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PROCERA NETWORKS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following is a discussion of our results of operations and current financial position. This discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this report and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2011, filed with the SEC on March 15, 2012, and as amended by Form 10-K/A, filed with the SEC on April 6, 2012. As used in this Quarterly Report on Form 10-Q, references to the "Company," "we," "us," "our" or similar terms include Procera Networks, Inc. and its consolidated subsidiaries. Cautionary Note Regarding Forward-Looking Statements Our disclosure and analysis in this Quarterly Report on Form 10-Q contain certain "forward-looking statements," as such term is defined in Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). These statements set forth anticipated results based on management's plans and assumptions. From time to time, we also provide forward-looking statements in other materials we release to the public as well as oral forward-looking statements. Such statements give our current expectations or forecasts of future events; they do not relate strictly to historical or current facts. We have attempted to identify such statements by using words such as "anticipate," "estimate," "expect," "project," "intend," "plan," "believe," "will," "could," "initial," "future," "may," "predict," "potential," "should" and similar expressions in connection with any discussion of future events or future operating or financial performance or strategies. Such forward-looking statements include, but are not limited to, statements regarding: our estimates and expenctions for revenue for full fiscal year 2012 and for cost of sales and operating expenses for the fourth fiscal quarter of 2012, as well as our future gross margin rates; our services, including the development and deployment of products and services and strategies to expand our targeted customer base and broaden our sales channels; the operation of our company with respect to the development of products and services; our liquidity and financial resources, including anticipated capital expenditures, funding of capital expenditures and anticipated levels of indebtedness; 16-------------------------------------------------------------------------------- Index trends related to and management's expectations regarding results of operations, required capital expenditures, revenues from existing and new products and sales channels, and cash flows, including but not limited to those statements set forth below in this Item 2; and sales efforts, expenses, interest rates, foreign exchange rates, and the outcome of contingencies, such as legal proceedings. We cannot guarantee that any forward-looking statement will be realized. Achievement of future results is subject to risks, uncertainties and potentially inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from past results and those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements. We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. We also provide the following cautionary discussion of risks and uncertainties related to our businesses. These are factors that we believe, individually or in the aggregate, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties. Our forward-looking statements are subject to a variety of factors that could cause actual results to differ significantly from current beliefs and expectations, identified under the caption "Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q, as well as general risks and uncertainties such as those relating to general economic conditions and demand for our products and services. Overview We are a leading provider of Intelligent Policy Enforcement ("IPE") solutions that enable mobile and broadband network operators and entities managing private networks including higher education institutions, businesses and government entities (collectively referred to as network operators), to gain enhanced visibility into, and control of, their networks. Our solutions provide granular network intelligence intended to enable network operators to improve the quality and longevity of their networks, better monetize their network infrastructure investments, control security hazards and create and deploy new services for their users. We believe that the intelligence we provide about users and their usage enables qualified business decisions. Our network operator customers include mobile service providers, broadband service providers, cable multiple system operators ("MSOs"), Internet Service Providers ("ISPs"), educational institutions, enterprises and government agencies. Our IPE products are part of the market for mobile packet and broadband core products. According to Infonetics Research, the market for IPE products is expected to grow from $344 million in 2010 to just under $2.0 billion in 2016, a compound annual growth rate of 34%. We have also entered the Application Delivery Networking market, which was a $2.6 billion addressable market in 2011, with our announcement of Carrier Grade NAT and Advanced Traffic Steering. Our solutions deliver a key element of the mobile packet and broadband core ecosystems by creating a policy enforcement layer in the network. Our solutions are often integrated with additional elements in the mobile packet and broadband core including Policy Management, Charging and Network Monitoring, Optimization and Assurance functions and are compliant with the widely adopted 3rd Generation Partnership Program ("3GPP") standard. In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, network operators are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers. We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products. Our products are marketed under the PacketLogic brand name. We have a broad spectrum of products delivering IPE at the access, edge and core layers of the network. Our products are designed to offer maximum flexibility to our customers and enable differentiated services and revenue-enhancing applications, all while delivering a high quality of service for subscribers. We face competition from suppliers of standalone IPE and deep packet inspection ("DPI") products, including Allot Communications Ltd., Arbor Networks (a subsidiary of Tektronix), Blue Coat Systems, Inc., Brocade Communications Systems, Inc., Cisco Systems, Inc., Cloudshield Technologies, Inc. (a subsidiary of SAIC, Inc.), Ericsson, Huawei Technologies Company, Ltd., Juniper Networks, Inc. and Sandvine Corporation. Some of our competitors supply platform products with different degrees of DPI functionality, such as switch/routers, routers, session border controllers and VoIP switches. Most of our competitors are larger and more established enterprises with substantially greater financial and other resources. Some competitors may be willing to reduce prices and accept lower profit margins to compete with us. As a result of such competition, we could lose market share and sales, or be forced to reduce our prices to meet competition. However, we do not believe there is a dominant supplier in our market. Based on our belief in the superiority of our technology, we believe that we have an opportunity to capture meaningful market share and benefit from what we believe will be growth in the DPI market. 17-------------------------------------------------------------------------------- Index Our Company is headquartered in Fremont, California and we have regional headquarters in Varberg, Sweden and Singapore. We sell our products through our direct sales force, resellers, distributors and systems integrators in the Americas, Asia Pacific and Europe. Critical Accounting Estimates Our discussion and analysis of our financial condition and results of operations are based upon financial statements which have been prepared in accordance with Generally Accepted Accounting Principles in the United States ("U.S. GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates. We base our estimates on historical experience and on assumptions that are believed to be reasonable. These estimates and assumptions provide a basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, and these differences may be material. We believe the following critical accounting policies reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements: Revenue Recognition; Valuation of Goodwill, Intangible and Long-Lived Assets; Allowance for Doubtful Accounts; Stock-Based Compensation; and Accounting for Income Taxes. These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2011. Results of Operations Comparison of Three and Nine Months Ended September 30, 2012 and 2011 Revenue Revenue for the three and nine months ended September 30, 2012 and 2011 was as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 Increase 2012 2011 Increase Net product revenue $ 12,948 $ 10,128 28 % $ 34,640 $ 24,007 44 % Net support revenue 3,113 2,065 51 % 8,418 4,765 77 % Total revenue $ 16,061 $ 12,193 32 % $ 43,058 $ 28,772 50 % Total revenue for the three and nine months ended September 30, 2012 was $16.1 million and $43.1 million, an increase of 32% and 50%, respectively, from the comparable periods in the prior year. Product revenue in the three and nine months ended September 30, 2012 was $12.9 million and $34.6 million, an increase of 28% and 44%, respectively. Support revenue in the three and nine months ended September 30, 2012 was $3.1 million and $8.4 million, an increase of 51% and 77%, respectively. The increase in product revenue in the three and nine months ended September 30, 2012 compared to the same periods in 2011 reflected increased sales of our mid-range PL8000 series products and PacketLogic Subscriber Management software to wireline, wireless and cable service provider customers. The increase in the support revenue in 2012 compared to the first nine months of 2011 reflected the continued expansion of the installed base of our products to which we have sold ongoing support services. For the three months ended September 30, 2012, revenues from Shaw Communications, Inc. and one additional customer represented 16%, and 24% of net revenues, respectively, with no other single customer accounting for more than 10% of net revenues. For the nine months ended September 30, 2012, revenues from Shaw Communications, Inc. and one additional customer represented 17% and 10% of net revenues, respectively, with no other single customer accounting for more than 10% of net revenues. For the three months ended September 30, 2011, revenues from two customers represented 41% and 22% of net revenues, respectively, and for the nine months ended September 30, 2011, revenue from one customer represented 28% of net revenues, with no other single customer accounting for more than 10% of net revenue. 18-------------------------------------------------------------------------------- Index Sales to customers located in the United States as a percentage of total revenues were 47% and 55% for the three and nine months ended September 30, 2012, respectively. Sales to customers located in the United States as a percentage of total revenues were 58% and 51% for the three and nine months ended September 30, 2011, respectively. For the year ending December 31, 2012, we expect total revenue to increase by approximately 40% compared with the total revenue reported for the year ended December 31, 2011. Cost of Sales Cost of sales includes direct labor and material costs for products sold, costs expected to be incurred for warranty, adjustments to inventory values, including the write-down of slow moving or obsolete inventory and costs for support personnel. The following table presents the breakdown of cost of sales by category for the three and nine months ended September 30, 2012 and 2011 (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 Increase/(Decrease) 2012 2011 Increase Product costs $ 4,053 $ 4,473 (9) % $ 12,671 $ 10,620 19 % Percent of net product revenue 31 % 44 % 37 % 44 % Support costs 487 256 90 % 956 516 85 % Percent of net support revenue 16 % 12 % 11 % 11 % Total cost of sales $ 4,540 $ 4,729 (4) % $ 13,627 $ 11,136 22 % Percent of total net revenue 28 % 39 % 32 % 39 % Total cost of sales in the three months ended September 30, 2012 decreased by $0.2 million while total cost of sales in the nine months ended September 30, 2012 increased by $2.5 million compared to the three and nine month periods in 2011. Cost of sales as a percentage of revenue decreased by 11 and 7 percentage points for the three and nine months ended September 30, 2012, respectively, from the comparable periods in the prior year. The decrease in cost of sales in the three months ended September 30, 2012 primarily reflected an increased proportion of software license sales compared to hardware products. The increase in cost of sales in the nine months ended September 30, 2012 reflected higher material costs associated with increased product sales. The decrease in cost of sales as a percentage of revenue for the three and nine months ended September 30, 2012 primarily reflected increased sales of our appliance-based PL8000 series products, which have lower material costs compared with our other products, and an increased proportion of license revenue. Support cost of sales increased by $231,000 and $440,000 for the three and nine months ending September 30, 2012, reflecting increased customer support and professional services headcount. We expect support cost of sales to further increase in the three months ending December 31, 2012, as compared with the three months ended September 30, 2012 because of additional hiring of customer support and professional services headcount and greater use of outside support services. Stock-based compensation recorded to cost of sales in the three and nine months ended September 30, 2012 was $34,000 and $98,000, respectively, compared to $26,000 and $77,000, respectively, in the corresponding periods of 2011. Gross Profit Gross profit for the three and nine months ended September 30, 2012 and 2011 was as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 Increase 2012 2011 Increase Gross profit $ 11,521 $ 7,464 55 % $ 29,431 $ 17,636 67 % Percent of total net revenue 72 % 61 % 68 % 61 % 19-------------------------------------------------------------------------------- Index Our gross profit margin for the three and nine months ended September 30, 2012 increased by 11% and 7%, respectively, from the comparable periods in the prior year. The improvement in margins for the three and nine months ended September 30, 2012 was a result of a favorable product mix, which included increased sales of our PacketLogic Subscriber Manager software license resulting in a higher proportion of software license revenue, and increased sales of our appliance-based hardware, which has higher margins compared to our chassis based products. We have experienced significant variability in our gross profit rate in the past. For example, our gross profit rate was 56%, 70%, 63% and 72% for the three-months ended December 31, 2011, March 31, 2012, June 30, 2012 and September 30, 2012. This variability results from many factors, including the mix of hardware and software in revenue as well as the degree of competitive pricing impacting our revenue. We expect this variability in our gross margin rate to continue in the future. Operating Expense Operating expenses for the three and nine months ended September 30, 2012 and 2011 were as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 Change 2012 2011 Change Research and development $ 1,931 $ 1,024 89 % $ 5,414 $ 3,304 64 % Sales and marketing 4,573 2,976 54 % 13,053 8,184 59 % General and administrative 2,386 1,394 71 % 6,823 3,982 71 % Total $ 8,890 $ 5,394 65 % $ 25,290 $ 15,470 63 % In 2012, our total operating expenses have steadily increased because we have been hiring additional employees in each function of our company, invested in testing equipment for the development of our products and have increased the use of outside services, including legal and accounting services. We anticipate that this trend will continue in subsequent quarters and that total operating expenses for the fourth quarter of 2012 will exceed those incurred in the quarter ended September 30, 2012. Research and Development Research and development expenses include costs associated with personnel focused on the development or improvement of our products, prototype materials, initial product certifications and equipment costs. Research and development costs include sustaining and enhancement efforts for products already released and development costs associated with planned new products. Research and development expenses for the three and nine months ended September 30, 2012 were as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 Increase 2012 2011 Increase Research and development $ 1,931 $ 1,024 89 % $ 5,413 $ 3,304 64 % As a percentage of net revenue 12 % 8 % 13 % 11 % Research and development expenses for the three and nine months ended September 30, 2012 increased by $0.9 million and $2.1 million, respectively, compared to the three and nine months ended September 30, 2011 as a result of hiring additional research and development personnel and the corresponding additional employee compensation costs, and costs for testing and testing equipment for new product introductions. Additional personnel are expected to allow us to enhance our core product features and functionality in order to support new sales and to achieve follow-on sales to our current customers. Stock-based compensation recorded to research and development expenses in the three and nine months ended September 30, 2012 was $0.1 million and $0.3 million, respectively, compared to $31,000 and $96,000, respectively, in the corresponding periods in 2011. Sales and Marketing Sales and marketing expenses primarily include personnel costs, sales commissions and marketing expenses, such as trade shows, channel development and literature. Sales and marketing expenses for the three and nine months ended September 30, 2012 were as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 Change 2012 2011 Change Sales and marketing $ 4,573 $ 2,976 54 % $ 13,053 $ 8,184 59 % As a percentage of net revenue 28 % 24 % 30 % 28 % 20-------------------------------------------------------------------------------- Index Sales and marketing expenses for the three and nine months ended September 30, 2012 increased by $1.6 million and $4.9 million, respectively, compared to the three and nine months ended September 30, 2011. The increase reflected the hiring of additional sales and marketing personnel in 2012 and the corresponding higher compensation costs, and higher commission costs as a result of the increase in revenue. Stock-based compensation recorded to sales and marketing expenses in the three and nine months ended September 30, 2012 was $0.3 million and $0.9 million, respectively, compared to $0.1 million and $0.3 million, respectively, in the corresponding periods in 2011. General and Administrative General and administrative expenses consist primarily of personnel and facilities costs related to our executive, finance functions and service fees for professional services. Professional services include costs for legal advice and services, accounting and tax professionals, independent auditors and investor relations. General and administrative expenses for the three and nine months ended September 30, 2012 were as follows (in thousands, except percentages): Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 Change 2012 2011 Change General and administrative $ 2,386 $ 1,393 71 % $ 6,823 $ 3,982 71 % As a percentage of net revenue 15 % 11 % 16 % 14 % General and administrative expenses for the three and nine months ended September 30, 2012 increased by $1.0 million and $2.8 million, respectively, compared to the three and nine months ended September 30, 2011, reflecting higher accrued bonus costs associated with exceeding revenue targets, business development expenses of $0.6 million, higher legal and audit fees and increased use of contractors and professionals as our business has grown. Stock-based compensation recorded to general and administrative expense in each of the three and nine months ended September 30, 2012 was $0.4 million and $0.9 million, respectively, compared to $0.3 million and $0.7 million, respectively, in the corresponding periods in 2011. Interest and Other Income (Expense), Net Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 Change 2012 2011 Change ($ in thousands) ($ in thousands) Interest and other income (expense), net $ 161 $ (26 ) 719 % $ 108 $ (91 ) 221 % Interest and other income (expense), net in the three months ended September 30, 2012, reflected interest income earned on our cash and investment balances and foreign exchange gains. Interest and other income (expense), net in the nine months ended September 30, 2012, reflected interest income earned on our cash and investment balances, partially offset by foreign exchange losses. Interest and other income (expense), net in the three and nine months ended September 30, 2011 primarily reflected interest expense associated with our credit facility. Interest expense in the three and nine months ended September 30, 2012 decreased from the prior year comparable periods, reflecting no borrowings under our credit facility in 2012. Provision for Income Taxes Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 Change 2012 2011 Change ($ in thousands) ($ in thousands) Provision for income taxes $ 29 $ - 100 % $ 141 $ 79 78 % We are subject to taxation primarily in the U.S., Australia, Japan, Singapore and Sweden as well as in a number of U.S. states, including California. The increase in the tax provision for the three and nine months ended September 30, 2012 compared to the three and nine months ended September 30, 2011 reflects higher state and foreign taxes as a result of the increase in taxable income. 21-------------------------------------------------------------------------------- Index We have established a valuation allowance for substantially all of our deferred tax assets. We calculated the valuation allowance in accordance with the provisions of FASB Accounting Standards Codification Topic 740, which requires that a valuation allowance be established or maintained when it is "more likely than not" that all or a portion of deferred tax assets will not be realized. We will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal. Liquidity and Capital Resources Cash and Cash Equivalents and Investments The following table summarizes the changes in our cash balance for the periods indicated: Nine Months Ended September 30, 2012 2011 ($ in thousands) Net cash provided by operating activities $ 7,587 $ 2,352 Net cash used in investing activities (80,445 ) (16,263 ) Net cash provided by financing activities 91,050 25,110 Effect of exchange rate changes on cash and cash equivalents 55 (160 ) Net increase in cash and cash equivalents $ 18,247 $ 11,039 During the nine months ended September 30, 2012, we generated $7.6 million in cash from operating activities compared to $2.4 million for the nine months ended September 30, 2011. Cash provided by operating activities during the nine months ended September 30, 2012 primarily consisted of our net income of $4.1 million, non-cash charges of $3.9 million and net working capital sources of cash of $0.4 million. Non-cash charges consisted primarily of stock-based compensation of $2.2 million and depreciation expense of $0.6 million. Working capital sources of cash consisted primarily of an increase in deferred revenue of $3.4 million, reflecting sales of support contracts to both new and existing customers, and an increase in accounts payable of $1.6 million due to an increase in inventory purchases. Working capital uses of cash consisted primarily of an increase in accounts receivable of $4.9 million due to higher credit sales. Net cash used in investing activities of $80.0 million during the nine months ended September 30, 2012 mainly consisted of purchases of short-term investments of $92.2 million and purchases of lab and testing equipment for use in research and development of $2.6 million, partially offset by proceeds from sales and maturities of short-term investments of $14.3 million. Net cash used in investing activities during the nine months ended September 30, 2011 of $16.3 million included purchases of short-term investments of $15.5 million and purchases of lab and testing equipment of $0.8 million. Net cash provided by financing activities of $91.1 million during the nine months ended September 30, 2012 reflected the net proceeds from the issuance of our common stock of $88.0 million and proceeds from the exercise of stock options and warrants of $3.0 million. Net cash provided by financing activities during the nine months ended September 30, 2011 of $25.1 million included net proceeds from the issuance of common stock of $26.5 million and proceeds from the exercise of stock options and warrants of $0.4 million, partially offset by net repayment of borrowings on our credit line of $1.7 million. Our cash, cash equivalents and short-term investments at September 30, 2012 consisted of bank deposits with third party financial institutions, money market funds, U.S. agency securities, certificates of deposit, commercial paper and corporate bonds. Our investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relationship to our investment guidelines and market conditions. Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase. Short-term investments have a remaining maturity of greater than three months at the date of purchase and an effective maturity of less than one year. All investments are classified as available for sale. On April 25, 2012, we completed a registered offering of 4.5 million shares of common stock. The shares were sold to the public at $21.00 per share for an aggregate gross sales price of $94.5 million. We received net proceeds of approximately $88.0 million after deducting underwriting commissions and other offering expenses. We intend to use the net proceeds for general working capital and corporate purposes, including potential acquisitions. On February 3, 2012, we amended and restated our two-year loan and security agreement with Silicon Valley Bank to increase the credit facility from $2.0 million to $10.0 million for an additional two-year period beginning on that date. Borrowings under the amended credit facility bear interest at the prime rate plus 1%, but not less than 4.25% on an annual basis. At September 30, 2012 and December 31, 2011, we had no borrowings outstanding under this credit facility. 22-------------------------------------------------------------------------------- Index Based on our current cash, cash equivalents and short-term investment balances, and anticipated cash flow from operations, we believe that our working capital will be sufficient to meet the cash needs of our business for at least the next twelve months. Our future capital requirements will depend on many factors, including our rate of growth, the expansion of our sales and marketing activities, development of additional channel partners and sales territories, the infrastructure costs associated with supporting a growing business and greater installed base of customers, introduction of new products, enhancement of existing products, and the continued acceptance of our products. We may also enter into arrangements that require investment such as entering into complementary businesses, service expansion, technology partnerships or acquisitions. Off-Balance Sheet Arrangements As of September 30, 2012, we had no off-balance sheet items as described by Item 303(a)(4) of Regulation S-K. We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligations under a variable interest in an unconsolidated entity that provides us with financing, liquidity, market risk or credit risk support. Contractual Obligations We lease facility space under non-cancelable operating leases in California and Sweden that extend through 2016. The details of these contractual obligations are further explained in Note 10 of the Notes to Condensed Consolidated Financial Statements. We use third-party contract manufacturers to assemble and test our hardware products. In order to reduce manufacturing lead-times and ensure an adequate supply of inventories, our agreements with some of these manufacturers allow them to procure long lead-time component inventory based on rolling production forecasts provided by us. We may be contractually obligated to purchase long lead-time component inventory procured by certain manufacturers in accordance with our forecasts. In addition, we issue purchase orders to our third-party manufacturers that may not be cancelable at any time. As of September 30, 2012, we had open non-cancelable purchase orders amounting to approximately $5.6 million, primarily with our third-party contract manufacturers. |