------------- Table of Contents deferred revenue is recognized as revenue (generally upon customer acceptance). In arrangements for which revenue recognition is limited to amounts due or non-contingent amounts, all related inventory costs are expensed at the date of acceptance; this will initially result in lower or negative product margins and cause higher margins in subsequent periods, as compared to similar arrangements with customary payment terms. (iv) Collectability is probable-Collectability is assessed on a customer-by-customer basis. We evaluate the financial position, payment history, and ability to pay of new customers, and of existing customers that substantially expand their commitments. If it is determined prior to revenue recognition that collectability is not probable, recognition of the revenue is deferred and recognized upon receipt of cash, assuming all other revenue recognitioncriteria are satisfied. In arrangements for which revenue recognition is limited to amounts of cash received because of collectability concerns, all related inventory costs are expensed at the date of acceptance or delivery if no acceptance is required; this will initially result in lower or negative product margins and cause higher margins in subsequent periods, as compared to similar arrangements with customary payment terms. Revenue received from maintenance contracts is presented as deferred revenue and is recognized into revenue on a straight-line basis over the term of the contract. License fee revenue is recognized upon delivery of the license or software and when all performance criteria are met. Revenue derived from the sale of products is generally recognized when title and risk of loss has been transferred to the customer. In addition, product, maintenance contract and license fee revenues are recognized when persuasive evidence of an arrangement exists, amounts are fixed or can be determined, and ability to collect is probable. Sales incentives that are offered on some of our products are recorded as a reduction of revenue as there are no identifiable benefits received. We record a provision for estimated sales returns and allowances as a reduction from sales in the same period during which the related revenue is recorded. These estimates are based on historical sales returns and allowances, analysis of credit memo data and other known factors. Sales returns and allowances are estimates based on historical sales returns and allowances, analysis of credit memo data, analysis of customer credit worthiness and other known factors. We also have agreements with certain distributors which allow for stock rotation rights. The stock rotation rights permit the distributors to return a defined percentage of their purchases in exchange for orders of an equal or greater amount. We recognize an allowance for stock rotation rights based on historical experience. The provision is recorded as a reduction in revenues in the consolidated statement of operations. Revenues are recognized net of sales taxes. Revenues include amounts billed to customers for shipping and handling. Shipping and handling fees represented less than 1% of revenues in each of the six months ended June 30, 2011 and 2010. Shipping and handling costs are included in cost of revenues. In October 2009, the Financial Accounting Standards Board ("FASB") amended the accounting standards for revenue recognition to remove tangible products containing software components and non-software components that function together to deliver the product's essential functionality from the scope of industry specific software revenue recognition guidance. In October 2009, the FASB also amended the standards for multiple deliverable revenue arrangements to: (i) provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and how the arrangement consideration should be allocated among its elements; (ii) require an entity to allocate revenue where no vendor specific objective evidence, or VSOE, exists by using third partyevidence of selling price, or TPE, or estimated selling prices, or ESP; and (iii) eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method. This new accounting guidance became applicable to us beginning the first quarter of its fiscal year 2011. We adopted this guidance for transactions that were entered into or materially modified on or after January 1, 2011 using the prospective basis of adoption. Our products typically have both software and non-software components that function together to deliver the products' essential functionality. Although our products are primarily marketed based on the software elements contained therein, the hardware sold generally cannot be used apart from the software. Therefore, we consider our principal hardware products to be subject to this new accounting guidance. Many of our sales involve multiple-element arrangements that include product, maintenance and various professional services. The adoption of the guidance discussed above affects our multiple-element arrangements when they contain tangible products (hardware) with software elements, which comprise the majority of our revenue transactions. We may enter into sales transactions that do not contain tangible hardware components, such as software-only add-on sales, which will continue to be subject to the previous software revenue recognition guidance in ASC 985-605. The multiple-deliverable revenue guidance requires that we evaluate each deliverable in an arrangement to determine whether such deliverable would represent a separate unit of accounting. The delivered item constitutes a separate unit of accounting when it has stand-alone value and there are no customer-negotiated refunds or return rights for the delivered elements. If the arrangement includes a customer-negotiated refund or return right relative to 29-------------------------------------------------------------------------------- Table of Contents the delivered item and the delivery and performance of the undelivered item are considered probable and substantially in our control, the delivered element constitutes a separate unit of accounting. In instances when the aforementioned criteria are not met, the deliverable is combined with the undelivered elements and revenue recognition is determined for the combination as a single unit of accounting. Most of our products and services qualify as separate units of accounting and revenue is recognized when the applicable revenue recognition criteria are met. The total arrangement fees are allocated to all the deliverables based on their respective relative selling prices. The relative selling price is determined using VSOE, when available. We generally use VSOE to derive the selling price for its maintenance and professional services deliverables. VSOE for maintenance is based on contractual stated renewal rates while professional services are based on historical pricing for standalone professional service transactions. When VSOE cannot be established, we attempt to determine the TPE for the deliverables. TPE is determined based on competitor prices for similar deliverables when sold separately by the competitors. Generally our product offerings differ from those of our competitors and comparable pricing of our competitors is often not available. Therefore, we are typically not able to determine TPE. When we are unable to establish selling price using VSOE or TPE, we use ESP in our allocation of arrangement fees. The ESP for a deliverable is determined as the price at which we would transact if the products or services were sold on a standalone basis. The ESP for each deliverable is determined using average historical discounted selling price based on several factors, including but not limited to, marketing strategy, customer considerations and pricing practices in a region. We use ESP to derive the relative selling price for our product deliverables. The impact of applying the relative selling price method in the allocation of revenue, compared to previous revenue recognition methodologies, increased revenues for the three and six months ended June 30, 2011 by approximately $2.1 million. In terms of the timing and pattern of revenue recognition, the new accounting guidance for revenue recognition is not expected to have a significant effect on revenues in periods after the initial adoption when applied to multiple element arrangements. However, as our marketing and product strategies evolve, we may modify our pricing practices in the future, which could result in changes in selling prices, including both VSOE and ESP which could impact future revenues. For transactions entered into prior to the first quarter of fiscal year 2011, we recognized revenue based on the software revenue recognition guidance in place during the period in which the order was received. When an arrangement involved multiple elements, such as hardware and software products, maintenance and/or professional services, we allocated the entire sales price to each respective element based on VSOE of the fair value for each element. When arrangements contained multiple elements and VSOE of fair value existed for all undelivered elements but not for the delivered elements, we recognized revenue for the delivered elements using the residual method. We based our determination of VSOE of the fair value of the undelivered elements based on substantive renewal rates of maintenance and support agreements, and on independently sold and negotiated service arrangements. In limited circumstances when arrangements containing multiple elements where VSOE of fair value did not exist for an undelivered element, we deferred revenue for the delivered and undelivered elements until VSOE of fair value existed for the undelivered elements or all elements had been delivered. Accounts Receivable and Allowance for Doubtful Accounts Generally, our receivables are recorded when billed and represent claims against third parties that will be settled in cash. The carrying value of the receivables, net of the allowance for doubtful accounts, represents their estimated net realizable value. We maintain an allowance for doubtful accounts for estimated losses inherent in our accounts receivable portfolio. In establishing the required allowance, management considers historical losses, current receivable aging and evaluates individual customer receivables by considering our knowledge of a customer's financial condition, credit history and current economic conditions. We write off trade receivables when they are deemed uncollectible. We review our allowance for doubtful accounts regularly. However, judgment is required to determine whether an increase or reversal of the allowance is warranted. We will record an increase of the allowance if there is a deterioration in past due balances, if economic conditions are less favorable than we had anticipated, or for customer-specific circumstances, such as bankruptcy. We will record a reversal of the allowance if there is significant improvement in collection rates. Historically, the allowance has been adequate to cover the actual losses from uncollectible accounts. Inventory Reserves Inventories are stated at the lower of cost or market, with cost being determined using the first-in, first-out method. In assessing the net realizable value of inventories, we are required to make judgments as to future demand requirements and compare these with the current or committed inventory levels. Once our inventory has been written down to its estimated net realizable value, our carrying value cannot be increased due to subsequent changes in demand forecasts. To the extent that a severe decline in forecasted demand occurs, or we experience a higher incidence of inventory obsolescence due to rapidly changing technology and customer requirements, we may incur significant charges for excess inventory. 30 -------------------------------------------------------------------------------- Table of Contents Impairment of Long-lived Assets and Goodwill Long-lived assets, such as property and equipment, and amortizable intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposal group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. Intangible assets with indefinite useful lives are not amortized and are tested for impairment annually, or more frequently, if events or changes in circumstances indicate that the asset may be impaired. The impairment test compares the carrying amount of the intangible asset with its fair value, and an impairment loss is recognized for the excess, if any. The impairment testing is performed during the last quarter of the fiscal year. Goodwill represents the excess of the purchase price over the fair value of the net assets acquired in a business acquisition. Goodwill is not subject to amortization and is tested for impairment annually or more frequently if events or circumstances indicate that the asset might be impaired. Impairment is identified by comparing the fair value of the reporting unit to which the goodwill relates to its carrying value. To the extent the carrying amount exceeds its fair value, we measure the amount of impairment by the excess of carrying value over the implied fair value of goodwill. The impairment is charged to income in the period in which it is determined. The impairment testing is performed during the last quarter of the fiscal year. Considerable judgment is required to estimate discounted future operating cash flows. Judgment is also required in determining whether an event has occurred that may impair the value of intangible assets, long-lived assets and goodwill. Factors that could indicate an impairment may exist include significant underperformance relative to plan or long-term projections, changes in business strategy, significant negative industry or economic trends and a significant change in circumstances relative to a large customer. We must make assumptions about future cash flows, future operating plans, discount rates and other factors in the models and valuation reports. To the extent these future projections and estimates change, the estimated amounts of impairment could differ from current estimates. Our annual testing for impairment of goodwill and intangible assets with indefinite useful lives for 2010 and 2009 indicated that no impairment of goodwill or the intangibles existed. Stock-Based Compensation We use a generally accepted valuation option-pricing model to determine the fair value of stock options granted to our employees. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. Our valuation models require the input of highly subjective assumptions, which represents our best estimate. The following are the key assumptions used to determine the stock-based compensation expense: • Expected Stock Price Volatility-The computation of expected volatility is based on the historical and implied volatility of comparable companies from a representative peer group based on such factors as industry and market capitalization data. • Expected Term of Option-The expected term was determined using the simplified method. • Expected Dividend Yield-The dividend yield assumption is based on our history and expectation of dividend payouts. We use a dividend yield of zero, as we have never paid cash dividends and do not expect to pay dividends in the future. • Expected Risk Free Interest Rate-The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for the expected term of the option. • Forfeiture Rate-The forfeiture rate is based on a review of recent forfeiture activity. Accounting for Income Taxes We account for income taxes using the asset and liability approach, which requires the recognition of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in our financial statements or tax returns. The measurement of current and deferred tax liabilities and assets are based on provisions of the enacted tax law. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be more likely than not realized. As a result of recent cumulative losses and uncertainty regarding future taxable income, we have determined based on all available evidence, that there was substantial uncertainty as to the realizability of recorded net deferred tax assets in future periods. Accordingly, we have recorded a valuation allowance for 100% of our deferred tax assets. 31-------------------------------------------------------------------------------- Table of Contents We account for uncertainty in income taxes using a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely to be realized upon ultimate settlement. An uncertain tax position is considered effectively settled on completion of an examination by a taxing authority if certain other conditions are satisfied. Business Combinations Amounts paid for each acquisition are allocated to the assets acquired and liabilities assumed based on their relative fair values at the date of acquisition. Fair value for the October 1, 2010 business combination was determined using the Income Approach (discounted cash flow approach) valuation methodology. Such valuations require management to make significant estimates and assumptions, especially with respect to the identifiable intangible assets. Management makes estimates of fair value based upon assumptions believed to be reasonable and that of a market participant. These estimates are based on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. The separately identifiable intangible assets generally include technology and customer relationships. We estimate the fair value of deferred revenue related to product support assumed in connection with acquisitions. The estimated fair value of deferred revenue is determined by estimating the costs related to fulfilling the obligations plus a normal profit margin. The estimated costs to fulfill the support contracts are based on the historical direct costs related to providing the support. We then allocate the purchase price in excess of net tangible assets acquired to identifiable intangible assets based on detailed valuations that use information and assumptions provided by management. We allocate any excess purchase price over the fair value of the net tangible and intangible assets acquired and liabilities assumed to goodwill. Results of Operations (amounts in 000's) Comparison of Three Months Ended June 30, 2011 and 2010 Revenues (amounts in thousands) Three Months Ended June 30, 2011 2010 Period-to-Period Change % of Total % of Total Amount Revenue Amount Revenue Amount Percentage Revenues: Products $ 45,614 82 % $ 39,252 93 % $ 6,362 16 % Services 10,173 18 2,853 7 7,320 257 Total revenues $ 55,787 100 % $ 42,105 100 % $ 13,682 32 % Revenues by geography: Americas $ 26,449 47 % $ 21,299 51 % $ 5,150 24 % Europe, Middle East and Africa 18,178 33 11,981 28 6,197 52 Asia Pacific 11,160 20 8,825 21 2,335 26 Total revenues $ 55,787 100 % $ 42,105 100 % $ 13,682 32 % Revenues Total revenues of $55.8 million for the quarter ended June 30, 2011 increased by 32% or $13.7 million from $42.1 million in the quarter ended June 30, 2010. Our product revenues were 82% of total revenues at $45.6 million for the quarter ended June 30, 2011 as compared to 93% of total revenues, or $39.3 million in the same quarter in 2010, an increase of 16% or $6.4 million. Our services revenues were 18% of total revenues at $10.2 million in the three months ended June 30, 2011 as compared to 7% of total revenues, or $2.9 million in the three months ended June 30, 2010, an increase of 257% or $7.3 million. Included in the total revenue increase is $20.0 million revenue attributable to the Dialogic Corporation acquisition, or acquisition, completed in the last quarter of 2010 and is comprised of $13.1 million in product revenue and $6.9 million in services revenues. Revenues, excluding the acquisition, were $35.8 million, for the quarter ended June 30, 2011, which represented a decrease of 15%, or $6.3 million, from $42.1 million in the quarter ended June 30, 2010. The decrease is generally attributable to reduced demand for TDM products whose revenue decreased by 32% or $9.3 million, which was partly offset by a 26% or $2.6 million, increase in IP product revenues and a 14%, or $0.4 million, increase in services revenues. 32 -------------------------------------------------------------------------------- Table of Contents Product Revenue Product revenues of $45.6 million for the quarter ended June 30, 2011 increased by 16%, or $6.4 million, from $39.3 million in the quarter ended June 30, 2010. Our TDM products were 44% of product revenues at $19.9 million in the three months ended June 30, 2011 as compared to 75% of product revenues, or $29.3 million in the three months ended 2010, representing a decrease of 32%, or $9.4 million. Included in product revenues for 2011 is an increase of $13.1 million due to the acquisition which was completed in the last quarter of 2010. Product revenues, excluding the acquisition, were $32.5 million for the quarter ended June 30, 2011 representing a decrease of $6.8 million, or 17%, from $39.3 million in the quarter ended June 30, 2010. The decline resulted from lower customer demand for our TDM products. Our TDM product revenues are expected to decline as there is a gradual conversion of the telecommunication networks to our IP technology. Service Revenue Service revenues of $10.2 million for the quarter ended June 30, 2011 increased by 257%, or $7.3 million, from $2.9 million in the quarter ended June 30, 2010. Included in service revenues for the quarter ended June 30, 2011 is an increase of $6.9 million due to the acquisition which was completed in the last quarter of 2010. Service revenues, excluding the acquisition, were $3.3 million for the quarter ended June 30, 2011 which increased by 14%, or $0.4 million, from $2.9 million in the quarter ended June 30, 2010. The increase in service revenue was the result of growth in our installed base of customers for IP products and a related increase in IP maintenance revenue. Revenues by geography The $13.7 million increase in total revenues for the quarter ended June 30, 2011 as compared to the quarter ended June 30, 2010 is attributable to an increase in sales of $6.2 million the Europe, Middle East and Africa region, $2.3 million in the Asia Pacific region and $5.2 million in the Americas regions over the same periods. Total revenues, excluding the acquisition, decreased by $6.3 million for the quarter ended June 30, 2011 compared to the same period of 2010, resulting from a decrease in sales in the Americas and Europe, Middle East and Africa regions. The Americas declined by $5.4 million and Europe, Middle East and Africa revenues decreased by $1.7 million. Asia Pacific increased by $0.8 million. The decrease in revenues in the two regions is due to the decline in demand for our TDM products. Americas: Total revenues in the Americas increased by $5.1 million to $26.4 million in the second quarter of 2011 from $21.3 million in the same period of the prior year. Included in the 2011 revenues for the Americas is $10.6 million due to the acquisition, which is comprised of $8.0 million related to IP product revenues and $2.6 million of services revenues. In the Americas, our IP product revenues, excluding the acquisition, increased by 27%, or $1.0 million, to $4.5 million in 2011 as compared to $3.5 million in the same period of the prior year. Our TDM product revenues decreased by 42%, or $6.7 million, to $9.5 million in the second quarter of 2011 as compared to $16.2 million in the same period of the prior year. Services revenues increased by $0.4 million in 2011 to $1.9 million as compared to $1.5 million in the same period of the prior year. Europe, Middle East and Africa: Total revenues in the Europe, Middle East and Africa region increased by $6.2 million to $18.2 million in the second quarter of 2011 from $12.0 million in the same period of the prior year. Included within the revenues for the Europe, Middle East and Africa region in 2011 is $7.9 million from the acquisition which is comprised of $4.3 million of IP product revenues and $3.6 million of services revenues. In Europe, Middle East and Africa, our IP product revenues, excluding the acquisition, decreased by 3%, or $0.1 million, to $3.6 million in the second quarter of 2011 as compared to $3.7 million in the same period in 2010. Our TDM product revenues decreased by 21%, or $1.5 million, to $5.8 million in the second quarter of 2011 as compared to $7.3 million in the same period in 2010. Services revenues decreased by $0.1 million in the second quarter of 2011 to $0.8 million as compared to $0.9 million in the same period in 2010. 33-------------------------------------------------------------------------------- Table of Contents Asia Pacific: Total revenues in the Asia Pacific region increased by $2.3 million to $11.1 million in the second quarter of 2011 from $8.8 million in the same period of the prior year. Included within the revenues for the Asia Pacific region in the second quarter of 2011 is $1.5 million from the acquisition which is comprised of IP product revenues of $0.8 million and Services revenues of $0.7 million. In Asia Pacific, our IP product revenues, excluding the acquisition, increased by $1.8 million to $4.5 million in the second quarter of 2011 from $2.7 million in the same period of the prior year. Our TDM product revenues decreased by 18%, or $1.0 million, to $4.7 million in the second quarter of 2011 as compared to $5.7 million in the same period in 2010. Services revenues increased by $0.1 million in the second quarter of 2011 to $0.5 million as compared to $0.4 million in the second quarter of 2010. Cost of Revenue and Gross Margin Three Months Ended June 30, 2011 2010 Period-to-Period Change % of Total % of Total Related Related Amount Revenue Amount Revenue Amount Percentage Cost of Revenues: Products $ 17,594 39 % $ 12,700 32 % $ 4,894 39 % Services 5,507 54 2,266 79 3,241 143 Total cost of revenues $ 23,101 41 % $ 14,966 36 % $ 8,135 54 % Gross Profit: Products $ 28,020 61 % $ 26,552 68 % $ 1,468 6 % Services 4,666 46 587 21 4,079 695 Total gross profit $ 32,686 59 % $ 27,139 64 % $ 5,547 20 % Cost of Revenue Total cost of revenues of $23.1 million for the quarter ended June 30, 2011 increased by 54%, or $8.1 million, from $15.0 million in the quarter ended June 30, 2010. Included in cost of revenues in the second quarter of 2011 is an increase of $8.8 million due to the acquisition completed in the last quarter of 2010. Cost of product revenues of $17.6 million for the quarter ended June 30, 2011 increased by 39%, or $4.9 million, from $12.7 million in the quarter ended June 30, 2010. Included in cost of product revenues in the second quarter of 2011 is an increase of $5.9 million due to the acquisition completed in the last quarter of 2010. Cost of product revenues, excluding the acquisition, decreased by $1.0 million in the quarter ended June 30, 2011 as compared to the quarter ended June 30, 2010. The decrease in the quarter ended June 30, 2011 compared to the same period of 2010 is attributable to a decrease in product revenue, $1.0 million in lower outsourced product manufacturing costs due to a decline in product quantities ordered, lower depreciation and amortization expense by $0.5 million, and lower operations overhead of $0.2 million due to reduced headcount. Offsetting these decreases was an increase in inventory obsolescence charges of $0.7 million in the second quarter of 2011 as compared to the same quarter in 2010. Cost of services revenues of $5.5 million for the quarter ended June 30, 2011 increased by 143%, or $3.2 million, from $2.3 million in the quarter ended June 30, 2010. Included in the cost of services revenues is an increase of $2.9 million due to the acquisition completed in the last quarter of 2010. Cost of services includes the direct costs of customer support and consists primarily of payroll, related benefits and travel for our support personnel. The incremental services costs related to the acquisition include salaries and related costs of $1.6 million for 72 employees, consultant expenses of $0.8 million, occupancy costs of $0.2 million and travel of $0.3 million. Cost of services, excluding the acquisition, was $2.6 million for the quarter ended June 30, 2011 compared to $2.3 million for the quarter ended June 30, 2010. The cost increase in the second quarter of 2011 as compared to the second quarter of 2010 primarily results from reinstatement of our employees to full pay in 2011 from the salary reduction initiative in 2009. Gross Profit Gross profit of $32.7 million for the quarter ended June 30, 2011 increased by 20%, or $5.5 million, from $27.1 million in the quarter ended June 30, 2010. Included within the gross profit is an increase of $11.2 million due to the acquisition completed in the last quarter of 2010. For the quarter ended June 30, 2011, gross profit, excluding the acquisition, decreased by 21%, or $5.6 million, 34 -------------------------------------------------------------------------------- Table of Contents from $27.1 million for the quarter ended June 30, 2010 to $21.5 million for the quarter ended June 30, 2011. The decrease is primarily a result of a decline in TDM product revenues. As a percentage of sales, excluding the acquisition, gross profit decreased to 60% in the quarter ended June 30, 2011 compared to 64% in the comparable period in 2010 which is due to the decline in TDM product revenues. As a percentage of product revenue, product gross profit was 61% in the three months ended June 30, 2011 compared to 68% in the comparable period in 2010. The decrease in product gross profit is primarily attributable to the effect of higher fixed operation and support overheads and higher variable operation expenses such as tooling, testing and freight charges. As a percentage of services revenue, services gross profit was 46% in the second quarter of 2011 as compared to 21% in comparable period in 2010. The acquisition contributed to the services gross profit increase as the former Veraz Networks Inc. had higher profit associated with its service revenues. Operating Expenses Three Months Ended June 30, 2011 2010 Period-to-Period Change % of Total % of Total Amount Revenue Amount Revenue Amount Percentage Research and development, net $ 13,932 25 % $ 10,404 25 % $ 3,528 34 % Sales and marketing 14,286 26 11,002 26 3,284 30 General and administrative 9,192 16 5,989 14 3,203 53 Acquisition costs - - 531 1 (531 ) (100 ) Restructuring charges 761 1 - - 761 100 Total operating expenses $ 38,171 68 % $ 27,926 66 % $ 10,245 37 % Research and Development Expenses Research and development expenses of $13.9 million for the quarter ended June 30, 2011 increased by 34%, or $3.5 million, from $10.4 million in the quarter ended June 30, 2010. Included in the total research and development expenses are $4.5 million in additional expenses due to the acquisition completed in the last quarter of 2010. The incremental research and development costs from the acquisition are comprised of salaries and related costs of $3.4 million for 93 employees, occupancy costs of $1.0 million, equipment depreciation of $0.3 million and consultants of $0.2 million partially offset by research grants from the Israeli government of $0.4 million. Research and development expenses, excluding the acquisition, were $9.4 million for the quarter ended June 30, 2011 and $10.4 million for the quarter ended June 30, 2010. The decrease was primarily caused by lower salaries and benefits from decreased headcount. Research and development expenses were 25% of total revenues in both of the quarters ended June 30, 2011 and June 30, 2010. We expect that research and development expenses as a percentage of total revenue will decrease in 2011 as we continue to integrate our research and development operations with those of Dialogic Corporation during the year. We expect that the research and development expenses will increase on an absolute dollar basis in 2011 since we will incur a full year's worth of post-acquisition expenses as compared to three months in 2010, and we intend to continue to invest in developing new products and enhance and refresh existing products. Sales and Marketing Sales and marketing expenses of $14.3 million for the quarter ended June 30, 2011 increased by 30%, or $3.3 million, from $11.0 million in the quarter ended June 30, 2010. Included in the sales and marketing expenses are $4.2 million in additional expenses due to the acquisition completed in the last quarter of 2010. The incremental sales and marketing costs related to the acquisition include salaries and related costs of $2.5 million for 39 employees, sales agents and consultant expenses of $0.3 million, depreciation and amortization of intangibles of $0.3 million, occupancy costs of $0.8 million and travel of $0.3 million. Sales and marketing expenses, excluding the acquisition, decreased by $1.1 million for the quarter ended June 30, 2011 as compared to the same quarter in 2010. Included within sales and marketing expenses is a decrease in amortization expense of $0.6 million. Offsetting these expense decreases are increases in salaries and related employee benefits of $0.2 million relating to a reinstatement of our employees to full pay in 2011 from the salary reduction initiative in 2009. Sales and marketing expenses were 26% of total revenues for the quarters ended June 30, 2011 and 2010. We expect that sales and marketing expenses as a percentage of total revenue will decrease in 2011 as we begin to integrate our sales and marketing operations during the year. We expect that the sales and marketing expenses will increase on an absolute dollar basis in 2011 since we will incur a full year's worth of post-acquisition expenses as compared to three months in 2010. 35 -------------------------------------------------------------------------------- Table of Contents General and Administrative General and administrative expenses of $9.2 million for the quarter ended June 30, 2011 increased by 53%, or $3.2 million, from $6.0 million in the quarter ended June 30, 2010. Included in general and administrative expenses is $3.4 million due to the acquisition completed in the last quarter of 2010. The incremental general and administrative expenses from the acquisition include salaries and related costs of $1.1 million for 37 employees, legal and accounting fees of $0.6 million, and consulting fees of $1.1 million and other costs of $0.6 million. General and administrative expenses, excluding the acquisition, decreased by 2%, or $0.2 million, in the quarter ended June 30, 2011 to $5.8 million as compared to $6.0 million in the quarter ended June 30, 2010. General and administrative expenses increased to 16% of total revenues in the quarter ended June 30, 2011, compared to 14% for the quarter ended June 30, 2010. We expect that general and administrative expenses as a percentage of total revenue will decrease in 2011 as we continue to integrate our general and administrative operations during the year and gain efficiencies in lower overhead and employee costs. We expect that the general and administrative expenses will increase on an absolute dollar basis in 2011 since we will incur a full year's worth of post-acquisition expenses as compared to three months in 2010. Restructuring Charges For the quarter ended June 30, 2011, we recorded a restructuring charge of $0.8 million compared to zero for the same period of the prior year. The restructuring charges in 2011 relate to $0.7 million of severance and related benefits for terminated employees and $0.1 million of future lease payments and other costs associated with vacated spaces in our Salem, New Hampshire facility. At June 30, 2011, we have an accrued liability in the amount of $4.7 million related to the restructuring activities, of which $1.9 million is included in our current liabilities and $2.8 million is recorded as a long-term liability. During the remainder of 2011, we expect to pay $2.0 million against this liability. The remaining $2.7 million relates to the consolidation of the leased space in our Parsippany, New Jersey office which we expect to pay over the remaining lease term ending at December 2015. Interest and Other Income, net Interest and other income, net increased by $17 thousand in the three months ended June 30, 2011 as compared to the same period ended June 30, 2010. Interest Expense Interest expense was $5.0 million in each of the quarters ended June 30, 2011 and 2010. The average interest rate was 15% on the Term Loan Agreement and 5.75% on the Revolving Credit Agreement in 2011, each as further described below, compared to 15.4%, inclusive of 2% payment-in-kind, or PIK interest, on the Term Loan Agreement and 6.0% on the Revolving Credit Agreement in 2010. The Shareholder Loan, as further described below, bears a contractual annual interest rate of 20% compounded monthly in the form of a PIK. During the three months ended June 30, 2011, we amortized an additional $0.9 million of deferred debt issuance costs related to the breach of the Minimum Liquidity Covenant under our Term Loan Agreement. Foreign Exchange Gains (Losses), net Foreign exchange loss was $0.2 million in the quarter ended June 30, 2011. Foreign exchange gains were $0.1 million in the quarter ended June 30, 2010. Income Tax Provision We recorded an income tax provision of $0.6 million and $0.3 million for the three months ended June 30, 2011 and 2010, respectively. The tax expense for the three months ended June 30, 2011 is primarily due to current tax payable in our profitable foreign entities with no corresponding tax attributes to offset current tax expense. The tax expense for the three months ended June 30, 2010 is primarily comprised of a provision for uncertain tax positions and foreign income tax expense. There was no deferred provision recorded for either quarter. 36 -------------------------------------------------------------------------------- Table of Contents Comparison of Six Months Ended June 30, 2011 and 2010 Revenues (amounts in thousands) Revenues Six Months Ended June 30, 2011 2010 Period-to-Period Change % of Total % of Total Amount Revenue Amount Revenue Amount Percentage Revenues: Products $ 81,824 81 % $ 77,808 93 % $ 4,016 5 % Services 18,827 19 5,753 7 13,074 227 Total revenues $ 100,651 100 % $ 83,561 100 % $ 17,090 20 % Revenues by geography: Americas $ 47,179 47 % $ 42,468 51 % $ 4,711 11 % Europe, Middle East and Africa 34,542 34 22,941 27 11,601 51 Asia Pacific 18,930 19 18,152 22 778 4 Total revenues $ 100,651 100 % $ 83,561 100 % $ 17,090 20 % Total revenues of $100.7 million for the first half of 2011 increased by 20%, or $17.1 million, from $83.6 million in the same period in 2010. Our product revenues were 81% of total revenues at $81.8 million in the six months ended June 30, 2011 as compared to 93% of total revenues, or $77.8 million, in the six months ended June 30, 2010, an increase of 5%, or $4.0 million. Our services revenues were 19% of total revenues at $18.8 million in the six months ended June 30, 2011 as compared to 7% of total revenues, or $5.8 million, in the six months ended June 30, 2010, an increase of 227%, or $13.1 million. Included in the total revenue increase is $33.2 million revenue attributable to the acquisition completed in the last quarter of 2010 which is comprised of $21.0 million in product revenue and $12.2 million in services revenues. Revenues, excluding the acquisition, were $67.5 million, for the six months ended June 30, 2011, which represented a decrease of 19%, or $16.1 million, from $83.6 million in the same period ended June 30, 2010. The decrease is generally attributable to reduced demand for TDM products whose revenue decreased by 35%, or $20.5 million, partially offset by an 18 %, or $3.5 million, increase in IP product revenues and a 15%, or $0.8 million, increase in services revenues. Product Revenue Product revenues of $81.8 million for the first half of 2011 increased by 5% or $4.0 million from $77.8 million in the same period in 2010. Our TDM products were 47% of product revenues at $38.3 million in the six months ended June 30, 2011 as compared to 76% of product revenues, or $58.8 million in the six months ended 2010, representing a decrease of 35% or $20.5 million. Our IP products were 53% of product revenues at $43.5 million in the six months ended 2011 as compared to 24% of product revenues, or $19.0 million, in the six months ended 2010, representing an increase of 129%, or $24.5 million. Product revenues, excluding $21.0 million due to the acquisition, were $60.8 million for the first half of 2011 representing a decrease of $17.0, million or 22%, from $77.8 million in the same period in 2010. The decline resulted from lower customer demand for our TDM products. Our TDM product revenues are expected to decline as there is a gradual conversion of the telecommunication networks to our IP technology. Service Revenue Service revenues of $18.8 million for the first half of 2011 increased by 227%, or $13.0 million, from $5.8 million in the same period in 2010. Service revenues, excluding $12.2 million due to the acquisition, were $6.6 million for the six months ended June 30, 2011 representing an increase of 14%, or $0.8 million, from $5.8 million in the six months ended June 30, 2010. The increase in service revenues was the result of growth in our installed base of customers for IP products and a related increase in IP maintenance revenue. Revenues by geography The $17.1 million increase in total revenues for the first half of 2011 as compared to the same period in 2010 is attributable to an increase in sales of $11.6 million the Europe, Middle East and Africa region, $4.7 million in the Americas regions and $0.8 million in the Asia Pacific region over the same periods. Total revenues, excluding the acquisition, decreased by $16.2 million for the first half of 2011 compared to the same period in 2010, resulting from a decrease in sales in the three regions. The Americas declined by $11.2 million, Europe, Middle East and Africa revenues decreased by $3.1 million and Asia Pacific decreased by $1.9 million. The decrease in revenues in the three regions is due to the decline in demand for our TDM products. 37-------------------------------------------------------------------------------- Table of Contents Americas: Total revenues in the Americas increased by $4.7 million to $47.2 million in the first half of 2011 from $42.5 million in the same period of the prior year. Included in the 2011 revenues for the Americas is $15.9 million due to the acquisition, which is comprised of $11.2 million related to IP product revenues and $4.7 million of services revenues. In the Americas, our IP product revenues, excluding the acquisition, increased by 23%, or $1.7 million, to $9.0 million in the six months ended June 30, 2011 as compared to $7.3 million in the same period of the prior year. Our TDM product revenues decreased by 43%, or $13.7 million, to $18.1 million in the first half of 2011 as compared to $31.8 million in the same period of the prior year. Services revenues increased by $0.8 million in the first half of 2011 to $4.1 million as compared to $3.3 million in the same period of the prior year. Europe, Middle East and Africa: Total revenues in the Europe, Middle East and Africa region increased by $11.6 million to $34.5 million in the first half of 2011 from $22.9 million in the same period of the prior year. Included within the revenues for the Europe, Middle East and Africa region in 2011 is $14.7 million from the acquisition which is comprised of $8.2 million of IP product revenues and $6.5 million of services revenues. In Europe, Middle East and Africa, our IP product revenues, excluding the acquisition, increased by 1%, or $0.1 million, to $6.8 million in the first half of 2011 as compared to $6.7 million in the same period in 2010. Our TDM product revenues decreased by 22%, or $3.2 million, to $11.4 million in the first half of 2011 as compared to $14.6 million in the same period in 2010. Services revenues remained at $1.7 million in both the first halves of 2011 and 2010. Asia Pacific: Total revenues in the Asia Pacific region increased by $0.8 million to $18.9 million in the first half of 2011 from $18.1 million in the same period of the prior year. Included within the revenues for the Asia Pacific region in the first half of 2011 is $2.6 million, which is comprised of $1.5 million in IP revenue and $1.1 million of services revenues. In Asia Pacific, our IP product revenues, excluding the acquisition, was $6.7 million in the first six months of 2011 as compared to $5.0 million during the same period in 2010. Our TDM product revenues decreased by 30%, or $3.7 million, to $8.7 million in the first half of 2011 as compared to $12.4 million in the same period in 2010. Services revenues remained at $0.8 million in both of the first halves of 2011 and 2010. Cost of Revenue and Gross Margin . Six Months Ended June 30, 2011 2010 Period-to-Period Change % of Total % of Total Related Related Amount Revenue Amount Revenue Amount Percentage Cost of Revenues: Products $ 31,537 39 % $ 25,607 33 % $ 5,930 23 % Services 10,857 58 4,545 79 6,312 139 Total cost of revenues $ 42,394 42 % $ 30,152 36 % $ 12,242 41 % Gross Profit: Products $ 50,287 61 % $ 52,201 67 % $ (1,914 ) (4 )% Services 7,970 42 1,208 21 6,762 560 Total gross profit $ 58,257 58 % $ 53,409 64 % $ 4,848 9 % Cost of Revenue Total cost of revenues of $42.4 million for the first half of 2011 increased by 41%, or $12.2 million, from $30.2 million in the same period in 2010. Included in cost of revenues in the first half of 2011 is an increase of $14.0 million due to the acquisition completed in the last quarter of 2010. Cost of product revenues of $31.5 million for the first half of 2011 increased by 23%, or $5.9 million, from $25.6 million in the same period in 2010. Cost of product revenues, excluding $8.5 million attributable to the acquisition, decreased by $2.5 million in the first half of 2011 as compared to the same period in 2010. The decrease in the six months ended June 30, 2011 compared to the same period of 2010 is attributable to decreased product revenue, $2.4 million in lower outsourced product manufacturing costs due to a decline in product quantities ordered, lower amortization expense by $0.9 million, and lower operations overhead of $0.3 million due 38-------------------------------------------------------------------------------- Table of Contents to reduced overhead. Offsetting these decreases were increases in variable operating costs of $0.2 million in the six months ended June 30, 2011 as compared to the comparable period in 2010 as a result of higher board assembly and royalty charges. In addition, there was an increase in inventory obsolescence charges of $0.9 million in the first half of 2011 as compared to the same period in 2010. Cost of services revenues of $10.9 million for the first half of 2011 increased by 139%, or $6.3 million, from $4.5 million in the same period in 2010. Included in the cost of services revenues is an increase of $5.6 million due to the acquisition completed in the last quarter of 2010. Cost of services includes the direct costs of customer support and consists primarily of payroll, related benefits and travel for our support personnel. The incremental services costs related to the acquisition include salaries and related costs of $3.0 million for 72 employees, consultant expenses of $1.3 million, occupancy costs of $0.5 million, travel of $0.6 million and other costs of $0.2 million. Cost of services, excluding the acquisition, was $5.3 million for the six months ended June 30, 2011 compared to $4.5 million for the same period in the prior year. The cost increase in the first half of 2011 as compared to the same period 2010 primarily results from the increase in services revenue. Gross Profit Gross profit of $58.3 million for the first half of 2011 increased by 9%, or $4.8 million, from $53.4 million in the same period in 2010. For the six months ended June 30, 2011, gross profit, excluding $19.2 million attributable the acquisition, decreased by 27%, or $14.4 million, from $53.4 million for the six months ended June 30, 2010 to $39.0 million for the same period in 2011. The decrease is primarily a result of a decline in TDM product revenues. As a percentage of sales, excluding the acquisition, gross profit decreased to 58% in the first half of 2011 compared to 64% in the comparable period in 2010 which is due to the decline in TDM product revenues. As a percentage of product revenue, product gross profit was 61% in the six months ended June 30, 2011 compared to 67% in the comparable period in 2010. The decrease in product gross profit is primarily attributable to the effect of higher fixed operation and support overheads and higher variable operation expenses such as tooling, testing and freight charges. As a percentage of services revenue, services gross profit was 42% in the first half of 2011 as compared to 21% in comparable period in 2010. The acquisition contributed to the services gross profit increase as the former Veraz Networks Inc. had higher profit associated with its service revenues. Operating Expenses Six Months Ended June 30, 2011 2010 Period-to-Period Change % of Total % of Total Amount Revenue Amount Revenue Amount Percentage Research and development, net $ 28,722 29 % $ 20,468 24 % $ 8,254 40 % Sales and marketing 29,165 29 22,277 27 6,888 31 General and administrative 18,162 18 11,664 14 6,498 56 Acquisition costs - - 915 1 (915 ) (100 ) Restructuring charges 4,746 5 - - 4,746 100 Total operating expenses $ 80,795 81 % $ 55,324 66 % $ 25,471 46 % Research and Development Expenses Research and development expenses of $28.8 million for the first half of 2011 increased by 40%, or $8.3 million, from $20.5 million in the same period in 2010. Included in the total research and development expenses are $9.2 million in additional expenses due to the acquisition completed in the last quarter of 2010. The incremental research and development costs from the acquisition are comprised of salaries and related costs of $7.0 million for 93 employees, occupancy costs of $1.9 million, equipment depreciation of $0.7 million, consultants of $0.3 million, and other costs of $0.2 million partially offset by research grants from the Israeli government of $0.9 million. Research and development expenses, excluding the acquisition, were $19.6 million for the six months ended June 30, 2011 and $20.5 million in the same period in 2010. Research and development expenses increased to 29% of total revenues in the first half of 2011 from 24% of total revenues in the same period in 2010. We expect that research and development expenses as a percentage of total revenue will decrease in 2011 as we 39 -------------------------------------------------------------------------------- Table of Contents continue to integrate our research and development operations with those of Dialogic Corporation during the year. We expect that the research and development expenses will increase on an absolute dollar basis in 2011 since we will incur a full year's worth of post-acquisition expenses as compared to three months in 2010, and we intend to continue to invest in developing new products and enhance and refresh existing products. Sales and Marketing Sales and marketing expenses of $29.2 million for the first half in 2011 increased by 31%, or $6.9 million, from $22.3 million in the same period in 2010. Included in sales and marketing expense is $8.0 million relating to the acquisition completed in the last quarter of 2010. The incremental sales and marketing costs from the acquisition are comprised of salaries and related costs of $4.6 million for 39 employees, occupancy costs of $1.4 million, equipment depreciation of $0.6 million, sales agents and consultants of $0.6 million, travel costs of $0.7 million and other costs of $0.1 million. Sales and marketing expenses, excluding the acquisition, were $21.2 million and $22.3 million for six months ended June 30, 2011 and 2010, respectively, a decrease of $1.1 million. This decrease was primarily caused by a decrease in amortization expense of $1.2 million. Sales and marketing expenses increased to 29% of total revenues in the first half in 2011 from 27% of total revenues in the same period in 2010. General and Administrative General and administrative expenses of $18.2 million for the first half of 2011 increased by 56%, or $6.5 million, from $11.7 million in the same period in 2010. Included in general and administrative expenses is $6.0 million due to the acquisition completed in the last quarter of 2010. The incremental general and administrative expenses from the acquisition include salaries and related costs of $2.3 million for 37 employees, legal and accounting fees of $1.1 million, consulting fees of $1.5 million and other costs of $1.1 million. General and administrative expenses, excluding the acquisition, increased by 3%, or $0.4 million, in the six months ended June 30, 2011 to $12.2 million as compared to $11.7 million in the same period 2010. General and administrative expenses increased to 18% of total revenues in the first half of 2011 from 14% of total revenues in the same period in 2010. We expect that general and administrative expenses as a percentage of total revenue will decrease in 2011 as we continue to integrate our general and administrative operations during the year and gain efficiencies in lower overhead and employee costs. We expect that the general and administrative expenses will increase on an absolute dollar basis in 2011 since we will incur a full year's worth of post-acquisition expenses as compared to three months in 2010. Restructuring Charges For the six months ended June 30, 2011, we recorded a restructuring charge of $4.7 million compared to zero for the same period of the prior year. The restructuring charges in 2011 relate to $1.2 million of severance and related benefits for terminated employees and $3.5 million of future lease payments and other costs associated with vacated spaces in our Parsippany, New Jersey and Salem, New Hampshire facilities. At June 30, 2011, we have an accrued liability in the amount of $4.7 million related to the restructuring activities, of which $1.9 million is included in our current liabilities and $2.8 million is recorded as a long-term liability. During the remainder of 2011, we expect to pay $2.0 million related to this liability. The remaining $2.7 million relates to the consolidation of the leased space in our Parsippany, NJ office which we expect to pay over the remaining lease term ending at December 2015. Interest and Other Income, net Interest and other income, was zero in the first half of 2011 as compared to $0.5 million during the same period in 2010. This decrease is primarily due to the gain of $0.5 million in January 2010 resulting from the settlement agreement reached between our subsidiary, Cantata Technology, Inc., or Cantata, and InterMetro Communications, Inc., or InterMetro, following the filing by Cantata of a complaint against InterMetro. Interest Expense, net Interest expense, net decreased by $0.5 million, or 5%, from $9.0 million in the first half of 2010 to $8.5 million in the same period in 2011. The decrease in 2011 is primarily attributable to lower interest rates in 2011 on our borrowings. The average interest rate in 2011 was 14% on the Term Loan Agreement, as discussed further below, and 5.75% on the Revolving Credit Agreement, as discussed further below, compared to 15.4%, inclusive of 2% PIK interest, on the Term Loan Agreement and 6.0% on the Revolving Credit Agreement in 2010. The Shareholder Loan, as discussed further below, bears a contractual annual interest rate of 20% compounded monthly in the form of a PIK. During the six months ended June 30, 2011, we amortized an additional $0.9 million of deferred debt issuance costs related to the breach of the Minimum Liquidity covenant. 40 -------------------------------------------------------------------------------- Table of Contents Foreign Exchange Gains (Losses), net Foreign exchange loss was $0.3 million in the six months ended June 30, 2011 as compared to a foreign exchange gain of $1 thousand in the same period in 2010. Income Tax Provision We recorded an income tax provision of $1.1 million and $0.5 million for the six months ended June 30, 2011 and 2010, respectively. The tax expense for the six months ended June 30, 2011 is primarily due to current tax payable in our profitable foreign entities with no corresponding tax attributes to offset current tax expense. The tax expense for the six months ended June 30, 2010 is primarily comprised of a provision for uncertain tax positions and foreign income tax expense. There was no deferred provision recorded for either quarter. Financial Position Liquidity and Capital Resources As of June 30, 2011, we had cash and cash equivalents of $14.7 million, compared to $24.6 million of cash and cash equivalents as of December 31, 2010. Of our cash and cash equivalents of $14.7 million at June 30, 2011, approximately $9.7 million was held by our subsidiaries outside the U.S. and could be subject to tax implications if repatriated to the U.S. Our primary anticipated sources of liquidity are funds generated from operations, and as required, funds borrowed under the Revolving Credit Agreement. As of June 30, 2011, we had borrowed $12.9 million under our Revolving Credit Agreement, as described below. Under the Revolving Credit Agreement, the unused line of credit totaled $12.1 million, of which $1.6 million was available to us. At June 30, 2011, we had total debt of $94.2 million under the Term Loan Agreement and Shareholder Loan, each as described below, of which $89.9 million had an original maturity in September 2013 and $4.3 million is due in March 2014. As of June 30, 2011, we were not in compliance with the Minimum Liquidity Covenant under our Term Loan Agreement. As a result, the lenders have the right to accelerate the maturity date of the long-term debt, but have agreed not to do so prior to January 15, 2012. Accordingly, the debt has been classified as a current liability in the accompanying unaudited June 30, 2011 condensed consolidated balance sheet. We increased borrowings by $0.1 million under the Revolving Credit Agreement and used net cash in operating activities of $7.5 million in the first half of 2011. As of June 30, 2011, total liquidity including cash and availability under the Revolving Credit Agreement was $16.3 million as compared to $28.1 million on December 31, 2010. We budget capital expenditures on an annual basis. For 2011, we budgeted capital expenditures for property and equipment of $3.0 million, of which $1.4 million was used in the six months ended June 30, 2011. In the six months ended June 30, 2011, we paid $6.3 million to service the interest payments on the Term Loan and Revolving Credit Agreements. We monitor and manage liquidity by preparing and updating annual budgets as well as monitor compliance with terms of our financing agreements. We believe that we will continue as a going concern. For the six months ended June 30, 2011, we incurred a net loss of $32.5 million and used cash in operating activities of $7.5 million. As of June 30, 2011, our cash and cash equivalents was $14.7 million, our current bank indebtedness was $12.9 million and our debt with related parties was $94.2 million. As discussed below, the related party Term Lenders have waived their right to accelerate the maturity date of the debt under any circumstances prior to January 15, 2012, including in the event we do not maintain compliance with our debt covenants. As of June 30, 2011, we were not in compliance with the Minimum Liquidity Covenant under our Term Loan Agreement. As a result, the lenders will have the right to accelerate the maturity date of the debt on January 15, 2012. We do not anticipate having sufficient cash and cash equivalents to repay the debt should the related party lenders accelerate the maturity date and we would be forced to seek alternative sources of financing. There can be no assurances that alternative financing will be available on acceptable terms or at all. This could harm us by: • increasing our vulnerability to adverse economic conditions in our industry or the economy in general; • requiring substantial amounts of cash to be used for debt servicing, rather than other purposes, including operations; • limiting our ability to plan for, or react to, changes in our business and industry; and • influencing investor and customer perceptions about our financial stability and limiting our ability to obtain financing or acquire customers. 41 -------------------------------------------------------------------------------- Table of Contents Unfavorable economic and market conditions in the United States and the rest of world could impact our business in a number of ways, including: • Deferment of purchases and orders by customers; • Negative impact from increased financial pressures on distributors and resellers of our product; and • Negative impact from increased financial pressures on key suppliers. In order for us to meet the debt repayment requirements, we may need to raise additional capital by refinancing our debt, raising equity capital or selling assets. Uncertainty in future credit markets may negatively impact our ability to access debt financing or to refinance existing indebtedness in the future on favorable terms, or at all. If additional capital is raised through the issuance of debt securities or other debt financing, the terms of such debt may include different financial covenants, restrictions and financial ratios other than what we currently operate under. Any equity financing transaction could result in additional dilution to our existing stockholders. Description of Existing Debt Obligations We have related party long-term debt under a Term Loan Agreement and Shareholder Loans, and bank indebtedness with a Revolving Credit Agreement. Term Loan Agreement In connection with the consummation of the business combination between us and Dialogic Corporation, we entered into a second amended and restated credit agreement dated as of October 1, 2010, as amended, or the Term Loan Agreement, with Obsidian, LLC, as agent, and Special Value Expansion Fund, LLC, Special Value Opportunities Fund, LLC and Tennenbaum Opportunities Partners V, LP, as lenders, or, collectively, the Term Lenders. Principal Amount and Maturity. At June 30, 2011 and December 31, 2010, term loan in the principal amount of $89.9 million were outstanding under the Term Loan Agreement ("Term Loan") with an original maturity of September 30, 2013. Voluntary and Mandatory Prepayments. The Term Loan may be prepaid, in whole or in part, from time to time, subject to payment of (i) if prepaid prior to the first anniversary of the closing date, a make-whole amount that includes a 5% premium, (ii) if prepaid after the first but prior to the second anniversary of the closing date, a premium of 5% and (iii) if prepaid after the second anniversary of the closing date, a premium of 2%. We are required to offer to prepay the Term Loan out of the net proceeds of certain asset sales (including asset sales by us) at 100% of the principal amount of Term Loan prepaid, plus the prepayment premiums described above, subject to our right to reinvest some or all of the net proceeds in its business in lieu of prepayment. We are also required to prepay the Term Loan out of net proceeds from certain equity issuances, at 50% plus the prepayment premiums. If we raise at least $50.0 million within the first year of the loan agreements, 100% of the net proceeds are to be applied against the Term Loan, with a prepayment premium of 2%. Interest Rates. The Term Loan bears interest, payable in cash, at a rate per annum equal to LIBOR (but in no event less than 2%) plus an applicable margin. The margin, which is currently 11%, is based on our consolidated net leverage ratio. Upon the occurrence and continuance of an event of default, the Term Loan will bear interest at a default rate equal to the applicable interest rate plus 2%. At June 30, 2011, the interest rate was 15% on the aggregate of the Term Loan. Guarantors. The Term Loan is guaranteed by Dialogic, Dialogic Corporation, Dialogic Networks (Israel) Ltd., and Veraz Networks LTDA, or, collectively the Term Loan Guarantors, with the exception of certain subsidiaries organized under the laws of countries other than the United States or Canada and certain immaterial U.S. subsidiaries that we have covenanted to wind-down and dissolve. Security. The Term Loan is secured by a pledge of all of our assets and of the Term Loan Guarantors, including all intellectual property, accounts receivable, inventory and capital stock in our direct and indirect subsidiaries (except for certain subsidiaries organized under the laws of countries other than the United States or Canada). The security interest of the Term Lenders in inventory, accounts receivable and our related property and the Term Loan Guarantors is subordinated to the security interest of the Revolving Credit Lender in those assets. 42 -------------------------------------------------------------------------------- Table of Contents Other Terms. We and our subsidiaries are subject to various affirmative and negative covenants under the Term Loan Agreement, including restrictions on incurring additional debt and contingent liabilities, granting liens, making investments and acquisitions, paying dividends or making other distributions in respect of its capital stock, selling assets and entering into mergers, consolidations and similar transactions, entering into transactions with affiliates and entering into sale and lease-back transactions. The Term Loan Agreement contains customary events of default, including our change in control without the Term Lenders consent. Term Loan Agreement Covenants The following summarizes the financial covenants as defined in the Term Loan Agreement at June 30, 2011: • Minimum Liquidity-Defined as liquidity consisting principally of cash and cash equivalents as adjusted, of at least $24.5 million as of June 30, 2011; $30.0 million as of September 30, 2011, December 31, 2011, March 31, 2012 and June 30, 2012; and $35.0 million as of September 30, 2012 and thereafter. • Minimum EBITDA-Defined as earnings plus interest expense, taxes, depreciation, amortization, foreign exchange gain or loss and subject to certain additional adjustments in accordance with U.S. GAAP of at least $28.5 million for the four quarters ending September 30, 2011, which is the first test period for this covenant; $30.0 million for the four quarters ending December 31, 2011, March 31, 2012 and June 30 2012; $32.5 million for the four quarters ending September 30, 2012, December 31, 2012, March 31, 2013 and June 30, 2013; $35.0 million for the four quarters ending September 30, 2013. • Minimum Interest Coverage Ratio-Defined as the ratio of (i) Consolidated EBITDA for such period minus Consolidated Capital Expenditures for such period to (ii) Consolidated Interest Expense for such period and is not permitted to be less than the correlative ratio of 2 to 1 for the four quarters ending September 30 2011, which is the first test period for this covenant; December 31 2011, March 31, 2012 and June 30, 2012, and 2.5:1 ratio for the four quarters ending September 30, 2012 and thereafter. • Maximum Consolidated Total Leverage Ratio-Defined as the ratio of (i) the total consolidated debt outstanding at the end of the quarter to (ii) the consolidated EBITDA for such period and is not permitted to be greater than a ratio of 3.65 to 1 for the four quarters ending September 30, 2011, which is the first test period for this covenant; ratio of 3.5 to 1 for the four quarters ending December 31 2011, March 31, 2012 and June 30, 2012; ratio of 3:0 to 1 for the four quarters ending September 30, 2012, December 31, 2012, March 31, 2013 and June 30, 2013; ratio of 2.5:1 for the four quarters ending September 30, 2013. As of June 30, 2011, we were not in compliance with the Minimum Liquidity covenant. For the other covenants, Minimum EBITDA, Minimum Interest Coverage Ratio and Maximum Consolidated Total Leverage Ratio, there are no required compliance tests until September 30, 2011. In the event that we violate any of the financial covenants under the Term Loan Agreement, the Term Lenders could accelerate the maturity date of the principal and the accrued interest to be immediately due and payable. At June 30, 2011, this amounted to $89.9 million for the Term Loan and $3.4 million in accrued interest payable. In March 2011, we obtained a letter from the Term Loan Lenders confirming that they will not under any circumstance accelerate the maturity date of the Term Loan prior to January 15, 2012. Accordingly, the debt has been classified as a current liability in the accompanying unaudited condensed consolidated financial statements. Shareholder Loans At each of June 30, 2011 and December 31, 2010, we had principal and accrued interest of $4.3 million and $3.9 million in long-term debt payable to certain of our shareholders, respectively, including our chief executive officer and members of our Board of Directors, bearing interest at an annual rate of 20% compounded monthly in form of a PIK and repayable six months from the maturity date of the Term Loan Agreement, which would be in March 2014, or, collectively, the Shareholder Loans. During each of the six months ended June 30, 2011 and 2010, we recorded interest expense of $0.4 million related to the Shareholder Loans. There are no covenants or cross default provisions associated with the Shareholder Loans. Total accrued interest as of June 30, 2011 and December 31, 2010 was $1.3 million and $0.9 million, respectively. If we consummate an equity financing before the Shareholder Loans are repaid, the noteholders, at their option, may convert all of the Shareholder Loan amount, including accrued PIK interest payable, into equity at the same rate and terms agreed to with other investors. The Shareholder Loan convertible option will apply solely to the first equity financing event consummated after October 1, 2010. Revolving Credit Agreement Revolving Credit Amount and Maturity. We have a working capital facility, a Revolving Credit Agreement or RCA, with Wells Fargo Foothill, or the Revolving Credit Lender. In connection with the reverse acquisition, the RCA maturity date was amended and extended to September 30, 2013. We may borrow, repay and reborrow revolving credit loans from time to time provided that the aggregate principal amount of revolving credit loans outstanding at any time does not exceed the lesser of (i) $25.0 million, which is referred to as the "maximum revolver amount" or (ii) 85% of the aggregate amount of eligible accounts receivable, reduced by certain reserves and offsets and subject to certain caps in the case of accounts receivable owed to us, which is referred to as the "borrowing base." 43 -------------------------------------------------------------------------------- Table of Contents As of June 30, 2011 and December 31, 2010, the borrowing base under the RCA amounted to $14.5 million and $16.3 million, respectively, we had borrowed $12.9 million and $12.8 million, respectively, and the unused line of credit totaled $12.1 and $12.2 million, respectively, of which $1.6 million and $3.5 million, respectively, was available for additional borrowings, respectively. The commitment of the Revolving Credit Lender to make revolving credit loans terminates and all outstanding revolving credit loans are due on September 30, 2013. We may repay the facility at our option with 30 days' notice to the Revolving Credit Lender. Mandatory Prepayments. We are required to prepay revolving credit loans in an amount equal to 100% of the net proceeds from the sale or other disposition of inventory other than in the ordinary course of business, subject to the right to apply the net proceeds to the acquisition of replacement property in lieu of prepayment. In certain instances if we terminate and prepay the revolving credit loans, such event may trigger a prepayment premium equal to (i) 1% if such event occurs prior to October 1, 2011 or (ii) 0.5% if such event occurs on or after October 1, 2011 and prior to October 1, 2012. Interest Rates and Fees. At our election, revolving credit loans may bear interest at a rate equal to the prime rate plus 2.5% or at a rate equal to reserve-adjusted one-, two- or three- month LIBOR plus 4%. Upon the occurrence and continuance of an event of default and at the election of the Revolving Credit Lender, the revolving credit loans will bear interest at a default rate equal to the then applicable interest rate or rates plus 2%. We pay the Revolving Credit Lender a monthly fee on the unused portion of the maximum revolver amount, as well as a monthly collateral management fee. Guarantors. The revolving credit loans are guaranteed by us, Dialogic Corporation, Cantata Technology, Inc., Dialogic Distribution Ltd., Dialogic Networks (Israel) Ltd. and Veraz Networks LTDA, (collectively, the "Revolving Credit Guarantors"). Security. The revolving credit loans are secured by a pledge of the assets of us and of the Revolving Credit Guarantors consisting of accounts receivable and inventory and related property. The security interest of the Revolving Credit Lenders is prior to the security interest of the Term Lenders in these assets, subject to the terms and conditions of an inter-creditor agreement. Other Terms. We and our subsidiaries are subject to affirmative and negative covenants, including restrictions on incurring additional debt, granting liens, entering into mergers, consolidations and similar transactions, selling assets, prepaying indebtedness, paying dividends or making other distributions on our capital stock, entering into transactions with affiliates and making capital expenditures. The RCA contains customary events of default, including a change in our control. Revolving Credit Agreement Covenants The following summarizes the Revolving Credit Agreement's covenants and compliance status as defined in the RCA at June 30, 2011 and December 31, 2010: • Minimum Cash Balance-Defined as maintaining at least $3.0 million in controlled non-restricted cash and cash equivalent accounts, (as defined between the lender and borrower) located in either the U.S. or Canada through December 31, 2011. • Minimum EBITDA-Defined as earnings plus interest expense, taxes, depreciation, amortization, foreign exchange gain or loss and subject to certain additional adjustments in accordance with U.S. GAAP of at least $28.5 million for the four quarters ending September 30, 2011, which is the first test period for this covenant; $30.0 million for the four quarters ending December 31, 2011, March 31, 2012 and June 30 2012; $32.5 million for the four quarters ending September 30, 2012, December 31, 2012, March 31, 2013 and June 30, 2013; and $35.0 million for the four quarters ending September 30, 2013. At June 30, 2011, we were in default under the RCA. Specifically, we had breached the Minimum Liquidity covenant under the Term Loan Agreement (as described above) as of June 30, 2011 which constitutes a breach under the terms of the Revolving Credit Agreement. The original maturity date of the loan was September 30, 2013. On July 26, 2011, the we executed a Limited Waiver and Sixteenth Amendment to Credit Agreement with the Revolving Credit Lender, whereby the Lenders agreed not to accelerate the Maturity Date of any loans during the Limited Waiver Period (which was defined as the earliest of (i) January 15, 2012; (ii) the occurrence of any additional Event of Default or (iii) the occurrence of any Termination Event (as defined in the Term Loan Agreement)). During the six months ended June 30, 2011, we amortized an additional $0.4 million of deferred debt issuance costs related to the breach of the Minimum Liquidity covenant. Operating Activities Net cash used in operating activities of $7.5 million in the six months ended June 30, 2011 was primarily attributable to our net loss of $32.5 million, partially offset by adjustments for non-cash items aggregating to $13.1 million for items such as depreciation, 44-------------------------------------------------------------------------------- Table of Contents amortization, stock-based compensation, PIK interest expense on long-term debt, allowance for doubtful accounts, deferred income taxes and other non-cash charges before net changes in operating assets and liabilities. Our operating assets decreased by $20.7 million and our liabilities decreased by $8.8 million. The decrease in operating assets relates to accounts receivable of $12.8 million, prepaid expenses of $4.7 million and inventories of $3.2 million. The decrease in our operating liabilities is primarily attributable to a decrease of $2.3 million in deferred revenue, and a decrease of $7.5 million in accounts payable and accrued liabilities, offset by an increase in income taxes payable of $0.6 million. Net cash provided by operating activities of $0.4 million in the six months ended June 30, 2010 was primarily attributable to our net loss of $10.9 million, offset by adjustments for non-cash items aggregating to $13.3 million for items such as depreciation, amortization, interest expense payable-in-kind on long-term debt, allowance for doubtful accounts, deferred income taxes and other non-cash charges before net changes in operating assets and liabilities. Our operating assets increased by $2.0 million and our operating liabilities decreased by $16 thousand in the six months ended June 30, 2010. The increase in our operating assets was driven by an increase in accounts receivable balances. The decrease in our operating liabilities is primarily attributable to a decrease in accounts payable and accrued liabilities offset by an increase in interest payable on long-term debt and deferred revenue. Investing Activities Net cash used by investing activities of $2.6 million in the six months ended June 30, 2011 consisted primarily of an increase of $1.0 million for restricted cash and $1.4 million in purchases of property and equipment. Net cash used in investing activities of $1.7 million in the six months ended June 30, 2010 consisted primarily of $1.4 million in purchases of property and equipment and $0.3 million in purchases of other assets. Financing Activities Net cash provided by financing activities of $0.2 million in the six months ended June 30, 2011 included $0.1 million in proceeds from our RCA facility to support our operations and $0.1 million in proceeds from the exercise of stock options. Net cash provided by financing activities of $0.3 million in the six months ended June 30, 2010 was due to the net proceeds from our borrowings under RCA facility. Off-Balance Sheet Arrangements At June 30, 2011, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, special purpose or variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. We do not have any off-balance sheet arrangements that are currently material or reasonably likely to be material to our consolidated financial position or results of operations. Recent Accounting Pronouncements See Note 3(d) of the Unaudited Condensed Consolidated Financial Statements for a full description of the recent accounting pronouncement related to revenue recognition, including the date of adoption and effect on results of operations and financial condition. See also Note 3(h) for a description of other new accounting pronouncements. [ Back To TMCnet.com's Homepage ]