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VITESSE SEMICONDUCTOR CORP - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled "Risk Factors" included in Part I, Item 1A. of this Annual Report on Form 10-K. Overview We are a leading supplier of high-performance integrated circuits ("IC's"), principally targeted at systems manufacturers in the communications industry. Within the communications industry, our products address Carrier and Enterprise networking, where they enable data to be transmitted at high-speeds and processed and switched under a variety of protocols. Over the last 10 years, the worldwide proliferation of the Internet and the rapid growth in the volume of data being sent over LANs and WANs has placed a tremendous strain on the existing communications infrastructure. Communication service providers have sought to increase their revenues by delivering a growing range of data services to their customers in a cost-effective manner. The resulting demand for increased bandwidth and services has created a need for faster, larger and more complex networks. In recent years, we focused our product development and marketing efforts on products that leverage the convergence of Carrier and Enterprise networking to Internet Protocol-based networks. These next-generation networks share the requirements of high reliability, scalability, interoperability and low cost. Increasingly, these networks will be delivered based on Ethernet technology. We believe that products in this emerging technology area represent the best opportunity for us to provide differentiation in the market. Industry Trends and Characteristics that Affect our Business In order to achieve sustained, increasing profitability, we must achieve a combination of revenue growth, increases in margins, and careful control of our operating expenses. We continue to focus on improving each of these components of our financial model. Our new products address the two largest and fastest growing segments of the communications industry-Carrier Ethernet and Enterprise networking. Many of our products also serve the biggest market within these segments, Carrier Mobile Infrastructure, which is beginning to require Carrier Ethernet capabilities. Our future revenue opportunities will, in part, be determined by our ability to participate and capture new design wins within our major customer base. This opportunity depends in large part on our ability to develop, deploy, and sell products in a timely manner with features that compete effectively against the competitors in our markets. We compete for market share based on our customers' selection of our components over our competitors during the design phase of our customers' systems. Our ability to compete is dependent on the needs of our customers, how well our products address these needs, our corporate relationships, and a variety of other factors. Once selected for a design win, we have a high probability of holding the majority market share for this product. Many of our large customers have their own internal design teams, which cause us to compete against these teams when our customers consider a "make vs. buy" decision. The trend in the industry has been, and continues to be, to outsource more designs to companies such as Vitesse. While 40 -------------------------------------------------------------------------------- Table of Contents we expect this trend to continue, we view these "internal" design efforts as a significant competitive threat. The "design win" is a critical milestone in the path to generating revenue, as our products, and our customers' products, are highly complex and typically require many years of development, testing, and qualification before they reach full production. As a result, it may be difficult to forecast the potential revenue from new and existing products at the time we begin our development efforts or achieve our "design wins." Our ability to improve margins depends upon several factors, including our ability to continue to reduce our cost of revenues, including our wafer, assembly, and test costs, our ability to improve manufacturing yields, our ability to continue to migrate our products to next-generation process nodes, and our ability to reduce average selling price ("ASP") erosion. We have active programs in place to address each of these factors. As a fabless semiconductor company, we outsource the majority of our manufacturing. As such, we must manage our supply chain efficiently to ensure competitive materials pricing and effective lead-times for the materials that we purchase. The semiconductor industry in which we compete is highly cyclical. Typically, in periods of strong demand in the semiconductor industry, we may experience longer lead times, difficulties in obtaining capacity and/or meeting commitments for our required deliveries. Today, 100% of our wafer fabrication and assembly is outsourced. During 2010, we successfully moved wafer probe and final testing from our in-house test facility at our headquarters to an outsourced operation at Asian subcontractors. This production model provides us substantial advantages in terms of lower fixed costs, reduced cycle times, and lower inventory levels. Improving product yields is critical to maintaining and improving our cost of revenues. We have a team of engineers focused on yield improvements. Yields are affected by a variety of factors including design quality, wafer fabrication, assembly and test processes and controls, product volumes, and life cycles. We work closely with all our manufacturing subcontractors to improve product manufacturability and yields. We manufacture a wide variety of products, some at low volumes, which likely limits our ability to improve yields on some products. Since 2009, our product gross margins have improved from 49.5% to 59.6% in 2011. Gross margin is also impacted by the ASP of our products, which is primarily determined by competitive factors within the specific markets we serve. Average margins vary widely within the markets we serve, with the Carrier networking market having the highest average margins and the Enterprise networking market having the lowest average margins. We endeavor to increase margins by providing products that have substantial added value relative to our competition. To remain competitive, we must efficiently deploy our engineering, research and development ("R&D") resources into markets that will provide our future revenue growth. Our R&D costs increased to $53.1 million in 2011 from $45.7 million in 2009 as a result of our developing and releasing 50 new products. The percentage of our total headcount that is attributed to R&D has steadily increased during the last three years from 42.2% in 2009 to 46.8% in 2010 to 49.3% in 2011. A large part of this growth is in our Hyderabad, India design center where we can more efficiently execute product verification and validation. Our Hyderabad design center has been re-targeted from storage products to products for Carrier and Enterprise networking applications. In 2011, we had two reductions in force that affected our R&D efforts. As a result, R&D expense will be lower in 2012. We continue to focus our R&D efforts and to seek opportunities to more efficiently deploy our R&D resources into larger, growing markets. As is common in the industry, we sell semiconductor products directly to OEMs and also use a number of distributors and logistics providers to sell products indirectly to our customer base. In 2011, we continued our plans to move more of our business to a direct model. Direct gross shipments to customers were $73.6 million or 55.4% of product revenue in fiscal year 2011, compared with $82.5 million or 49.8% of product revenue in fiscal year 2010, and $49.8 million or 32.1% in fiscal year 41 -------------------------------------------------------------------------------- Table of Contents 2009. Our accounting policy uses the "sell-through" model for sales to our distributors. The "sell-through" model recognizes revenue only upon shipment of the merchandise from our distributor to the final customer. Because we use the "sell-through" methodology we may have variability in our revenue from quarter to quarter as customers have substantial flexibility to reschedule backlog with most of our channel partners as part of the terms and conditions of sale. In addition, the "sell-through" policy requires that we include all distributor channel inventory on our balance sheet as part of our reported inventory. Our indirect gross channel sales were $59.2 million, $83.1 million, and $105.1 million in fiscal years 2011, 2010, and 2009, respectively. Our sales are distributed geographically around the world. In 2011, 46.0% of our sales were to the United States, 38.6% to Asia, and 11.2% to Europe, the Middle East and Africa ("EMEA"), with the remaining 4.2% going to other countries. In 2010, 33.3% of our sales were to the United States, 44.2% to Asia, 15.5% to EMEA, and the remaining 7.0% going to other countries. In 2009, 37.3% of our sales were to the United States, 47.4% to Asia, 11.1% to EMEA, and the remaining 4.2% going to other countries It is critical that we efficiently deploy our capital. Inventory levels decreased to $20.9 million as of September 30, 2011, from $27.3 million as of September 30, 2010. Inventory decreased as our channel partners and distributors took action to decrease their inventory in response to weaker demand. We were able to respond quickly to the change in demand by decreasing orders from our suppliers. Realization of Our Strategy Several years ago, we embarked on a process to substantially re-invent Vitesse to take advantage of the dramatic ongoing transformation of our target networking markets. Towards that goal, we re-positioned our R&D teams and invested heavily to enter new markets, develop new products, and penetrate new customers in an effort to diversify ourselves and provide new opportunities for growth. As with any high-technology company, these growth opportunities begin with new products. We improved the efficiency of our R&D by focusing our resources on two large, but independent markets: Carrier networking and Enterprise networking, which both rely increasingly on Ethernet technology, allowing us to maximize the impact of our R&D budget. After two years of development, Vitesse introduced over 30 new products in 2010 and over 20 new products in 2011. These included many new "platform" products and technology that will serve as the basis for future product development. This was nearly double our historic rate of product introductions. These new products allowed us to substantially increase our served markets in both Carrier and Enterprise networking, providing us better growth opportunities. The next step to generating growth is creating market traction and design wins where we are selected by our customers over our competitors. As we took our new products to market in 2011, we saw a dramatic increase in our customer engagements and the number of design opportunities that were being identified by our sales team. Early adoption of our products by our customers has exceeded our goals. In 2011, we recorded over 300 new design wins, a 250% increase from the prior year. Of these design wins, we expect 80% of the value to come from our Tier-1 and Tier-2 customers, and nearly 50% to come from our new products introduced in 2010 and 2011. Together with our customers, we are now preparing to take these new products into production. In our industry it typically takes twelve to eighteen months for our customers to go from first product sample received to first customer shipment as customers do the necessary development work to complete and qualify their systems in the network. In 2011, we shipped samples and pre-production on the majority of these new products, and we expect our customers to phase into volume production over the course of 2012. As these new products ramp, we will begin a migration of our revenues to our new products, providing a new growth cycle for the company. In 2011, only five percent of our revenue was from 42 -------------------------------------------------------------------------------- Table of Contents products sampled in the last three years. Based on our observed market traction and the design wins captured in 2011, we expect revenue from our new products to increase to 10-15% of revenues in 2012 and continue to grow strongly from there. We've also made solid progress on our strategy to strengthen our operational performance and execution. Our efforts in operations include reduction in materials costs and cycle times, improved product yields, implementation of programs such as lean manufacturing, and an increased emphasis on the importance of our customers. During the last three years, we accelerated our comprehensive efforts to increase our product gross margins and operating margins which together have substantially increased the operating leverage of the company. During the last three years we have: º • º Expanded our business in Europe and Asia, primarily in China, as the result of improved penetration into Tier 1 networking OEMs. º • º Transitioned to a fully outsourced manufacturing model by moving the majority of our California probe and test function to an outsourced, offshore Asian test contractor, which was completed in 2010. This production model substantially reduced our fixed costs, headcount, and reduced cost of testing, and will allow us to reduce our manufacturing cycle times and better serve our growing customer base in Asia. º • º Closed the Calle Carga facility and the Westford design center in fiscal year 2011 and the Portland facility closure is planned for the first quarter of 2012, in order to gain efficiencies by consolidating locations and streamlining costs. We also closed sales offices in Japan and Canada. Critical Accounting Policies and Estimates Management's Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The preparation of these financial statements requires us to make estimates and assumptions that affect the amounts we report as assets, liabilities, revenue and expenses, and the related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are reasonable in the circumstances. We regularly discuss with our audit committee the basis of our estimates. These estimates could change under different assumptions or conditions. Our significant accounting policies are outlined in the notes to the consolidated financial statements. In management's opinion the following critical accounting policies require the most significant judgment and involve complex estimation. We also have other policies that we consider to be key accounting policies; however these policies do not meet the definition of critical accounting estimates as they do not generally require us to make estimates or judgments that are difficult or subjective. Revenue recognition Product revenues In accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 605, Revenue Recognition ("ASC 605"), we recognize product revenue when the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred; (iii) the price to the customer is fixed or determinable, and (iv) collection of the sales price is reasonably assured. Delivery occurs when goods are shipped and title and risk of loss transfer to the customer, in accordance with the terms specified in the arrangement with the customer. Revenue recognition is deferred in all instances where the earnings process is incomplete. We recognize revenue on goods shipped directly to customers at the time of shipping, as that is when title passes to the customer and all revenue recognition criteria specified above are met. 43 -------------------------------------------------------------------------------- Table of Contents A portion of our product sales is made through distributors under agreements allowing for pricing credits and/or right of return. Our past experience with these pricing credits and/or right of return provisions prevent us from being able to reasonably estimate the final price of our inventory to be sold and the amount of inventory that could be returned pursuant to these agreements. As a result, the fixed and determinable revenue recognition criterion has not been met at the time we deliver products to our distributors. Accordingly, product revenue from sales made through these distributors is not recognized until the distributors ship the product to their end customers. We also maintain inventory, or hub, arrangements with certain of our customers. Pursuant to these arrangements, we deliver products to a customer or a designated third party warehouse based upon the customers' projected needs, but do not recognize revenue unless and until the customer reports that it has removed our product from the warehouse and taken title and risk of loss. Intellectual property revenues We derive intellectual property ("IP") revenues from the license of our intellectual property, maintenance and support, the sale of patents, and royalties' revenue following the sale by our licensees of products incorporating the licensed technology. We enter into IP licensing agreements that generally provide licensees the right to incorporate our IP components in their products with terms and conditions that vary by licensee. Our IP licensing agreements may include multiple elements with an IP license bundled with support services. For such multiple element IP licensing arrangements, we follow the guidance in FASB ASU No. 2009-13, Revenue Recognition (ASC Topic 605) Multiple Deliverable Revenue Arrangements, to determine whether there is more than one unit of accounting. License and contract revenues are recorded upon delivery of the technology when there is persuasive evidence of an arrangement, fees are fixed or determinable, delivery has occurred, and collectability is reasonably assured. Other than maintenance and support, there is no continuing obligation under these arrangements after delivery of the IP. Deferred revenue is created when we bill a customer in accordance with a contract prior to having met the requirements for revenue recognition. Certain of our agreements may contain maintenance and support obligations. Under such agreements we provide unspecified bug fixes and technical support. No other upgrades, products, or post-contract support are provided. These arrangements may be renewable annually by the customer. Maintenance and support revenue is recognized ratably over the period during which the obligation exists, typically 12 months or less. We recognize revenue from the sale of patents when there is persuasive evidence of an arrangement, fees are fixed or determinable, delivery has occurred, and collectability is reasonably assured. All of the requirements for revenue recognition are generally fulfilled upon execution of the patent sale arrangement. We recognize royalty revenue in the period in which the licensee reports shipment of products incorporating our IP components. Royalties are calculated on a per unit basis, as specified in our agreement with the licensee. We may, at our discretion and in accordance with our agreements, engage a third party to perform royalty audits of our licensees. Any correction of royalties previously reported would occur when the results are resolved. Multiple Element Transactions For multiple-element arrangements we allocate revenue to all deliverables based on their relative selling prices. In such circumstances, we use a hierarchy to determine the selling price to be used for allocating revenues to deliverables: (i) vendor-specific objective evidence of fair value (VSOE), (ii) third-party evidence of selling price (TPE), and (iii) best estimate of the selling price (ESP). VSOE generally exists only when we sell the deliverable separately and is the price actually charged by us for that deliverable. Generally, we are not able to determine TPE because our licensing arrangements differ from that of our peers. We concluded that no VSOE or TPE exists because it is rare that either 44 -------------------------------------------------------------------------------- Table of Contents we or our competitors sell the deliverables on a stand-alone basis. ESPs reflect our best estimate of what the selling prices of the elements would be if they were sold regularly on a stand-alone basis. While changes in the allocation of the estimated sales price between the units of accounting will not affect the amount of total revenue recognized for a particular sales arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could affect our results of operations. In determining ESPs, we employ a pricing model in which we apply significant judgment as we weigh a variety of factors, based on the facts and circumstances of the arrangement. The facts and circumstances we may consider include but are not limited to prices charged for similar offerings, if any, our historical pricing practices, as well as the nature and complexity of different technologies being licensed, geographies, and the number of uses allowed for a given license. Inventory Valuation We value inventories at the lower of cost or market value on a first-in, first-out basis. Provision for potentially obsolete or slow-moving inventory is made based on management's analysis of inventory levels and future sales forecasts. Our estimates of future product demand may prove to be inaccurate, and we may understate or overstate the provision required for excess and obsolete inventory. Long Lived Assets We periodically evaluate the realizability of long-lived assets as events or circumstances indicate a possible inability to recover the carrying amount. Long-lived assets that will no longer be used in our business are written off in the period identified since they will no longer generate any positive cash flows for us. Such evaluation is based on various analyses, including cash flow and profitability projections. The analyses necessarily involve significant management judgment. In the event the projected undiscounted cash flows are less than net book value of the assets, the carrying value of the assets will be written down to their estimated fair value. Our future cash flows may vary from estimates. Valuation of Compound Embedded Derivative related to Subordinated Debentures In accordance with ASC Topic 815, Derivatives and Hedging ("ASC 815"), management evaluated the terms and features of the 2014 Debentures ("2014" Debentures") and identified a compound embedded derivative (the "compound embedded derivative" or "derivative liability") requiring bifurcation and accounting at fair value because the economic and contractual characteristics of the compound embedded derivative meet the criteria for bifurcation and separate accounting due to the conversion price not being indexed to our own stock. Any gain or loss on the fair value of the compound embedded derivative is reflected in current earnings. The compound embedded derivative is comprised of the conversion option and a make-whole payment for foregone interest if the holder converts the debenture early. We estimated the approximate fair value of the compound embedded derivative as the difference between the estimated value of the 2014 Debentures with and without the compound embedded derivative features. The fair value of the 2014 Debentures was estimated using a convertible bond valuation model within a lattice framework. These valuations were determined using Level 3 inputs. The valuation of the compound embedded derivative required considerable judgment. The valuation methodologies used by us as described above may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, although management believes our valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date. 45 -------------------------------------------------------------------------------- Table of Contents Valuation of Term A and B Loans We estimated the fair value of our Term A and B Loan for purposes of accounting for a debt exchange transaction during fiscal year 2011 and for year-end disclosure of the fair value of the two loans. We estimated the fair value of the Term A Loan at its inception using a cash flow analysis in which the periodic cash coupon payments and the principal payment at maturity are discounted to the valuation date using an appropriate market discount rate. The discount rate is determined by analyzing the seniority and securitization of the instrument, our financial condition, and observing the quoted bond yields in the fixed income market as of the valuation date. We estimated the fair value of the Term B Loan at its inception using a convertible bond valuation model within a lattice framework. These valuations are determined using Level 3 inputs. The valuation model combines expected cash outflows with market-based assumptions regarding risk-adjusted yields, stock price volatility, recent price quotes and trading information of our common stock into which the Term B loan is convertible. The valuation methodologies used by us in determining the fair value of the Term A and B loans requires considerable judgment. The fair value calculation may not be indicative of net realizable value or reflective of future fair values. Furthermore, although management believes our valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the debt exchange date and the period-end reporting date. Accounting for Stock-Based Compensation We account for stock based compensation under ASC Topic 718, Compensation-Stock Compensation, which requires us to record such related compensation costs. Calculating the fair value of stock-based compensation awards requires the input of highly subjective assumptions, including the expected life of the awards and expected volatility of our stock price. Expected volatility is a statistical measure of the amount by which a stock price is expected to fluctuate during a period. Our estimates of expected volatilities are based on weighted historical implied volatility. The expected forfeiture rate applied in calculating stock-based compensation cost is estimated using historical data and is updated annually. The assumptions used in calculating the fair value of stock-based awards involve estimates that require management judgment. If factors change and we use different assumptions, our stock-based compensation expense could change significantly in the future. In addition, if our actual forfeiture rate is different from our estimate, our stock-based compensation expense could change significantly in the future. Income Taxes We account for income taxes in accordance with ASC Topic 740, Income Taxes, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the differences between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense represents the tax payable for the period and the change during the period in deferred tax assets and liabilities. Our valuation allowance against the deferred tax assets is based on our assessments of historical losses and projected operating results in future periods. If and when we generate future taxable income 46 -------------------------------------------------------------------------------- Table of Contents in the United States against which these tax assets may be applied, some portion or all of the valuation allowance would be reversed and an increase in net income would consequently be reported in future years. Restructuring Charges-Facility In calculating the cost to abandon our unutilized facility, we had to estimate the amount to be paid in lease termination payments, the future lease and operating costs to be paid until the lease is terminated, and the amount, if any, of sublease revenues. This required us to estimate the timing and costs of the lease to be terminated, the amount of operating costs for the affected facility and the timing and rate at which we might be able to sublease or complete negotiations of a lease termination agreement. To form our estimates for these costs we performed an assessment of the affected facility and considered the current market conditions. We believe our estimates of the obligations for the closing of the site remain sufficient to cover anticipated settlement costs. However, our assumptions on the lease termination payments, operating costs until termination, or the amounts and timing of offsetting sublease revenues may turn out to be incorrect and our actual cost may be materially different from our estimates. If our actual costs exceed our estimates, we would incur additional expenses in future periods. Impact of Recent Accounting Pronouncements For information with respect to recent accounting pronouncements and the impact of these pronouncements, see "The Company and Its Significant Accounting Policies" footnote on the consolidated financial statements. 47 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth statements of operations data for the fiscal years indicated: September 30, 2011 2010 2009 $ % $ % $ % (in thousands, except percentages) Net revenues: Product revenues $ 132,742 94.2 % $ 165,633 99.8 % $ 154,927 92.1 % Intellectual property revenues 8,225 5.8 % 357 0.2 % 13,250 7.9 % Net revenues 140,967 100.0 % $ 165,990 100.0 % $ 168,177 100.0 % Costs and expenses: Cost of revenues 53,674 38.1 % 71,557 43.1 % 78,212 46.5 % Engineering, research and development 53,129 37.7 % 51,100 30.8 % 45,650 27.1 % Selling, general and administrative 41,233 29.2 % 37,618 22.7 % 39,936 23.7 % Restructuring and impairment charges 3,656 2.6 % 854 0.5 % 528 0.3 % Accounting remediation & reconstruction expense & litigation costs - 0.0 % 73 0.0 % (9,922 ) (5.9 )% Goodwill impairment - 0.0 % - 0.0 % 191,418 113.8 % Amortization of intangible assets 348 0.2 % 797 0.5 % 1,360 0.8 % Costs and expenses 152,040 107.8 % 161,999 97.6 % 347,182 206.3 % (Loss) income from operations (11,073 ) (7.8 )% 3,991 2.4 % (179,005 ) (106.3 )% Other expense (income) : Interest expense, net 8,456 6.0 % 9,495 5.7 % 4,653 2.8 % (Gain) loss on compound embedded derivative (7,680 ) (5.4 )% (7,869 ) (4.7 )% 12,209 7.3 % Loss on extinguishment of debt 3,874 2.7 % 21,311 12.8 % - 0.0 % Other (income), net (292 ) (0.2 )% (291 ) (0.2 )% (304 ) (0.2 )% Other expense , net 4,358 3.1 % 22,646 13.6 % 16,558 9.9 % Loss before income tax (benefit) expense (15,431 ) (10.9 )% (18,655 ) (11.2 )% (195,563 ) (116.2 )% Income tax (benefit) expense (619 ) (0.4 )% 1,521 0.9 % (1,451 ) (0.9 )% Loss from continuing operations (14,812 ) (10.5 )% (20,176 ) (12.1 )% (194,112 ) (115.3 )% Income from discontinued operations, net of tax - 0.0 % 121 0.1 % 71 0.0 % Net loss (14,812 ) (10.5 )% (20,055 ) (12.0 )% (194,041 ) (115.3 )% Fair value adjustment of Preferred Stock-Series B - 0.0 % 126 0.1 % - 0.0 % Net loss available to common stockholders $ (14,812 ) (10.5 )% $ (20,181 ) (12.1 )% $ (194,041 ) (115.3 )% Fiscal Years Ended September 30, 2011 and 2010 Product Revenues We sell our products into the following markets: (i) Carrier networking, (ii) Enterprise networking and (iii) Non-Core. The Carrier networking market includes core, metro, access, mobile and backhaul networks. The Enterprise networking market covers Ethernet switching and transmission within LANs in small-medium enterprise ("SME") and small-medium business ("SMB") markets. The Non-Core market is comprised of legacy products that have not received additional investment over the last five years and, as a result, have generally been in decline. 48 -------------------------------------------------------------------------------- Table of Contents The following table summarizes our product revenues by market: September 30, 2011 2010 % of % of Product Product % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Carrier networking $ 61,685 46.5 % $ 72,380 43.7 % $ (10,695 ) (14.8 )% Enterprise networking 64,754 48.8 % 75,975 45.9 % (11,221 ) (14.8 )% Non-core 6,303 4.7 % 17,278 10.4 % (10,975 ) (63.5 )% Product revenues $ 132,742 100.0 % $ 165,633 100.0 % $ (32,891 ) (19.9 )% The decrease in Carrier networking revenues is largely attributable to the continued weakness in the Asia Pacific region, which declined 26.9% to $28.6 million in fiscal year 2011. The weakness was seen across a wide range of customers and products, primarily in China. This decrease was partially offset by 12.0% increased sales in North America to $23.6 million. The decrease in Enterprise networking revenues is driven by declines in 1 Gigabit Ethernet switch and PHY products selling into low-end SME/SMB applications due to overall weak market conditions, primarily in Asia. Enterprise switch revenue decreased 30.6% to $9.9 million, and 1 Gigabit Ethernet PHY revenue decreased 16.7% to $16.3 million. The decrease in Non-core revenues is largely attributable to a decline of our legacy network processor product line and legacy Fibre Channel PHY products. We also classify our product revenues based on our three product lines: (i) Connectivity, (ii) Ethernet switching and (iii) Transport processing. September 30, 2011 2010 % of % of Product Product % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Connectivity $ 67,734 51.0 % $ 82,522 49.8 % $ (14,788 ) (17.9 )% Ethernet switching 37,940 28.6 % 46,714 28.2 % (8,774 ) (18.8 )% Transport processing 27,068 20.4 % 36,397 22.0 % (9,329 ) (25.6 )% Product revenues $ 132,742 100.0 % $ 165,633 100.0 % $ (32,891 ) (19.9 )% The reduction in Connectivity revenues is largely attributable to a decrease of 60.5% in products for legacy Fibre Channel applications and a decrease of 36.5% in10G Laser Drivers for long haul DWDM applications. The declines were partially offset by gains of 18.1% in PMD components for Fiber to the Home and 10GbE. The reduction in Ethernet switching revenue is largely attributable to overall market softness in our Gigabit Ethernet switches and Gigabit Ethernet PHYs selling primarily into SME and SMB markets. Gigabit Ethernet Switch revenue decreased 31.3%, and Gigabit Ethernet PHY revenue decreased 13.9%. The lower Transport processing revenue is largely attributable to an 79.5% decline in Network Processor (NPU) products and a 46.7% decline in Switch Fabric products. The decrease was partially offset by a 53.9% increase in our legacy SONET framers. 49 -------------------------------------------------------------------------------- Table of Contents Intellectual Property (IP) Revenues September 30, 2011 2010 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) IP revenues $ 8,225 5.8 % $ 357 0.2 % $ 7,868 2203.9 % The increase in IP revenue is attributable to $7.6 million from the sale and licensing of IP during fiscal year 2011, as well as royalty revenues of $0.6 million. The royalties received or recognized for the same periods in fiscal year 2010 were minimal. Costs associated with the sale of IP are included in selling, general and administrative expenses. Cost of Revenues September 30, 2011 2010 % of Net % of Net Product Product % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Cost of revenues $ 53,674 40.4 % $ 71,557 43.2 % $ (17,883 ) (25.0 )% We use third-parties for wafer fabrication and assembly services. Cost of revenues consists predominantly of: (i) purchased finished wafers; (ii) assembly services; (iii) test services; and (iv) labor and overhead costs associated with product procurement, planning, and quality assurance. The overall decrease in cost of revenues is largely attributable to lower product revenues. The decrease in the cost of net revenues as a percent of product revenues is due to a reduction in fixed costs of operations of $4.6 million, enabled by outsourcing wafer and final testing from our headquarters to an outsourced model using an offshore facility. In fiscal year 2011, we decreased production volumes in response to lower demand and improvements in availability of capacity at foundries and assembly sub-contractors eliminating the need to maintain higher inventory balances. As a result, production costs per unit have increased due to certain fixed costs of manufacturing operations. We expect to continue to adjust our inventory levels and anticipate that the sales of these higher cost inventories will temporarily increase our cost of net product revenues in future periods until our revenues return to prior levels. As it is customary in the semiconductor industry for product prices of maturing products to decline over time, it is imperative that we continue to reduce our cost of revenues. We continue to focus our efforts on improving operating efficiencies, including improving product yields, reducing scrap, and improving cycle times. In September 2011, we completed a reduction in force that is expected to lower manufacturing expenses in the future by $0.7 million annually. Engineering, Research and Development September 30, 2011 2010 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Engineering, research and development $ 53,129 37.7 % $ 51,100 30.8 % $ 2,029 4.0 % 50 -------------------------------------------------------------------------------- Table of Contents Engineering, research and development ("R&D") expenses consist primarily of salaries and related costs, including stock-based compensation expense for employees engaged in research, design and development activities. R&D also includes costs of mask sets and electronic design automation tools, software licensing contracts, subcontracting and fabrication costs, depreciation and amortization, and facilities expenses. The level of R&D expenditures as a percentage of net revenues will vary from period to period, depending, in part, on the level of net revenues. We view research and development expenditures as critical to maintaining a high level of new product introductions, which in turn are critical to our plans for future growth. The higher R&D expense in fiscal year 2011 is largely attributable to increased costs of $3.2 million associated with mask sets and wafers purchased, electronic design automation tools and new product evaluation boards associated with our two years of significant new product introductions and bringing those new products to market. This increase in R&D expense was partially offset by lower compensation expenses of $1.2 million related to the reassignment of employees to selling and marketing activities and headcount reductions. In October 2010, we commenced a reduction in force at our Westford design center, which we completed in June 2011. The Westford reduction in force will result in a decrease of approximately $1.7 million from fiscal year 2011 R&D spending levels. In September 2011, we commenced a reduction in force at our Portland design center, which was completed in October 2011. The Portland reduction in force will result in a decrease of approximately $1.7 million from fiscal year 2011 R&D spending levels. We will continue to concentrate our spending in R&D to meet customer requirements and to respond to market conditions, and we do not anticipate that the reduction in R&D headcount will negatively impact product development in fiscal year 2012. Selling, General and Administrative September 30, 2011 2010 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Selling, general and administrative $ 41,233 29.2 % $ 37,618 22.7 % $ 3,615 9.6 % Selling, general and administrative ("SG&A") expense consists primarily of personnel-related expenses, including stock based compensation expense as well as legal and other professional fees, facilities expenses, outside labor and communication expenses. The increase in SG&A is largely attributable to an increase of $2.2 million in our allowance for doubtful accounts related to specific, potentially uncollectable accounts receivable balances identified during our fourth quarter, $2.2 million related to increased compensation, and $1.0 million due to higher facility costs partially offset by a $1.9 million decrease in professional fees. The increased compensation expense results from the reassignment of employees from R&D, additional marketing personnel, and increased non-cash stock compensation. The increase in facility costs is primarily due to the re-allocation of expenses from cost of revenues due to the outsourcing of our wafer and final testing from our headquarters to an outsourced model. In September 2011, we completed a reduction in force in our SG&A organization that will result in approximately $1.5 million lower SG&A expenses on an annualized basis going forward. 51 -------------------------------------------------------------------------------- Table of Contents Restructuring and Impairment Charges September 30, 2011 2010 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Restructuring and impairment charges $ 3,656 2.6 % $ 854 0.5 % $ 2,802 328 % In September 2011, as part of our ongoing cost reduction efforts, we exited our small Calle Carga office and warehouse facility and moved the 42 employees occupying this facility into our adjacent headquarters. Concurrently, we implemented the closure of the Portland design center and additional workforce reductions impacting a total of 41 employees, primarily in the United States. Restructuring and impairment charges consist of $2.5 million related to the Calle Carga facility. We also incurred $0.6 million of severance costs due to the reduction in force. In October 2010, in order to reduce costs and streamline the product design process, we commenced the planned reduction in workforce at our Westford design center. The Westford reduction in workforce was completed by June 2011 and affected 27 employees with the related severance costs of $0.6 million paid as of June 2011. In October 2009, in an effort to reduce costs and shorten manufacturing time, we eliminated test activities at our headquarters and outsourced testing to a third-party, offshore facility. This restructuring plan included the termination of approximately 50 employees. We recorded restructuring charges of $0.9 million in fiscal year 2010. Amortization of Intangible Assets September 30, 2011 2010 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Amortization of intangible assets $ 348 0.2 % $ 797 0.5 % $ (449 ) (56.3 )% The decrease in amortization expense for fiscal year 2011 compared to fiscal year 2010 is due to the amortization of existing intangible assets, some of which became fully amortized during fiscal year 2011. Interest Expense, net September 30, 2011 2010 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Interest expense, net $ 8,456 6.0 % $ 9,495 5.7 % $ (1,039 ) (10.9 )% Net interest expense is comprised of interest expense, net of interest income, and amortization of debt discount and premium, and amortization of debt issuance costs. The decrease in net interest expense for fiscal year 2011 compared to fiscal year 2010 was primarily due to the pay-down of $8.0 million on the Senior Term Loan in January 2011, the restructuring of the Senior Term Loan on February 4, 2011, and the $1.5 million principal payment on the Term A Loan in July 2011. 52 -------------------------------------------------------------------------------- Table of Contents Gain on Compound Embedded Derivative September 30, 2011 2010 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Gain on compound embedded derivative $ (7,680 ) (5.4 )% $ (7,869 ) (4.7 )% $ 189 (2.4 )% The gain on our compound embedded derivative related to our 2014 Debentures is primarily generated by the change in the price of our underlying common stock. In fiscal year 2010, the gain on the compound embedded derivative was partially offset by a loss of $1.1 million recorded upon the exercise of the premium put associated with our then outstanding 2024 Debentures, which did not recur in fiscal year 2011. Loss on Extinguishment of Debt September 30, 2011 2010 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Loss on extinguishment of debt $ 3,874 2.7 % $ 21,311 12.8 % $ (17,437 ) (81.8 )% In fiscal year 2011, the loss on extinguishment of debt of $3.9 million results from the restructuring of the Senior Term Loan on February 4, 2011. In fiscal year 2010, the loss on extinguishment of debt occurred when we recorded the new instruments issued in extinguishment of the 2024 Debentures at fair value and recognized a $21.6 million loss for the difference between the fair values of the new instruments, including approximately $0.8 million for fees paid to the noteholders, compared to the net carrying value of the 2024 Debentures. Income Tax (Benefit) Expense September 30, 2011 2010 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Income tax (benefit) expense $ (619 ) (0.4 )% $ 1,521 0.9 % $ (2,140 ) (140.7 )% Our effective tax rate for fiscal year 2011 was 4.03%. The income tax benefit in the current year is primarily due to the reversal of uncertain tax positions due to the statute of limitations expiration, refundable federal income tax, reversal of foreign deferred tax liabilities, minimum taxes, and foreign taxes. Our effective tax rate for fiscal year 2010 was (8.13%), which was lower than the federal and state statutory rate due to the utilization of NOL carryforwards and tax credits to offset taxes, other than federal and state minimum taxes, and foreign taxes. 53 -------------------------------------------------------------------------------- Table of Contents Fiscal Years Ended September 30, 2010 and 2009 Product Revenues The following tables summarize our product revenues by market: September 30, 2010 2009 % of % of Product Product % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Carrier networking $ 72,380 43.7 % $ 69,020 44.5 % $ 3,360 4.9 % Enterprise networking 75,975 45.9 % 60,356 39.0 % 15,619 25.9 % Non-core 17,278 10.4 % 25,551 16.5 % (8,273 ) (32.4 )% Product revenues $ 165,633 100.0 % $ 154,927 100.0 % $ 10,706 6.9 % The increase in Carrier networking revenues for fiscal year 2010 as compared to fiscal year 2009 was largely attributable to improved market conditions within United States and EMEA markets, partially offset by some weakness in Asia, particularly China. Ethernet switch and PHY products grew by 47.6% to $8.8 million from fiscal year 2009 to fiscal year 2010. This increase was partially offset by a decrease in legacy SONET mapper products of 20% to $6.8 million in fiscal year 2010. In the Connectivity product line, Crosspoint switch revenues grew nearly 170% to $6.9 million and 10 Gigabit Ethernet grew 178.7% to $2.1 million. Again, this revenue growth was partially offset by declines in of some of our older SONET products. Revenues from older generation low-speed SONET PHYs decreased 53% to $6.0 million from fiscal year 2009 to fiscal year 2010. The increase in Enterprise networking revenues for fiscal year 2010 compared to fiscal year 2009 was primarily due to increased strength in connectivity products, including our crosspoint switch and 10 Gigabit Ethernet products selling into large Enterprise and datacenter applications. Crosspoint switch products grew 24.3% from fiscal year 2009 to fiscal year 2010 to $12.3 million. Revenues from our 10 Gigabit Ethernet PHY's and PMD products grew 105% from fiscal year 2009 to fiscal year 2010 to $10.7 million. The decrease in Non-core revenues for fiscal year 2010 compared to fiscal year 2009 was primarily due to a decline of our legacy Raid-on-Chip and legacy Fibre Channel PHY products, partially offset by growth in our Network Processing Unit ("NPU") product line. NPU products increased 13.1% from fiscal year 2009 to fiscal year 2010 to just over $5.6 million. We also classify our product revenues based on our three product lines: (i) Connectivity, (ii) Ethernet switching and (iii) Transport processing. September 30, 2010 2009 % of % of Product Product % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Connectivity $ 82,522 49.8 % $ 72,573 46.8 % $ 9,949 13.7 % Ethernet switching 46,714 28.2 % 42,002 27.1 % 4,712 11.2 % Transport processing 36,397 22.0 % 40,352 26.1 % (3,955 ) (9.8 )% Product revenues $ 165,633 100.0 % $ 154,927 100.0 % $ 10,706 6.9 % The higher Connectivity product line revenue was driven by a 53.8% increase in Crosspoint switches, a 36.4% increase in 10G SONET PHYs, a 255.6% increase in PMD, and a 90.4% increase in 54 -------------------------------------------------------------------------------- Table of Contents 10GEthernet PHYs. This growth was partially offset by a 53.6% decrease in 10G PMD and PHYs for long haul DWDM applications and a 52.2% decrease in low-speed SONET PHYs. The higher Ethernet switching product revenue was driven by a 16.3% increase in CuPHY revenues. The lower Transport processing product revenue was driven by an 82.1% decrease in legacy Raid-on-Chip products, partially offset by a 25.9% increase in EOS Mappers, Switch Fabrics and NPUs. Intellectual Property (IP) Revenues September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) IP revenues $ 357 0.2 % $ 13,250 7.9 % $ (12,893 ) (97.3 )% IP revenue in fiscal year 2010 was primarily related to engineering design fees. In fiscal year 2009, IP revenue of $13.3 million included licensing revenue of $8.3 million from the sale of patents from our IP portfolio and $5.0 million from an arrangement, entered into in the first quarter of fiscal year 2008, to license IP to a third-party. No material royalties were received or recognized for the fiscal years ended September 30, 2010 or 2009. Cost of Revenues September 30, 2010 2009 % of Net % of Net Product Product % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Cost of revenues $ 71,557 43.2 % $ 78,212 50.5 % $ (6,655 ) (8.5 )% The decrease in the cost of net revenues for fiscal year 2010 compared to fiscal year 2009 was largely attributable to improved product yields and lower test costs due to the transition of the test manufacturing activities from our headquarters to an outsource model using an offshore facility. Engineering, Research and Development September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Engineering, research and development $ 51,100 30.8 % $ 45,650 27.1 % $ 5,450 11.9 % The increase in R&D expenses for fiscal year 2010 compared to fiscal year 2009 was mainly attributable to increased engineering tool costs of $2.9 million, primarily for mask sets, and electronic design automation tools required in the support of new product development. In addition, labor costs increased approximately $2.3 million due to the reinstatement of salaries that had been temporarily reduced in fiscal year 2009, as well as increased medical and dental insurance premiums. 55 -------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Selling, general and administrative $ 37,618 22.7 % $ 39,936 23.7 % $ (2,318 ) (5.8 )% The decrease in SG&A expense for fiscal year 2010 as compared to fiscal year 2009 was attributable to extensive cost-reduction efforts, including a legal fee reduction of $2.3 million, an accounting fee reduction of $2.1 million, as well as other cost reductions including travel, supplies and facilities costs of approximately $1.3 million. We also reduced compensation costs by $1.6 million as a result of headcount reductions. During fiscal year 2009, we recognized a gain on the sale of our Colorado building, which offset selling, general and administrative expense in that year by $2.9 million. We also recovered a net $1.9 million in sales tax, returned by a foreign authority. Restructuring and Impairment Charges September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Restructuring and impairment charges $ 854 0.5 % $ 528 0.3 % $ 327 62 % In October 2009, in an effort to reduce costs and shorten manufacturing time, we eliminated test activities at our headquarters and outsourced testing to a third-party facility. This restructuring plan was approved during October 2009 with implementation efforts starting immediately and full transition of testing to the third-party completed by the third quarter of fiscal year 2010. This restructuring plan included the termination of approximately 50 employees. In connection with this restructuring, we recorded restructuring charges of $0.7 million in the first quarter and $0.2 million in the second quarter, totaling $0.9 million for severance costs for fiscal year 2010. 56 -------------------------------------------------------------------------------- Table of Contents As of March 31, 2009, we eliminated 64 positions; approximately 12% of our total workforce. Of the positions eliminated, 53 positions, or approximately 10% of the reductions in workforce, related to full-time employees; the remaining reductions related to temporary staffing. We did not incur any facilities costs related to workforce reductions Accounting Remediation and Reconstruction Expense and Litigation Costs September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Accounting remediation & reconstruction expense & litigation costs $ 73 0.0 % $ (9,922 ) (5.9 )% $ 9,995 (100.7 )% During fiscal year 2009, we recorded a settlement with our former independent registered public accountant, which resulted in a net credit of $16.0 million. We recorded costs of $4.1 million for work performed on stock option accounting and inventory valuation, revision of our revenue recognition policies, and other legal and financial issues. We recorded a $3.0 million accrual due to the proposed settlement with the SEC's Division of Enforcement related to the investigation of our historical stock option practices and certain other accounting irregularities. Lastly, we reached a settlement with the IRS related to the exercise of backdated options, resulting in a credit of $1.0 million as the settlement was less than we had previously estimated and accrued. Goodwill Impairment September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Goodwill impairment $ - 0.0 % $ 191,418 114 % $ (191,418 ) 100 % During the first quarter of the fiscal year ended September 30, 2009, we performed an analysis of our goodwill and determined that the carrying amount of goodwill exceeded the implied fair value of that goodwill. As a result of the analysis, we recorded an impairment charge to fully write off our goodwill balance of $191.4 million. Amortization of Intangible Assets September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Amortization of intangible assets $ 797 0.5 % $ 1,360 0.8 % $ (563 ) (41.4 )% The decrease in amortization expense for fiscal year 2010 compared to fiscal year 2009 is primarily due to intangible assets related to the acquisition of Adaptec becoming fully amortized during fiscal year 2009. 57 -------------------------------------------------------------------------------- Table of Contents Interest Expense, net September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Interest expense, net $ 9,495 5.7 % $ 4,653 2.8 % $ 4,842 104.1 % The increase in interest expense is the result of the higher combined effective interest rate on indebtedness as a result of the debt exchange and an increase in the interest rate on our Senior Term Loan. (Gain) Loss on Compound Embedded Derivative September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) (Gain) loss on compound embedded derivative $ (7,869 ) (4.7 )% $ 12,209 7.3 % $ (20,078 ) (164.5 )% We recognized a gain on our compound embedded derivative, of $9.0 million in fiscal year 2010, related to our 2014 Debentures. The gain on our 2014 Debentures was partially offset by a $1.1 million loss on the compound embedded derivative related to our 2024 Debentures in fiscal year 2010. We recognized a $12.2 million gain on the compound embedded derivative related to our 2024 Debentures, in fiscal year 2009. Loss on Extinguishment of Debt September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Loss on extinguishment of debt $ 21,311 12.8 % $ - 0.0 % $ 21,311 100 % In fiscal year 2010, we finalized negotiations with the noteholders of the 2024 Debentures to settle our obligations, including all amounts owed under the derivative liability for the premium put option, with a combination of cash; shares of our common stock, shares of our Series B Preferred stock, and $50.0 million face value of 2014 Debentures. We recorded the new instruments issued in extinguishment of the 2024 Debentures at fair value and recognized a $21.6 million loss for the difference between the fair values of the new instruments, including approximately $0.8 million for fees paid to the noteholders, compared to the net carrying value of the 2024 Debentures. For the purposes of calculating this loss on extinguishment, the net carrying amount of the 2024 Debentures includes the $96.7 million of the 2024 Debentures and $13.3 million of the premium put derivative, recorded at fair value. 58 -------------------------------------------------------------------------------- Table of Contents Other Income, net September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Other (income), net $ (291 ) (0.2 )% $ (304 ) (0.2 )% $ 13 4 % The change in other income primarily relates to changes in foreign exchange rates. Income Tax Expense (Benefit) September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Income tax expense (benefit) $ 1,521 0.9 % $ (1,451 ) (0.9 )% $ 2,972 204.8 % Our effective tax rate for 2010 was (8.13%), which was lower than the federal and state statutory rate due to the utilization of NOL carryforwards. Our effective tax rate for 2009 was 0.74%, which was lower than the federal and state statutory rate due to the utilization of NOL carryforwards. Income tax expense was $1.5 million for fiscal year 2010 compared to income tax benefit of $1.5 million for fiscal year 2009, an increase in expense of $3.0 million. The increase is primarily due to limitations on the Company's NOL carryforwards as a result of an "ownership change" experienced for tax purposes on October 30, 2009. Net income tax expense for the year ended September 30, 2010 represents minimum federal, state and foreign income tax on income eligible for offset by loss carryforwards. Income from Discontinued Operations September 30, 2010 2009 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Income from discontinued operations, net of tax $ 121 0.1 % $ 71 0.0 % $ 50 70.4 % Income from discontinued operations, consisted solely of income from the earn-out, in connection with our sale of a portion of our Storage Products business to Maxim Integrated Products, Inc. ("Maxim") in October 2007. The income, net of tax, totaled $0.1 million for each of the years ended September 30, 2010 and 2009, respectively. The contract with Maxim is complete and we do not anticipate any additional gains or losses to be incurred from this transaction. 59 -------------------------------------------------------------------------------- Table of Contents Financial Condition and Liquidity Cash Flow Analysis Cash decreased to $17.3 million at September 30, 2011, from $38.1 million at September 30, 2010. During fiscal year 2011 we used cash in operations, for capital expenditures and payment of debt. Our cash flows from operating, investing and financing are summarized as follows: September 30, 2011 2010 2009 (in thousands) Net cash (used in) provided by operating activities $ (7,211 ) $ 1,472 $ 19,197 Net cash (used in) provided by investing activities (3,457 ) (3,188 ) 1,649 Net cash used in financing activities (10,141 ) (17,701 ) (24 ) Net (decrease) increase in cash (20,809 ) (19,417 ) 20,822 Cash at beginning of year 38,127 57,544 36,722 Cash at end of year $ 17,318 $ 38,127 $ 57,544 Net Cash (Used In) Provided by Operating Activities During fiscal year 2011, cash used in operating activities totaled $7.2 million. Excluding changes in working capital, cash used to fund our losses totaled $6.0 million. We also used $9.8 million to pay down our accounts payable and accrued liabilities and $3.0 million related to a decrease in deferred revenue due to lower purchases from distributors. These uses were partially offset by the generation of cash from the collection of accounts receivable of $4.0 million and operating with lower inventory levels of $6.4 million. The decrease in accounts receivable is primarily due to lower revenues compared to the same period last year. The lower inventory of $6.4 million is due to reduced purchases and production in response to lower sales, lower demand, and lower inventory held by distributors and easing of prior years' material shortages. Lower accounts payable of $8.0 million is due to the reduction in inventory purchases, the timing of payments to our vendors and other service providers and due to the payment of the $3.0 million SEC settlement. Accrued expenses and other liabilities decreased $1.8 million primarily due to the timing of payments to our vendors and other service providers. During fiscal year 2010, cash provided by operating activities totaled $1.5 million. Cash generated by operations excluding changes in working capital totaled $2.6 million. Accounts payable and accrued liabilities generated cash of $4.0 million and related to higher inventory purchases near year end and increases in accruals for software licensing, interest payable and payroll. Deferred revenue increased $2.4 million resulting from an increase in distributor purchases near end of the year. These sources were partially offset by an $8.5 million use of cash to build up our inventory levels in anticipation of higher sales demand and anticipated material shortages and increased accounts receivable of $0.7 million resulting from higher sales near year end. During the fiscal year 2009, our operating activities provided $19.2 million in cash. Cash generated by operations excluding changes in working capital totaled $14.9 million. During the year we operated with lower inventory levels which generated $18.7 million cash. The decrease in inventory resulted from lower sales demand, and consequently our inventory purchases and production, and its channel partners and distributors taking action to reduce their inventory in response to the economic slowdown. Accounts receivable increased $5.0 million and resulted from higher sales near the end of the fiscal year. We used $6.6 million to pay down our accounts payable and accrued expenses and $1.6 million related to a decrease in deferred revenues due to lower purchases by distributors. Lower accounts payable of $1.9 million is primarily due to lower inventory purchases. Accrued expenses and other 60 -------------------------------------------------------------------------------- Table of Contents liabilities decreased $4.7 million during the year due to lower accrued wages of $1 million resulting from lower headcount and salary reductions, $0.9 million paid to the IRS upon the settlement of taxes related to backdated stock options and lower accrued income taxes due to tax payments made during the year. Net Cash (Used In) Provided by Investing Activities Investing activities used $3.5 million in cash in fiscal year 2011 for capital expenditures of $2.2 million and an initial investment in an ERP system of $1.3 million. Investing activities used $3.2 million in cash in fiscal year 2010 primarily for capital expenditures. In fiscal year 2009, our investing activities provided $1.6 million in cash from proceeds from the sale of the Colorado building of $6.0 million, net of commissions and transaction costs, partially offset by capital expenditures of $2.3 million and the purchase of intangibles of $2.0 million. Net Cash Used In Financing Activities Financing activities used $10.1 million in cash in fiscal year 2011 primarily relating to a principal payment of $8.0 million on the Senior Term loan, $1.5 million payment of our Term A Loan, and $0.6 million for the repurchase and retirement of restricted stock units for payroll taxes. In 2010, our financing activities used $17.7 million in cash, which was primarily due to a cash payment of $10.0 million to the holders of the 2024 Debentures, $5.0 million to pay down the principal amount of the Senior Term Loan and equity and debt issuance costs of $2.5 million. Capital Resources, including Long-Term Debt, Contingent Liabilities and Operating Leases Prospective Capital Needs Our principal sources of liquidity are our existing cash and cash equivalent balances, cash generated from product sales, and the sales or licensing of our intellectual property, including the sale of patents. As of September 30, 2011, our cash totaled $17.3 million. Our working capital at September 30, 2011 was $26.7 million. In order to achieve sustained profitability and positive cash flows from operations, we may need to further reduce operating expenses and/or increase revenue. We have completed a series of cost reduction actions, which have improved our operating expense structure. We will continue to perform additional actions, as necessary. Our ability to maintain, or increase, current revenue levels to sustain profitability will depend, in part, on demand for our products. We believe that our existing cash and cash equivalent balances, along with cash expected to be generated from product sales and the sale or licensing of our intellectual property, including the sale of patents, and the reduction in working capital requirements from lower inventory levels, will be sufficient to fund our operations and research and development efforts, anticipated capital expenditures, working capital, and other financing requirements for the next 12 months. In order to increase our working capital, we may seek to obtain additional debt or equity financing. However, we cannot assure you that such financing will be available to us on favorable terms, or at all, particularly in light of recent economic conditions in the capital markets. We do not have principal payments on currently outstanding debt due in the next 12 months. 61 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations The following table summarizes our significant contractual obligations as of September 30, 2011: Payment Obligations by Fiscal Year 2017 and 2012 2013 - 2014 2014 - 2016 thereafter Total (in thousands) Convertible subordinated debt(1) $ - $ - $ 46,493 $ - $ 46,493 Term A Loan(2) - 7,857 - - 7,857 Term B Loan(3) - - 9,341 - 9,341 Operating leases(4) 3,104 4,864 1,349 - 9,317 Software licenses(5) 8,483 6,933 5,600 5,600 26,616 Inventory and related purchase obligations(6) 3,642 434 - - 4,076 Total $ 15,229 $ 20,088 $ 62,783 $ 5,600 $ 103,700 -------------------------------------------------------------------------------- º (1) º Convertible subordinated debt represents amounts due for our 8% convertible 2014 Debentures due October 2014. º (2) º Term A loan represents amounts due for our 10.5% fixed rate senior notes due February 2014. º (3) º Term B loan represents amounts due for our 8.0% fixed rate senior notes due October 2014. º (4) º We lease facilities under non-cancellable operating lease agreements that expire at various dates through 2016. During 2011, we elected to exit our Calle Carga facility, but still have obligations under the lease. Gross lease amounts for the Calle Carga facility are included in these amounts. The Calle Carga lease amounts presented have not been adjusted for any potential sublease income as allowed under relevant accounting guidance. º (5) º Software license commitments represent non-cancellable licenses of IP from third-parties used in the development of our products. º (6) º Inventory and related purchase obligations represent non-cancellable purchase commitments for wafers and substrate parts. For purposes of the table above, inventory and related purchase obligations are defined as agreements that are enforceable and legally binding and that specify all significant terms. Our purchase orders are based on our current manufacturing needs and are typically fulfilled by our vendors within a relatively short time. Off-Balance Sheet Arrangements At September 30, 2011 we had no material off-balance sheet arrangements, other than operating leases. 62 -------------------------------------------------------------------------------- Table of Contents |