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SONUS NETWORKS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion of the financial condition and results of operations of Sonus Networks, Inc. should be read in conjunction with the condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and the audited financial statements and notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2011, which was filed with the U.S. Securities and Exchange Commission on February 24, 2012. Overview We are a leading provider of next-generation session initiation protocol ("SIP")-based solutions, including Voice over Internet Protocol ("VoIP"), video and Unified Communications through secure, reliable and scalable Internet Protocol ("IP") networks. Our infrastructure solutions allow efficient and reliable delivery of voice and multimedia sessions over IP networks while allowing our customers to manage the flows of such sessions in their networks using business policies. Currently, we sell our products principally through a direct sales force in the United States, Europe, Asia-Pacific and the Middle East. We continue to expand our presence into new geographies and markets through our relationships with regional channel partners. In May 2012, we implemented our indirect sales channel program, which is focused primarily on enterprise customers, to capture a larger percentage of the Session Border Controller ("SBC") and Unified Communications markets. Our target customers are comprised of both service providers and enterprises. Customers and prospective customers in the service provider space are traditional and emerging communications service providers, including long distance carriers, local exchange carriers, Internet service providers, wireless operators, cable operators, international telephone companies and carriers that provide services to other carriers. Enterprise customers and target enterprise customers include financial institutions, retailers, state and local governments and other multinational corporations. We collaborate with our customers to identify and develop new, advanced services and applications that can help to reduce costs, improve productivity and generate new revenue. We continue to focus on the key elements of our strategy, which is designed to capitalize on our technology and market lead, and build a premier franchise in multimedia infrastructure solutions. We are currently focusing our major efforts on the following aspects of our business: º • º leveraging our TDM (time division multiplexing)-to-IP gateway technology leadership with service providers to accelerate adoption of SIP-enabled Unified Communication services; º • º expanding our solutions to address emerging IP-based markets, such as SBC; º • º embracing the principles outlined by 3GPP, 4GPP2 and LTE architectures and delivering the industry's most advanced IMS (IP Multimedia Subsystem)-ready SBC product suite; º • º expanding and broadening our customer base by targeting the enterprise for SIP trunking solutions; º • º assisting our customers' ability to differentiate themselves by offering a sophisticated application development platform and service creation environment; º • º expanding our global sales distribution, marketing and support capabilities; º • º actively contributing to the SIP standards definition and adoption process; and º • º pursuing strategic transactions and alliances. On August 24, 2012, we completed the acquisition of Network Equipment Technologies, Inc. ("NET"), a Delaware corporation, for a cash purchase price of $1.35 per share of outstanding NET 31 -------------------------------------------------------------------------------- Table of Contents common stock, or $41.5 million. We believe the acquisition of NET expands our SBC portfolio, opens new sales channels and adds a government installed base to our customer base. The financial results of NET are included in our financial results for the period subsequent to the acquisition. In August 2012, we announced that we were implementing a restructuring initiative to streamline operations and reduce our operating costs. The restructuring plan resulted in a workforce reduction of approximately 90 people worldwide. In connection with this action, we recorded restructuring expense of $2.0 million for severance and related costs and the closing of our office in France in the third quarter of fiscal 2012. We reported a loss from operations of $14.8 million for the three months ended September 28, 2012 and income from operations of $1.2 million for the three months ended September 30, 2011. We reported losses from operations of $32.8 million for the nine months ended September 28, 2012 and $17.0 million for the nine months ended September 30, 2011. We reported a net loss of $15.6 million for the three months ended September 28, 2012 and net income of $1.9 million for the three months ended September 30, 2011. We reported net losses of $33.8 million for the nine months ended September 28, 2012 and $16.4 million for the nine months ended September 30, 2011. Our revenue decreased by $9.3 million in the three months ended September 28, 2012, compared to the three months ended September 30, 2011, and by $6.4 million in the nine months ended September 28, 2012, compared to the nine months ended September 30, 2011. Our gross profit decreased by $9.8 million, to $32.4 million, in the three months ended September 28, 2012, compared to the three months ended September 30, 2011. Our gross profit increased by $8.2 million, to $107.0 million, in the nine months ended September 28, 2012, compared to the nine months ended September 30, 2011. Our gross profit as a percentage of revenue ("total gross margin") was 56.9% in the three months ended September 28, 2012 and 63.6% in the three months ended September 30, 2011. Our total gross margin was 59.8% in the nine months ended September 28, 2012 and 53.3% in the nine months ended September 30, 2011. Operating expenses increased $6.2 million, to $47.2 million, for the three months ended September 28, 2012, compared to $41.0 million for the three months ended September 30, 2011. Operating expenses increased $24.0 million, to $139.8 million, for the nine months ended September 28, 2012, compared to $115.8 million for the nine months ended September 30, 2011. Our operating expenses for both the three and nine months ended September 28, 2012 include $3.7 million in the aggregate of research and development, sales and marketing, and general and administrative expenses attributable to NET. Our operating expenses include acquisition-related expenses of $4.1 million in the three months ended September 28, 2012 and $5.1 million in the nine months ended September 30, 2012. Our operating expenses also include restructuring expense of $2.0 million in both the three and nine months ended September 28, 2012. See "Results of Operations" in this Management's Discussion and Analysis of Financial Condition and Results of Operations for a discussion of these changes in our revenue and expenses. Critical Accounting Policies and Estimates Our Management's Discussion and Analysis of Financial Condition and Results of Operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current 32 -------------------------------------------------------------------------------- Table of Contents conditions and beliefs of what could occur in the future given available information. We consider the following accounting policies to be both those most important to the portrayal of our financial condition and those that require the most subjective judgment. If actual results differ significantly from management's estimates and projections, there could be a material effect on our condensed consolidated financial statements. The significant accounting policies that we believe are the most critical include the following: º • º Revenue recognition; º • º Inventory valuation; º • º Loss contingencies and reserves; º • º Stock-based compensation; º • º Business combinations; º • º Goodwill and intangible assets; and º • º Accounting for income taxes. For a further discussion of our critical accounting policies and estimates, please refer to our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, which was filed with the U.S. Securities and Exchange Commission on February 24, 2012. There were no significant changes to our critical accounting policies from December 31, 2011 through September 28, 2012, with the exception of the addition of the critical accounting policy below: Business Combinations. We allocate the purchase price of acquired companies to identifiable assets acquired and liabilities assumed at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed and represents the expected future economic benefits arising from other assets acquired in the business combination that are not individually identified and separately recognized. Significant management judgments and assumptions are required in determining the fair value of assets acquired and liabilities assumed, particularly acquired intangible assets which typically are comprised of developed technology, trademarks and trade names, customer contracts/relationships, order backlog, internal use software and covenants not to compete. The valuation of purchased intangible assets is principally based upon estimates of the future performance and cash flows from the acquired business. If different assumptions are used, it could materially impact the purchase price allocation and our financial position and results of operations. Management's estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. As a result, during the measurement period, which may be up to one year from the acquisition date, we record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill to the extent that we identify adjustments to the preliminary purchase price allocation. 33 -------------------------------------------------------------------------------- Table of Contents Results of Operations Three and Nine Months Ended September 28, 2012 and September 30, 2011 Revenue. Revenue for the three and nine months ended September 28, 2012 and September 30, 2011 was as follows (in thousands, except percentages): Three months ended (Decrease) September 28, September 30, from prior year 2012 2011 $ % Product $ 33,520 $ 41,892 $ (8,372 ) (20.0 )% Service 23,529 24,461 (932 ) (3.8 )% Total revenue $ 57,049 $ 66,353 $ (9,304 ) (14.0 )% Nine months ended Increase (decrease) September 28, September 30, from prior year 2012 2011 $ % Product $ 107,517 $ 107,291 $ 226 0.2 % Service 71,481 78,133 (6,652 ) (8.5 )% Total revenue $ 178,998 $ 185,424 $ (6,426 ) (3.5 )% Product revenue is comprised of sales of our communication infrastructure products. The products typically incorporated into our trunking and communication application solutions include our GSX9000 and GSX4000 Open Services Switches and our ASX Voice Application Server. The products typically incorporated into our SBC solutions include our SBC 9000 (formerly the NBS9000), SBC 5200 (formerly the NBS5200) and our new SBC 5100 Session Border Controllers. Additionally, in connection with our acquisition of NET, we began selling the SBC 1000 (formerly the NET UX 1000) and the SBC 2000 (formerly the NET UX 2000). The SBC 1000 provides SBC SIP communication capability to the enterprise branch and small and medium businesses, while the SBC 2000 provides SBC SIP communication capability to the enterprise branch and medium to large businesses. Certain of our products may be incorporated into either our trunking, communication applications or SBC solutions; these products include, but are not limited to, our PSX Policy & Routing Server, SGX Signaling Gateway, Sonus Insight Management System, ASX Access Gateway Control Function and our suite of network analytical products. Product revenue for the three and nine months ended September 28, 2012 and September 30, 2011 was comprised of the following (in thousands, except percentages): Three months ended Increase (decrease) September 28, September 30, from prior year 2012 2011 $ % Trunking and communication applications $ 13,126 $ 31,494 $ (18,368 ) (58.3 )% SBC 20,394 10,398 9,996 96.1 % Total product revenue $ 33,520 $ 41,892 $ (8,372 ) (20.0 )% Nine months ended Increase (decrease) from prior September 28, September 30, year 2012 2011 $ % Trunking and communication applications $ 60,449 $ 86,890 $ (26,441 ) (30.4 )% SBC 47,068 20,401 26,667 130.7 % Total product revenue $ 107,517 $ 107,291 $ 226 0.2 % 34 -------------------------------------------------------------------------------- Table of Contents We recognized $1.8 million of product revenue in the aggregate from 40 new customers, including 29 new NET customers, in the three months ended September 28, 2012 and $4.8 million of product revenue in the aggregate from 50 new customers, including 29 new NET customers, in the nine months ended September 28, 2012. We recognized $24.4 million of product revenue from a multi-year project for Bahamas Telecommunications Company Ltd. ("Bahamas Telecom") that was completed and for which all revenue recognition criteria were met in the first quarter of fiscal 2011. Bahamas Telecom was our only new customer for both products and service revenue in the nine months ended September 30, 2011. Our product revenue for both the three and nine months ended September 28, 2012 includes $5.9 million attributable to NET for the period since the acquisition. New customers are those from whom we recognize revenue for the first time, although we may have had outstanding orders from such customers for several years, especially for certain multi-year projects. The timing of the completion of customer projects, revenue recognition criteria satisfaction and customer payments included in multiple element arrangements may cause our product revenue to fluctuate from one quarter to the next. Service revenue is primarily comprised of hardware and software maintenance and support ("maintenance revenue") and network design, installation and other professional services ("professional services revenue"). Service revenue for the three and nine months ended September 28, 2012 and September 30, 2011 was comprised of the following (in thousands, except percentages): Three months ended (Decrease) from September 28, September 30, prior year 2012 2011 $ % Maintenance $ 18,665 $ 19,159 $ (494 ) (2.6 )% Professional services 4,864 5,302 (438 ) (8.3 )% Total service revenue $ 23,529 $ 24,461 $ (934 ) (3.8 )% Nine months ended (Decrease) September 28, September 30, from prior year 2012 2011 $ % Maintenance $ 55,994 $ 56,869 $ (875 ) (1.5 )% Professional services 15,487 21,264 (5,777 ) (27.2 )% Total service revenue $ 71,481 $ 78,133 $ (6,652 ) (8.5 )% The decrease in service revenue in the three months ended September 28, 2012 compared to the three months ended September 30, 2011 is attributable to $0.4 million of lower professional services revenue and $0.5 million of lower maintenance revenue. The decrease in service revenue in the nine months ended September 28, 2012 compared to the nine months ended September 30, 2011 is attributable to $5.8 million of lower professional services revenue and $0.9 million of lower maintenance revenue. In the nine months ended September 30, 2011, we recognized $11.5 million of service revenue from the completion of the Bahamas Telecom project described above, which was comprised of $1.2 million of maintenance revenue and $10.3 million of professional services revenue. The completion of this large, multi-year project contributed to the decrease in total service revenue in the nine months ended September 28, 2012 compared to the nine months ended September 30, 2011. The timing of the completion of projects for revenue recognition, customer payments and maintenance contracts may cause our services revenue to fluctuate from one quarter to the next. Our service revenue for both the three and nine months ended September 28, 2012 includes $1.1 million attributable to NET for the period since the acquisition. 35 -------------------------------------------------------------------------------- Table of Contents The following customers each contributed 10% or more of our revenue in at least one of the three and nine month periods ended September 28, 2012 and September 30, 2011: Three months ended Nine months ended September 28, September 30, September 28, September 30, Customer 2012 2011 2012 2011 AT&T * 22% 24% 13 % Bahamas Telecommunications Company Ltd. * * * 20 % Level 3 Communications 12% * * * -------------------------------------------------------------------------------- º * º Represents less than 10% of revenue International revenue was approximately 24% of our revenue in the three months ended September 28, 2012 and approximately 37% of our revenue in the three months ended September 30, 2011. International revenue was approximately 25% of our revenue in the nine months ended September 28, 2012 and approximately 42% of our revenue in the nine months ended September 30, 2011. Due to the timing of project completions, we expect that the domestic and international components as a percentage of our revenue will fluctuate from quarter to quarter and year to year. Our deferred product revenue was $10.7 million at September 28, 2012 and $8.9 million at December 31, 2011. Our deferred service revenue was $31.6 million at September 28, 2012 and $41.3 million at December 31, 2011. Our deferred revenue balance may fluctuate as a result of the timing of revenue recognition, customer payments, maintenance contract renewals, contractual billing rights and maintenance revenue deferrals included in multiple-element arrangements. Cost of Revenue/Gross Profit. Our cost of revenue consists primarily of amounts paid to third-party manufacturers for purchased materials and services, royalties, manufacturing and professional services personnel and related costs, and provision for inventory obsolescence. Our cost of revenue and gross profit as a percentage of revenue ("gross margin") for the three and nine months ended September 28, 2012 and September 30, 2011 was as follows (in thousands, except percentages): Three months ended September 28, September 30, Increase from prior year 2012 2011 $ % Cost of revenue Product $ 11,768 $ 11,504 $ 264 2.3 % Service 12,839 12,633 206 1.6 % Total cost of revenue $ 24,607 $ 24,137 $ 470 1.9 % Gross margin Product 64.9 % 72.5 % Service 45.4 % 48.4 % Total gross margin 56.9 % 63.6 % 36 -------------------------------------------------------------------------------- Table of Contents Nine months ended September 28, September 30, (Decrease) from prior year 2012 2011 $ % Cost of revenue Product $ 31,988 $ 44,283 $ (12,295 ) (27.8 )% Service 40,019 42,364 (2,345 ) (5.5 )% Total cost of revenue $ 72,007 $ 86,647 $ (14,640 ) (16.9 )% Gross margin Product 70.2 % 58.7 % Service 44.0 % 45.8 % Total gross margin 59.8 % 53.3 % The decrease in product gross margin in the three months ended September 28, 2012 was primarily due to higher royalty costs, coupled with the inclusion of NET's historically higher cost base in our results, which decreased our product gross margin by approximately five percentage points. Our product gross margin for the three months ended September 28, 2012 was also negatively impacted by higher manufacturing-related costs against lower product revenue, which decreased our product gross margin by approximately three percentage points. The increase in product gross margin in the nine months ended September 28, 2012 was primarily due to lower third-party costs coupled with product mix, which increased our product gross margin by approximately 13 percentage points, partially offset by higher manufacturing operations costs, which decreased our product gross margin by approximately two percentage points. Our product gross margin in the nine months ended September 28, 2012 benefitted from the absence of third-party costs related to the Bahamas Telecom project, which was completed in the first quarter of fiscal 2011, and which had negatively impacted our product gross margin for the nine months ended September 30, 2011 by approximately ten percentage points. The decrease in service gross margin in the three months ended September 28, 2012 was primarily attributable to higher costs within the service organization, which decreased our service gross margin by approximately three percentage points. The decrease in service gross margin in the nine months ended September 28, 2012 was primarily attributable to higher costs within the service organization, which decreased our service gross margin by approximately eight percentage points, partially offset by lower third-party costs, which increased our service gross margin by approximately six percentage points. Our service gross margin in the nine months ended September 28, 2012 benefitted from the absence of costs for the lower gross margin Bahamas Telecom project, which had negatively impacted our service gross margin for the nine months ended September 30, 2011 by approximately six percentage points. The higher costs within the service organization are primarily related to increased headcount in our customer support organization in support of our expanding customer base and new product initiatives. Our service cost of revenue is relatively fixed in advance of any particular quarter and therefore, changes in service revenue will typically have a significant impact on service gross margins. Research and Development Expenses. Research and development expenses consist primarily of salaries and related personnel expenses and prototype costs related to the design, development, testing and enhancement of our products. 37 -------------------------------------------------------------------------------- Table of Contents Research and development expenses for the three and nine months ended September 28, 2012 and September 30, 2011 were as follows (in thousands, except percentages): Increase (decrease) from prior September 28, September 30, year 2012 2011 $ % Three months ended $ 15,612 $ 16,231 $ (619 ) (3.8 )% Nine months ended $ 51,094 $ 47,026 $ 4,068 8.7 % Our research and development expenses for the three months ended September 28, 2012 include $1.2 million of expense attributable to NET for the period since the acquisition. The decrease in research and development expenses in the three months ended September 28, 2012 is attributable to $0.4 million of lower expense for product development (third-party development, prototype and test equipment costs) and $0.5 million of lower employee-related costs, comprised primarily of lower salary expense, to support our product initiatives, partially offset by $0.3 million of net increases in other research and development expenses. Our research and development expenses for the nine months ended September 28, 2012 include $1.2 million of expense attributable to NET for the period since the acquisition. The increase in research and development expenses in the nine months ended September 28, 2012 is attributable to $4.2 million of higher employee-related costs, partially offset by $0.1 million of net decreases in other research and development expenses. The increase in employee-related expenses represents higher salary and related expenses primarily resulting from increased headcount. Some aspects of our research and development efforts require significant short-term expenditures, the timing of which may cause significant variability in our expenses. We believe that rapid technological innovation is critical to our long-term success, and we are tailoring our investments to meet the requirements of our customers and market. We believe that our research and development expenses for fiscal 2012 will increase from fiscal 2011 levels due to our increased focus on new product development and the acquisition of NET. Sales and Marketing Expenses. Sales and marketing expenses consist primarily of salaries and related personnel costs, commissions, travel and entertainment expenses, promotions, customer trial and evaluations inventory and other marketing and sales support expenses. Sales and marketing expenses for the three and nine months ended September 28, 2012 and September 30, 2011 were as follows (in thousands, except percentages): September 28, September 30, Increase from prior year 2012 2011 $ % Three months ended $ 17,613 $ 14,651 $ 2,962 20.2 % Nine months ended $ 56,339 $ 42,246 $ 14,093 33.4 % Our sales and marketing expenses for the three months ended September 28, 2012 include $2.0 million of expense attributable to NET for the period since the acquisition. The increase in sales and marketing expenses in the three months ended September 28, 2012 is attributable to $2.5 million of higher employee-related expenses, $0.3 million of higher expense related to evaluation equipment at customer sites, $0.1 million of higher marketing and trade show expenses and $0.1 million of net increases in other sales and marketing expenses. The higher employee-related expense is primarily attributable to higher headcount related to our continued focus on expanded geographical coverage as well as the acquisition of NET, and is comprised of $2.6 million of higher salary-related and commissions expense and $0.1 million of higher stock-based compensation expense, partially offset by $0.2 million of lower employee recruiting, travel and training expenses. 38 -------------------------------------------------------------------------------- Table of Contents Our sales and marketing expenses for the nine months ended September 28, 2012 include $2.0 million of expense attributable to NET for the period since the acquisition. The increase in sales and marketing expenses in the nine months ended September 28, 2012 is attributable to $13.4 million of higher employee-related expenses, $0.5 million of higher marketing and trade show expenses and $0.2 million of higher expense for evaluation equipment. The higher employee-related expense is primarily attributable to the aforementioned higher headcount and is comprised of $11.5 million of higher salary-related and commissions expense and $1.9 million of higher employee recruiting, travel and training expenses. We believe that our sales and marketing expenses will increase in fiscal 2012 from fiscal 2011 levels, primarily attributable to higher personnel and related costs, including such costs attributable to the acquisition of NET. General and Administrative Expenses. General and administrative expenses consist primarily of salaries and related personnel costs for executive and administrative personnel, recruiting expenses and audit and professional fees. General and administrative expenses for the three and nine months ended September 28, 2012 and September 30, 2011 were as follows (in thousands, except percentages): (Decrease) September 28, September 30, from prior year 2012 2011 $ % Three months ended $ 7,939 $ 10,133 $ (2,194 ) (21.6 )% Nine months ended $ 25,302 $ 26,526 $ (1,224 ) (4.6 )% On August 7, 2012, we entered into a letter agreement with Raymond P. Dolan, our President and Chief Executive Officer ("Mr. Dolan"), under which Mr. Dolan elected to accept shares of restricted stock in lieu of base salary through December 31, 2012. Mr. Dolan also elected to receive his fiscal year 2012 target bonus, if earned, in the form of restricted shares. As a result, the expense for Mr. Dolan's base salary and target bonus is now reported as a component of stock-based compensation expense within general and administrative employee-related expenses, resulting in lower salary and bonus expense offset by higher stock-based compensation expense. Our general and administrative expenses for the three months ended September 28, 2012 include $0.5 million of expense attributable to NET for the period since the acquisition. The decrease in general and administrative expenses in the three months ended September 28, 2012 is attributable to $1.0 million of lower expense related to foreign currency translation, $0.8 million of lower employee-related expenses and $0.4 million of net decreases in other general and administrative expenses. The decrease in employee-related expenses is comprised of $1.2 million of lower salary and related expenses, partially offset by $0.3 million of higher stock-based compensation and $0.1 million of higher expenses for employee recruiting and training. Our general and administrative expenses for the nine months ended September 28, 2012 include $0.5 million of expense attributable to NET for the period since the acquisition. The decrease in general and administrative expenses in the nine months ended September 28, 2012 is attributable to $0.8 million of lower audit and professional fees, $0.5 million of lower expense related to foreign currency translation and $0.5 million of net decreases in other general and administrative expenses, partially offset by $0.6 million of higher employee-related expenses. The increase in employee-related expenses is comprised of $0.7 million of higher stock-based compensation, partially offset by $0.1 million of lower salary and related expenses. We believe that our general and administrative expenses will increase in fiscal 2012 from fiscal 2011 levels, primarily due to higher employee-related expenses, including such costs attributable to the acquisition of NET. 39 -------------------------------------------------------------------------------- Table of Contents Acquisition-Related Expenses. Acquisition-related expenses include those costs related to the acquisition of NET that would otherwise not have been incurred by us. These costs are primarily comprised of professional and service fees, such as legal, audit, consulting, transfer agent and other fees, and expenses related to cash payments to former NET executives under their NET change of control agreements. We recorded acquisition-related expenses of $4.1 million in the three months ended September 28, 2012, comprised of $2.0 million of professional and services fees and $2.1 million related to change of control agreements. We recorded acquisition-related expenses of $5.1 million in the nine months ended September 28, 2012, comprised of $3.0 million of professional and services fees and $2.1 million related to change of control agreements. Restructuring Expense. In August 2012, we announced and initiated a plan to streamline operations and reduce operating costs, including a corporate-wide restructuring plan. In the three months ended September 28, 2012, we recorded restructuring expense of $2.0 million related to this restructuring initiative, comprised of $1.9 million of expense to reduce our workforce by approximately 90 employees worldwide and $0.1 million related to the consolidation of our offices in France. We did not record restructuring expense in either the three or nine months ended September 30, 2011. We expect to record additional restructuring expense of $6.0 million in the fourth quarter of fiscal 2012, comprised of approximately $5 million for facility-related charges and $1 million for severance and other related charges. Interest Income, net. Interest income consists of interest earned on our cash equivalents, marketable securities and long-term investments. Interest expense relates to interest on capital lease obligations and, in the three and nine months ended September 28, 2012, interest on the debt assumed in connection with the acquisition of NET. Interest expense in the three and nine months ended September 30, 2011 relates to interest on capital lease obligations. We reported interest income, net, of $20,000 for the three months ended September 28, 2012, compared to $0.3 million for the nine months ended September 30, 2011. The decrease in the three months ended September 28, 2012 is attributable to a lower average portfolio yield on lower invested amounts in the current year period, coupled with one month of interest expense resulting from our assumption of $34.2 million of debt in connection with our acquisition of NET. However, $23.7 million of aggregate principal amount of assumed debt was paid on September 26, 2012 and $8.2 million of assumed debt and the related accrued interest and fees, was paid on October 12, 2012. We recorded interest income, net, of $0.5 million for the nine months ended September 28, 2012, compared to $1.0 million for the nine months ended September 30, 2011. The decrease in the nine months ended September 28, 2012 is attributable to a lower average portfolio yield on lower invested amounts in the current year period, as well as the aforementioned interest expense related to the assumed NET debt. Income Taxes. We recorded provisions for income taxes of $1.4 million for the nine months ended September 28, 2012 and $0.4 million for the nine months ended September 30, 2011. These amounts reflect our estimates of the effective rates expected to be applicable for the respective full fiscal years, adjusted for any discrete events, which are recorded in the period that they occur. These estimates are reevaluated each quarter based on our estimated tax rate for the full fiscal year. The provisions for income taxes for the nine months ended September 28, 2012 and September 30, 2011 represent forecasted tax expense on the earnings of our foreign operations. Our effective tax rate for both three year periods was less than the statutory federal and state rates due to the existence of a valuation allowance on our domestic losses. 40 -------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Liquidity and Capital Resources Our condensed consolidated statements of cash flows are summarized as follows (in thousands): Nine months ended September 28, September 30, 2012 2011 Change Net loss $ (33,782 ) $ (16,433 ) $ (17,349 ) Adjustments to reconcile net loss to cash flows used in operating activities 16,548 15,343 1,205 Changes in operating assets and liabilities (10,848 ) (15,119 ) 4,271 Net cash used in operating activities $ (28,082 ) $ (16,209 ) $ (11,873 ) Net cash provided by investing activities $ 17,163 $ 29,405 $ (12,242 ) Net cash provided by (used in) financing activities $ (22,116 ) $ 1,020 $ (23,136 ) Our cash, cash equivalents, marketable securities and long-term investments totaled $303.3 million at September 28, 2012. Our operating activities used $28.1 million of cash in the nine months ended September 28, 2012, compared to $16.2 million of cash used in operating activities in the nine months ended September 30, 2011. Cash used in operating activities in the nine months ended September 28, 2012 was primarily the result of lower deferred revenue, accrued expenses and other long-term liabilities, and accounts payable, as well as higher other operating assets and inventory. These amounts were partially offset by lower accounts receivable. The decrease in accrued expenses and other long-term liabilities primarily reflects income tax payments. The increase in other operating assets is primarily related to pre-payments of royalties, licenses and maintenance. The increase in inventory levels is primarily due to purchases of materials to fulfill our expected shipments in the near-term. The decrease in accounts receivable primarily reflects our continued focus on cash collections, coupled with lower revenue. Our net loss, adjusted for non-cash items such as depreciation, amortization and stock-based compensation, used $17.2 million of cash. Cash used in operating activities in the nine months ended September 30, 2011 was primarily the result of lower deferred revenue, accrued expenses and accounts payable. These amounts were offset by lower inventory, other operating assets and accounts receivable. The reduction in deferred revenue is primarily attributable to a multi-year project for which revenue had been previously deferred. The reduction in accrued expenses is primarily related to employee compensation and related costs, including payments made in connection with our Company-wide employee incentive bonus program and payments in 2011 related to the departures in 2010 of our former President and Chief Executive Officer and our former Executive Vice President and Chief Operating Officer. The lower inventory levels are primarily related to the recognition of deferred cost of goods sold in connection with the completion of the previously discussed multi-year project, partially offset by increased inventory levels as we transitioned to our new contract manufacturer. The decrease in accounts receivable primarily reflects payments in the current year. Our net loss, adjusted for non-cash items such as depreciation, amortization and stock-based compensation, used $1.1 million of cash. 41 -------------------------------------------------------------------------------- Table of Contents Our investing activities provided $17.2 million of cash in the nine months ended September 28, 2012, comprised of $60.5 million of net maturities of marketable securities, partially offset by $35.5 million of cash paid, net of cash acquired, for the acquisition of NET on August 24, 2012. We used $7.8 million for investments in property and equipment in the nine months ended September 28, 2012. Our investing activities provided $29.4 million of cash in the nine months ended September 30, 2011, comprised of $40.4 million of net maturities of marketable securities, partially offset by $11.0 million of investments in property and equipment. Our financing activities used $22.1 million of cash in the nine months ended September 28, 2012, comprised of $23.7 million for the settlement of the 73/4% redeemable convertible subordinated debentures assumed in connection with the acquisition of NET, $0.2 million of cash used to pay withholding obligations to the net share settlement of restricted stock awards upon vesting and $0.1 million for payments on our capital leases for office equipment. These amounts were partially offset by $1.7 million of proceeds from the sale of our common stock in connection with our Amended and Restated 2000 Employee Stock Purchase Plan ("ESPP") and $0.2 million of proceeds from the exercise of stock options. Our financing activities provided $1.0 million of cash in the nine months ended September 30, 2011, comprised of $1.5 million of proceeds from the sale of our common stock in connection with our ESPP and $0.8 million of proceeds from the exercise of stock options. These amounts were partially offset by $1.2 million of cash used to pay withholding obligations related to the net share settlement of restricted stock awards upon vesting and $66,000 for payments on our capital leases for office equipment. Based on our current expectations, we believe our cash, cash equivalents, marketable securities and long-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures, including the payment of $8.2 million we made in October 2012 for the redemption of the majority of the 33/4% convertible senior notes assumed in connection with our acquisition of NET and restructuring initiatives, for at least the next 12 months. However, it is difficult to predict future liquidity requirements with certainty. The rate at which we will use cash will be dependent on the cash needs of future operations, including changes in working capital, which will, in turn, be directly affected by, among other things, the levels of demand for our products, the timing and rate of expansion of our business, the resources we devote to developing our products and any litigation settlements. We anticipate devoting substantial capital resources to continue our research and development efforts, to maintain our sales, support and marketing operations and for other general corporate activities, as well as to vigorously defend against existing and potential litigation. See Note 15 to our condensed consolidated financial statements for a description of our legal contingencies. Recent Accounting Pronouncements On June 16, 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income ("ASU 2011-05"), which revises the manner in which entities present comprehensive income in their financial statements. The new guidance requires companies to report components of comprehensive income in either: (1) a continuous statement of comprehensive income; or (2) two separate consecutive statements. ASU 2011-05 does not change the items that must be reported in other comprehensive income. On December 23, 2011, the FASB issued ASU No. 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 ("ASU 2011-12"), which defers certain provisions of ASU 2011-05, including the provision that requires entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. The unaffected provisions of ASU 42 -------------------------------------------------------------------------------- Table of Contents 2011-05 became effective for us in our reporting of the first quarter of fiscal 2012. The adoption of ASU 2011-05 did not have any impact on our results of operations, financial position or cash flows. |