[May 24, 2012] 8X8 INC /DE/ - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Tweet (Edgar Glimpses Via Acquire Media NewsEdge) OVERVIEW We were founded in 1987 and completed an initial public offering of common stock in 1997. We develop and market telecommunications services for Internet protocol, or IP, telephony and video applications as well as web-based conferencing and unified communications services. We offer the 8x8 Virtual Office hosted PBX service, 8x8 Virtual Contact Center service, the 8x8 Virtual Office Pro unified communications solution and 8x8 Cloud-Based Computing solutions. As of March 31, 2012, we had more than 28,500 business customers. Each business customer subscribes to a number of various lines and services (e.g. physical phone extensions, contact center seats, virtual extensions, fax lines, toll free numbers, receptionist software, unified communications services, etc.). Since fiscal 2004, substantially all of our revenues have been generated from the sale, license and provision of VoIP products, services and technology. Prior to fiscal 2003, our focus was on our VoIP semiconductor business. CRITICAL ACCOUNTING POLICIES & ESTIMATES Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. Note 1 to the consolidated financial statements in Part II, Item 8 of this Report describes the significant accounting policies and methods used in the preparation of our consolidated financial statements. We have identified the policies below as some of the more critical to our business and the understanding of our results of operations. These policies may involve a higher degree of judgment and complexity in their application and represent the critical accounting policies used in the preparation of our financial statements. Although we believe our judgments and estimates are appropriate, actual future results may differ from our estimates. If different assumptions or conditions were to prevail, the results could be materially different from our reported results. The impact and any associated risks related to these policies on our business operations is discussed throughout Management's Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. 27-------------------------------------------------------------------------------- Use of Estimates The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and equity and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including, but not limited to, those related to bad debts, valuation of inventories, and litigation and other contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates under different assumptions or conditions. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets, liabilities and equity that are not readily apparent from other sources. Actual results could differ from those estimates under different assumptions or conditions. Additional information regarding risk factors that may impact our estimates is included above under Part I, Item 1A, "Risk Factors." Revenue Recognition Our revenue recognition policies are described in Note 1 to the consolidated financial statements in Part II, Item 8 of this Report. As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments or utilized different estimates. Under the terms of our typical subscription agreement, new customers can terminate their service within 30 days of order placement and receive a full refund of fees previously paid. We have determined that we have sufficient history of subscriber conduct to make a reasonable estimate of cancellations within the 30-day trial period. Therefore, we recognize new subscriber revenue in the month in which the new order was shipped, net of an allowance for expected cancellations. Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 605-25 requires that revenue arrangements with multiple deliverables be divided into separate units of accounting if the deliverables in the arrangement meet specific criteria. In addition, arrangement consideration must be allocated among the separate units of accounting based on their relative fair values, with certain limitations. The provisioning of the 8x8 service with the accompanying 8x8 IP Telephone constitutes a revenue arrangement with multiple deliverables. In accordance with the guidance of ASC 605-25, we allocate 8x8 revenues, including activation fees, among the 8x8 IP telephones and subscriber services based on the fair value determined by their relative selling prices. Revenues allocated to these devices are recognized as product revenues during the period of the sale less the allowance for estimated returns during the 30-day trial period. All other revenues are recognized when the related services are provided. We record revenue net of any sales-related taxes that are billed to our customers. We believe this approach results in financial statements that are more easily understood by investors. The cost of the products sold is recognized contemporaneously with the recognition of product revenue. At the time of each revenue transaction, we assess whether the revenue amount is fixed and determinable and whether collection is reasonably assured. We assess whether the fee is fixed and determinable based on the payment terms associated with the transaction. If a significant portion of a fee is due after our normal payment terms, which are 30-90 days from invoice date, we account for the fee as not being fixed and determinable. In these cases, we recognize revenue as the fees become due. We assess collection based on a number of factors, including past transaction history with the customer and the creditworthiness of the customer. We generally do not request collateral from our customers. If we determine that collection of a fee is not reasonably assured, we defer the fee and recognize revenue at the time collection becomes reasonably assured, which is generally upon receipt of payment. We defer recognition of revenue on product sales to retailers where the right of return exists until products are resold to the end user and the trial period has expired. Under our revenue recognition accounting principles, if a software license arrangement includes acceptance criteria, we do not recognize revenue until we can demonstrate objectively that the software or service can meet the acceptance criteria or that the customer has signed formal acceptance documentation. If a software license arrangement obligates us to deliver unspecified future products, we recognize revenue on a subscription basis, ratably over the term of the contract. 28 -------------------------------------------------------------------------------- For all sales, except those completed via the Internet, we use either a binding purchase order or other signed agreement as evidence of an arrangement. For sales over the Internet, we use a credit card authorization as evidence of an arrangement, and recognize revenue upon settlement of the transaction, if there are no customer acceptance conditions. We do not settle credit card transactions until equipment related to the transaction, if any, is shipped to a customer. Our ability to enter into revenue generating transactions and recognize revenue in the future is subject to a number of business and economic risks discussed above under Item 1A,"Risk Factors." Collectability of Accounts Receivable We must make estimates of the collectability of our accounts receivable. Management specifically analyzes accounts receivable, including historical bad debts, customer concentrations, customer creditworthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. As of March 31, 2012, the accounts receivable balance was $2,279,000, net of an allowance for doubtful accounts of $140,000, including a reserve for disputed credits, and an estimated returns reserve of $98,000. If the financial condition of our customers deteriorates, our actual losses may exceed our estimates, and additional allowances would be required. Valuation of Inventories We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand, market conditions and replacement costs. If actual future demand or market conditions are less favorable than those projected by us, additional inventory write-downs may be required. Income and Other Taxes As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process requires us to estimate our actual current tax expense and to assess temporary differences resulting from book-tax accounting differences for items such as deferred revenue. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. In the event that we determine that we would be able to realize deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Significant management judgment is required to determine the valuation allowance recorded against our net deferred tax assets, which include net operating loss and tax credit carry forwards. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. As of March 31, 2011, we provided a full valuation allowance of approximately $65.5 million related to our net deferred tax assets due to uncertainties related to our ability to utilize most of our deferred tax assets before they expire. During the fourth quarter of fiscal 2012, we reassessed the need for a valuation allowance against our net deferred tax asset and concluded that it was more likely than not that we would be able to realize a portion of our deferred tax assets. Accordingly, we released a portion of our valuation allowance related to our deferred tax asset which resulted in a credit to the income statement of approximately $62.1 million. We determined that a release of a portion of our valuation allowance was appropriate as a result of the following discrete events: (1) our attainment of three consecutive years of net income, (2) the acquisition of Contactual in the second quarter of fiscal 2012, (3) the completion of the Section 382 ownership analysis under the Internal Revenue Code for Contactual in the fourth quarter of fiscal 2012. In making this determination, we considered all available positive and negative evidence, including our recent earnings trend and expected continued future taxable income. As of March 31, 2012, the net deferred tax asset on the balance sheet represented the projected tax benefit we expect to realize and we continue to maintain a valuation allowance against the remainder of our deferred tax assets that we believe we will not be able to utilize. We have received inquiries, demands or audit requests from several state, municipal and 9-1-1 taxing agencies seeking payment of taxes that are applied to or collected from the customers of providers of traditional public switched telephone network services. We recorded no expense for the years ended March 31, 2012, 2011 and 2010 for estimated tax exposure for such assessments. 29-------------------------------------------------------------------------------- Stock-Based Compensation We account for our employee stock options and stock purchase rights granted under the 1996 Stock Plan, 1996 Director Option Plan, 1999 Nonstatutory Stock Option Plan, the 2006 Stock Plan, the 2003 Contactual Plan, and stock purchase rights under the 1996 Employee Stock Purchase Plan (collectively "Purchase Plans") under the provisions of ASC 718 - Stock Compensation. Under the provisions of ASC 718, share-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as an expense over the employee's requisite service period (generally the vesting period of the equity grant), net of estimated forfeitures. Stock-based compensation expense recognized in the Consolidated Statements of Operations for fiscal 2012, 2011 and 2010, was measured based on ASC 718 criteria. Compensation expense for all share-based payment awards is recognized using the straight-line single-option method and includes the impact of estimated forfeitures. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. To value option grants and stock purchase rights under the Purchase Plans for actual and pro forma stock-based compensation we used the Black-Scholes option valuation model. Fair value determined using the Black-Scholes option valuation model varies based on assumptions used for the expected stock prices volatility, expected life, risk free interest rates and future dividend payments. For fiscal years 2012, 2011 and 2010, we used the historical volatility of our stock over a period equal to the expected life of the options to their fair value. The expected life assumptions represent the weighted-average period stock-based awards are expecting to remain outstanding. These expected life assumptions were established through the review of historical exercise behavior of stock-based award grants with similar vesting periods. The risk free interest was based on the closing market bid yields on actively traded U.S. treasury securities in the over-the-counter market for the expected term equal to the expected term of the option. The dividend yield assumption was based on our history and expectation of future dividend payout. ASC 718 requires us to calculate the additional paid in capital pool ("APIC Pool") available to absorb tax deficiencies recognized subsequent to adopting ASC 718, as if we had adopted ASC 718 at its effective date of January 1, 1995. There are two allowable methods to calculate our APIC Pool: (1) the long form method or (2) the short form method as set forth in ASC 718. We have elected to use the long form method under which we track each award grant on an employee-by-employee basis and grant-by-grant basis to determine if there is a tax benefit or tax deficiency for such award. We then compared the fair value expense to the tax deduction received for each grant and aggregated the benefits and deficiencies to establish the APIC Pool. Due to the adoption of ASC 718, some option exercises result in tax deductions in excess of previously recorded benefits based on the option value at the time of grant, or windfalls. We recognize windfall tax benefits associated with the exercise of stock options directly to stockholders' equity only when realized. Accordingly, we are not recognizing deferred tax assets for net operating loss carryforwards resulting from windfall tax benefits occurring from April 1, 2006 onward. A windfall tax benefit occurs when the actual tax benefit realized by the company upon an employee's disposition of a share-based award exceeds the deferred tax asset, if any, associated with the award that the company had recorded. We use the "with and without" approach as described in ASC 740, in determining the order in which our tax attributes are utilized. The "with and without" approach results in the recognition of the windfall stock option tax benefits only after all other tax attributes of ours have been considered in the annual tax accrual computation. Also, we have elected to ignore the indirect tax effects of share-based compensation deductions in computing our research and development tax expenses and as such, we recognize the full effect of these deductions in the income statement in the period in which the taxable event occurs. 30-------------------------------------------------------------------------------- SELECTED OPERATING STATISTICS We periodically review certain key business metrics, within the context of our articulated performance goals, in order to evaluate the effectiveness of our operational strategies, allocate resources and maximize the financial performance of our business. The selected operating statistics include the following: Selected Operating Statistics March 31, Dec 31, Sept. 30, June 30, March 31, Dec 31, Sept. 30, June 30, 2012 2011 2011 2011 2011 2010 2010 2010 Gross business customer additions (1) 2,892 2,836 3,176 2,897 3,009 2,798 2,450 2,756 Gross business customer cancellations (less cancellations within 30 days of sign-up) 1,697 1,642 1,620 1,593 1,645 1,524 1,459 1,592 Business customer churn (less cancellations within 30 days of sign-up) (2) 2.0% 2.0% 2.1% 2.1% 2.3% 2.2% 2.2% 2.5% Total business customers (3) 28,671 27,677 26,727 25,455 24,385 23,251 22,167 21,362 Business customer average monthly servicerevenue per customer (4) $ 244 $ 239 $ 207 $ 200 $ 204 $ 209 $ 209 $ 208 Overall service margin 76% 77% 77% 78% 78% 77% 78% 78% Overall product margin -15% -24% -45% -53% -73% -65% -57% -38% Overall gross margin 68% 68% 66% 67% 67% 68% 68% 68% Business subscriber acquisition cost per service (5) $ 99 $ 92 $ 101 $ 89 $ 91 $ 99 $ 108 $ 109 Average number of services subscribed to per business customer 9.8 9.4 9.0 8.4 8.0 7.8 7.7 7.5 Business customer subscriber acquisition cost (6) $ 965 $ 867 $ 906 $ 743 $ 725 $ 768 $ 826 $ 818 (1) Includes 49 and 250 customers acquired directly from our acquisitions in the first quarter of fiscal 2011 and second quarter of fiscal 2012 from Central Host, Inc. ("Central Host") and Contactual, respectively, and does not include customers of Virtual Office Solo or Zerigo, Inc. ("Zerigo"). (2) Business customer churn is calculated by dividing the number of business customers that terminated (after the expiration of the 30-day trial) during that period by the simple average number of business customers during the period and dividing the result by the number of months in the period. The simple average number of business customers during the period is the number of business customers on the first day of the period plus the number of business customers on the last day of the period divided by two. (3) Business customers are defined as customers paying for service. Customers that are currently in the 30- day trial period are considered to be customers that are paying for service. Customers subscribing to Virtual Office Solo or Zerigo services are not included as business customers. (4) Business customer average monthly service revenue per customer is service revenue from business customers in the period divided by the number of months in the period divided by the simple average number of business customers during the period. (5) Business subscriber acquisition cost per service is defined as the combined costs of advertising, marketing, promotions, sales commissions and equipment subsidies for business services sold during the period divided by the number of gross business services added during the period. (6) Business customer subscriber acquisition cost is business subscriber acquisition cost per service times the average number of services subscribed to per business customer. We believe it is useful to monitor these metrics together and not individually, as we do not make business decisions based upon any single metric. RESULTS OF OPERATIONS The following discussion should be read in conjunction with our Consolidated Financial Statements and related notes included elsewhere in this Report. REVENUE Years Ended March 31, Year-over-Year Change 2012 2011 2010 2011 to2012 2010 to 2011 (dollar amounts in thousands) Service revenue $ 78,382 $ 64,998 $ 58,683 $ 13,384 20.6% $ 6,315 10.8% Percentage of total revenue 91.4% 92.6% 92.6% 31 -------------------------------------------------------------------------------- Service revenue consists primarily of revenues attributable to the provision of our 8x8 services and royalties earned under our VoIP technology licenses. We expect that 8x8 service revenues will continue to comprise nearly all of our service revenues for the foreseeable future. The increase in fiscal year 2012, compared with fiscal year 2011, was primarily attributable to an increase in 8x8 service revenues resulting from growth of our business service subscriber base and an increase in revenue from the Contactual acquisition that closed on September 15, 2011. Our business service subscriber base grew from approximately 24,000 customers at the end of fiscal 2011 to approximately 28,500 customers on March 31, 2012. The increase was partially offset by a decrease in customers of our residential services. These changes were consistent with the redirection of our marketing efforts toward our business customer service. We expect the trends to continue in future periods. The increase in fiscal year 2011, compared with fiscal year 2010, was primarily attributable to an increase in 8x8 service revenues resulting from growth of our business service subscriber base. Our business service subscriber base grew from approximately 20,000 customers at the end of fiscal 2010 to approximately 24,000 customers on March 31, 2011. The increase was partially offset by a decrease in customers of our residential services. Years Ended March 31, Year-over-Year Change 2012 2011 2010 2011 to 2012 2010 to 2011 (dollar amounts in thousands) Product revenue $ 7,421 $ 5,165 $ 4,713 $ 2,256 43.7% $ 452 9.6% Percentage of total revenue 8.6% 7.4% 7.4% Product revenue consists primarily of revenues from sales of IP telephones, primarily attributable to our 8x8 service. The increase in fiscal year 2012 from fiscal year 2011 resulted from a $2.3 million increase in product revenue attributable to growth in our business customer subscriber base, for which we have been subsidizing equipment purchases. The increase in fiscal year 2011 from fiscal year 2010 also resulted from a $0.6 million increase in product revenue attributable to growth in our business customer subscriber base because of subsidized equipment purchases. However, product revenue attributable to residential and video service declined by $0.1 million. No single customer represented more than 10% of our total revenues during fiscal 2012, 2011 or 2010. The following table illustrates our net revenues by geographic area. Revenues are attributed to countries based on the destination of shipment (in thousands): Years Ended March 31, 2012 2011 2010 United States $ 83,841 $ 69,455 $ 63,272 Other locations 1,962 708 124 $ 85,803 $ 70,163 $ 63,396 COST OF REVENUE Years Ended March 31, Year-over-Year Change 2012 2011 2010 2011 to 2012 2010 to 2011 (dollar amounts in thousands) Cost of service revenue $ 18,065 $ 14,508 $ 13,599 $ 3,557 24.5% $ 909 6.7% Percentage of service revenue 23.0% 22.3% 23.2% Cost of service revenue primarily consists of costs associated with network operations and related personnel, telephony origination and termination services provided by third party carriers and technology license and royalty expenses. 32 -------------------------------------------------------------------------------- The increase in the cost of service revenue for fiscal 2012 from fiscal 2011 was primarily due to a $1.2 million increase in third party network service expenses, $1.1 million increase in payroll and related expenses, a $0.4 million increase in consultant and outside service expenses, a $0.4 million increase in amortization expense due to intangibles acquired in acquisition of Contactual, Inc. and Zerigo, Inc., a $0.3 million increase in depreciation expenses, a $0.2 million increase in expensed computer equipment and furniture and fixtures, and a $0.1 million increase in repair and maintenance expenses. The increase in cost of service revenues was partially offset by a $0.2 million reduction in license and fee expenses and a $0.1 million decrease in recruiting expenses. The increase in the cost of service revenue for fiscal 2011 from fiscal 2010 was primarily due to a $0.9 million increase in payroll and related expenses, a $0.3 million increase in depreciation expenses, a $0.2 million increase in expensed computer equipment and furniture and fixtures, a $0.1 million increase in recruiting expenses, a $0.1 million increase in license and fee expenses, and a $0.1 million increase in repair and maintenance expenses. The increase in cost of service revenues was partially offset by a $0.7 million reduction in the prices we paid to third party network service vendors, reduction of related accruals, as well as our use of multiple third party network provider vendors, which allowed us to route call and network traffic to the third party network provider vendor with the most favorable pricing, and a $0.1 decrease in consultant and outside service expenses. Years Ended March 31, Year-over-Year Change 2012 2011 2010 2011 to 2012 2010 to 2011 (dollar amounts in thousands) Cost of product revenue $ 9,822 $ 8,115 $ 7,257 $ 1,707 21.0% $ 858 11.8% Percentage of product revenue 132.4% 157.1% 154.0% The cost of product revenue consists of costs associated with systems, components, system manufacturing, assembly and testing performed by third party vendors, estimated warranty obligations and direct and indirect costs associated with product purchasing, scheduling, quality assurance, shipping and handling. We allocate a portion of service revenues to product revenues but these revenues are less than the cost of the product. The increase in the cost of product revenue for fiscal 2012 from fiscal 2011 was primarily due to a $1.8 million increase in the shipment of equipment to our business customers and a $0.1 million increase in freight costs. The increase in cost of product revenues was partially offset by a $0.2 million decrease in payroll and related expenses due to reduction in headcount. The increase in the cost of product revenues for fiscal 2011 from fiscal 2010 was primarily due to a $1.0 million increase in the shipment of equipment to our business customers. The increase in cost of product revenues was partially offset by a $0.1 million decrease in freight costs. RESEARCH AND DEVELOPMENT EXPENSES Years Ended March 31, Year-over-Year Change 2012 2011 2010 2011 to 2012 2010 to 2011 (dollar amounts in thousands) Research and development $ 6,745 $ 4,819 $ 5,049 $ 1,926 40.0% $ (230) -4.6% Percentage of total revenue 7.9% 6.9% 8.0% Historically, our research and development expenses have consisted primarily of personnel, system prototype design, and equipment costs necessary for us to conduct our development and engineering efforts. We expense research and development costs, including software development costs, as they are incurred. The increase in research and development expenses for fiscal 2012 from fiscal 2011 was primarily attributable to a $1.5 million increase in payroll and related expenses and a $0.3 million increase in consulting and outside service expenses. The decrease in research and development expenses for fiscal 2011 from fiscal 2010 was primarily attributable to the sale of our French research and development subsidiary in April 2010 offset by an increase in payroll and related expenses in the United States. 33-------------------------------------------------------------------------------- SALES AND MARKETING EXPENSES Years Ended March 31, Year-over-Year Change 2012 2011 2010 2011 to 2012 2010 to 2011 (dollar amounts in thousands) Sales and marketing $ 37,980 $ 31,744 $ 29,134 $ 6,236 19.6% $ 2,610 9.0% Percentage of total revenue 44.3% 45.2% 46.0% Sales and marketing expenses consist primarily of personnel and related overhead costs for sales, marketing, and customer service. Such costs also include outsourced customer service call center operations, sales commissions, as well as trade show, advertising and other marketing and promotional expenses. The increase in sales and marketing expenses for fiscal 2012 from fiscal 2011 was primarily due to a $4.3 million increase in payroll and related expenses due to an increase in our sales force, a $0.7 million increase in advertising expenses, a $0.5 million increase in sales promotion expenses, a $0.3 million increase in amortization of customer relationship intangible, a $0.2 million increase in temporary personnel, consulting and outside service expenses, a $0.2 million increase in travel and meal expenses, a $0.2 million increase in tradeshow expenses, a $0.1 million increase in public relation expenses, a $0.1 million increase in bad debt expense and a $0.1 million increase in credit card processing fees. This increase was partially offset by a $0.6 million reduction in legal expenses, due to a $0.6 million accrual related to the memorandum of understanding to settle a lawsuit against us in fiscal 2011. The increase in sales and marketing expenses for fiscal 2011 from fiscal 2010 was primarily due to a $2.2 million increase in payroll and related expenses, a $0.8 million increase in advertising expenses, a $0.6 million increase in legal expenses, due to a $0.6 million accrual related to the settlement of a lawsuit against us, a $0.1 million increase in recruiting expenses, a $0.1 million increase in amortization of customer relationship intangible asset and a $0.1 million increase in bad debt expenses. This increase was partially offset by a $0.6 million reduction in consulting and outside service expenses primarily due to reduction in third party customer service fees, reduction or conversion of temporary personnel, and reduction of outside service expense due to the completion of a non-recurring project in fiscal 2010, a $0.4 million reduction in indirect channel commission expenses, a $0.1 million reduction in printing expenses and a $0.2 million reduction in other sales and marketing expenses. GENERAL AND ADMINISTRATIVE EXPENSES Years Ended March 31, Year-over-Year Change 2012 2011 2010 2011 to 2012 2010 to 2011 (dollar amounts in thousands) General and administrative $ 6,012 $ 4,733 $ 4,382 $ 1,279 27.0% $ 351 8.0% Percentage of total revenue 7.0% 6.7% 6.9% General and administrative expenses consist primarily of personnel and related overhead costs for finance, human resources and general management. The increase in general and administrative expenses for fiscal 2012 from fiscal 2011 was primarily due to a $0.5 million increase in legal expenses related to patent litigation and merger and acquisitions, a $0.4 million increase in payroll and related expenses, a $0.2 million increase in temporary personnel, consulting and outside service expenses, a $0.1 million increase in facility related expenses and a $0.1 million increase in meals, travel and entertainment costs. The increase in general and administrative expenses was partially offset by $0.1 million reduction in sales, property and franchise taxes due to settlement and release of outstanding state sales tax audit. The increase in general and administrative expenses for fiscal 2011 from fiscal 2010 was primarily due to a $0.2 million increase in payroll and related expenses, a $0.2 million increase in legal expenses, and a $0.1 million increase in other general and administrative expenses. This increase was partially offset by a $0.1 million reduction in consulting and outside service expenses primarily. 34-------------------------------------------------------------------------------- INTEREST INCOME (LOSS) AND OTHER, NET Years Ended March 31, Year-over-Year Change 2012 2011 2010 2011 to 2012 2010 to 2011 (dollar amounts in thousands) Interest income (loss) and other, net $ (305) $ 138 $ 53 $ (443) -321.0% $ 85 160.4% Percentage of total revenue -0.4% 0.2% 0.1% Our interest income (loss) and other, net, primarily consists of an impairment charge to write down the strategic investment in Stonyfish, Inc. and interest and investment income earned on our cash, cash equivalents and investment balances. This item primarily consisted of capital gains distribution and interest income in fiscal 2011 and 2010. The decrease in other income (loss) for fiscal 2012 from fiscal 2011 consists primarily of the impairment charge due to the write down of our strategic investment of $0.4 million offset by capital gain distributions earned on our mutual funds and interest income earned on our cash, cash equivalents and investment balances of $0.1 million. The increase in other income for fiscal 2011 from fiscal 2010 consists primarily of an increase in capital gain distributions due on mutual funds purchased in the third quarter of fiscal 2011. INCOME (LOSS) ON CHANGE IN FAIR VALUE OF WARRANT LIABILITY Years Ended March 31, Year-over-Year Change 2012 2011 2010 2011 to 2012 2010 to 2011 (dollar amounts in thousands) Income (loss) on change in fair value of warrant liability $ - $ 167 $ (146) $ (167) -100.0% $ 313 -214.4% Percentage of total revenue 0.0% 0.2% -0.2% In connection with the sale of shares of our common stock in fiscal 2005 and 2006, we issued warrants in three different equity financings. The change in income on change in fair value of the warrant liability for fiscal 2012 compared to fiscal 2011 is due to the partial exercise and expiration of all remaining warrants in the third quarter of fiscal 2011. The change in income on change in fair value of the warrant liability for fiscal 2011 compared to fiscal 2010 is due to the partial exercise and expiration of all remaining warrants in the third quarter of fiscal 2011. PROVISION (BENEFIT) FOR INCOME TAXES Years Ended March 31, Year-over-Year Change 2012 2011 2010 2011 to 2012 2010 to 2011 (dollar amounts in thousands) Provision (benefit) for income taxes $ (62,354) $ 55 $ 3 $ (62,409) -113470.9% $ 52 1733.3% Percentage of total revenue -72.7% 0.1% 0.0% We recorded an income tax benefit of $62.4 million in fiscal 2012, primarily related to the release of $62.1 million of our valuation allowance in the fourth quarter of fiscal 2012 and the release of $0.4 million of our valuation allowance due to the acquisition of Zerigo in the first fiscal quarter of 2012 partially offset by $0.1 million of state income tax expense. As of March 31, 2011, we provided a full valuation allowance related to our net deferred tax assets as we believed the objective and verifiable evidence of our historical pre-tax net losses outweighed the existing positive evidence regarding our ability to realize our deferred tax assets. During the fourth quarter of fiscal 2012, we reassessed the need for a valuation allowance against our net deferred tax assets and concluded that it was more likely than not that we would be able to realize our deferred tax assets primarily as a result of continued profitability and forecasted future results. Accordingly, in the fourth quarter of fiscal 2012, we released a portion of our valuation allowance related to our net deferred tax assets. As a result of the release of a portion of our valuation allowance, we expect our tax rate will increase in the future. However, we intend to use our net operating loss 35-------------------------------------------------------------------------------- carryforwards and tax credits, to the extent available, to reduce the corporate income tax liability associated with our operations. The effective tax rate for the fiscal year ended March 31, 2012 differed from the statutory federal income tax rate primarily because we utilized prior net operating losses and available tax credits when we had a valuation allowance against our deferred tax assets. Therefore, our income tax provision consisted primarily of minimum and capital state income taxes and foreign income tax. At March 31, 2012, we had net operating loss carryforwards for federal and state income tax purposes of approximately $168.8 million and $105.5 million, respectively, that expire at various dates beginning in 2013 and continuing through 2032. In addition, at March 31, 2012, we had research and development credit carryforwards for federal and state tax reporting purposes of approximately $1.8 million and $3.2 million, respectively. The federal credit carryforwards will begin expiring in 2021 continuing through 2032, while the California credit will carry forward indefinitely. Under the ownership change limitations of the Internal Revenue Code of 1986, as amended, the amount and benefit from the net operating losses and credit carryforwards may be limited in certain circumstances. At March 31, 2012 and 2011, we had net deferred tax assets before valuation allowances of approximately $63.8 million and $65.5 million, respectively. LIQUIDITY AND CAPITAL RESOURCES As of March 31, 2012, we had $24.4 million of cash and cash equivalents and investments. By comparison, at March 31, 2011, we had $18.4 million in cash and cash equivalents. We currently have no borrowing arrangements. 2012 to 2011 Net cash provided by operating activities for fiscal 2012 was $9.2 million, compared with $8.6 million provided by operating activities for fiscal 2011. Cash used in or provided by operating activities has historically been affected by: º the amount of net income; º sales of subscriptions; º changes in working capital accounts, particularly in deferred revenue due to timing of annual plan renewals; º add-backs of non-cash expense items such as depreciation and amortization; and º the expense associated with stock options and stock-based awards. Net cash used in investing activities was $3.0 million in fiscal 2012, compared with $5.4 million used in investing activities in fiscal 2011. The decrease in cash used in investing activities during fiscal 2012 was primarily related to the purchase of investments in December 2010 ($2.0 million), the acquisition of a strategic investment in Stonyfish in April 2010 ($0.3 million) and a net decrease in cash used in the acquisition of businesses ($0.3 million). The decrease in cash used in investing activities during fiscal 2012 was partially offset by an increase in the cash used to purchase equipment in fiscal 2012 ($0.2 million). Net cash used in financing activities was $0.3 million in fiscal 2012, compared with $4.8 million used in financing activities in fiscal 2011. Our financing activities for fiscal 2012 used cash of $2.6 million for the repurchase of shares of common stock under our share repurchase plan, $0.4 million for the buyout of stock options under the existing provisions of our 1996 Stock Plan and 1999 Nonstatutory Stock Option Plan and $0.3 million for capital lease payments. The use of cash in financing activities in fiscal 2012 was partially offset by $3.0 million in cash provided by the issuance of common stock under our employee stock option plans and employee stock purchase plan , as well as the issuance of restricted shares. 2010 to 2011 Net cash provided by operating activities for fiscal 2011 was $8.6 million, compared with $2.5 million provided by operating activities for fiscal 2010. Cash used in or provided by operating activities has historically been affected by: º the amount of net income; º sales of subscriptions; º changes in working capital accounts, particularly in deferred revenue due to timing of annual plan renewals; º add-backs of non-cash expense items such as depreciation and amortization; and 36-------------------------------------------------------------------------------- º the expense associated with stock-based awards. Net cash used in investing activities was $5.4 million in fiscal 2011, compared with $0.9 million used in investing activities in fiscal 2010. The increase in cash used in investing activities during fiscal 2011 is primarily related to the purchase of investments ($2.0 million), the acquisition of Central Host in May 2010 ($1.0 million), a strategic investment in Stonyfish in April 2010 ($0.3 million) and the purchase of additional equipment ($2.1 million) related to the build-out of our new East Coast data center and growth in our data centers on the West Coast for voice and managed hosting services. Net cash used in financing activities was $4.8 million in fiscal 2011, compared with $0.1 million provided by financing activities in fiscal 2010. Our financing activities for fiscal 2011 used cash of $7.7 million for the repurchase of shares of common stock under our share repurchase plan and $0.5 million for the buyout of employee stock options under the existing provisions of our 1996 Stock Plan and 1999 Nonstatutory Stock Option Plan. The use of cash in financing activities in fiscal 2011 was partially offset by $3.4 million in cash provided by the issuance of common stock under our employee stock purchase plan, the issuance of shares related to the exercise of warrants, and the issuance of restricted shares. Contractual Obligations Future operating lease payments, capital lease payments and purchase obligations at March 31, 2012 for the next five years were as follows (in thousands): Year Ending March 31, 2013 2014 2015 2016 2017 Total Capital leases $ 69 $ 32 $ 21 $ 8 $ - $ 130 Office leases 938 1,578 1,625 1,674 6,422 12,237 Purchase obligations Third party customer support provider 2,158 - - - - 2,158 Third party network service providers 664 70 7 - - 741 Open purchase orders 48 - - - - 48 $ 3,877 $ 1,680 $ 1,653 $ 1,682 $ 6,422 $ 15,314 On April 27, 2012, the Company entered into a seven-year lease for a new primary facility in San Jose, California, with a scheduled commencement date of August 1, 2012. The lease is an industrial net lease with monthly base rent of $130,821 for the first 15 months with a 3% increase each year thereafter. The table above includes this commitment. In the third quarter of 2010, we amended our contract with one of our third party customer support vendors containing a minimum monthly commitment of approximately $430,000. The agreement requires a 150-day notice to terminate. At March 31, 2012, the total remaining obligation under the contract was $2.2 million. We entered into contracts with multiple vendors for third party network service providers which expire on various dates in fiscal 2013 through 2015. At March 31, 2012, the total remaining obligations under these contracts were $0.7 million. At March 31, 2012, we had open purchase orders of $48,000, primarily related to inventory purchases from our contract manufacturers. These purchase commitments are reflected in our consolidated financial statements once goods or services have been received or at such time when we are obligated to make payments related to these goods or services. [ Back To TMCnet.com's Homepage ]