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APPLIED MICRO CIRCUITS CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) This management's discussion and analysis of financial condition and results of operations ("MD&A") is provided as a supplement to the accompanying consolidated financial statements and footnotes to help provide an understanding of our financial condition, changes in our financial condition and results of our operations. The MD&A is organized as follows: • Caution concerning forward-looking statements. This section discusses how forward-looking statements made by us in the MD&A and elsewhere in this quarterly report are based on management's present expectations about future events and are inherently susceptible to uncertainty and changes in circumstances. • Overview. This section provides an introductory overview and context for the discussion and analysis that follows in the MD&A. • Critical accounting policies. This section discusses those accounting policies that are both considered important to our financial condition and operating results and require significant judgment and estimates on the part of management in their application. • Results of operations. This section provides an analysis of our results of operations for the three and nine months ended December 31, 2012 and 2011. A brief description is provided of transactions and events that impact the comparability of the results being analyzed. • Financial condition and liquidity. This section provides an analysis of our cash position and cash flows, as well as a discussion of our financing arrangements and financial commitments. CAUTION CONCERNING FORWARD-LOOKING STATEMENTS The MD&A should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto included in this report. This discussion contains forward-looking statements. These forward-looking statements are made as of the date of this report. Any statement that refers to an expectation, projection or other characterization of future events or circumstances, including the underlying assumptions, is a forward-looking statement. We use certain words and their derivatives such as "anticipate", "believe", "plan", "expect", "estimate", "predict", "intend", "may", "will", "should", "could", "future", "potential", and similar expressions in many of the forward-looking statements. The forward-looking statements are based on our current expectations, estimates and projections about our industry, management's beliefs, and other assumptions made by us. These statements and the expectations, estimates, projections, beliefs and other assumptions on which they are based are subject to many risks and uncertainties and are inherently subject to change. We describe many of the risks and uncertainties that we face in Part II, Item 1A, "Risk Factors" and elsewhere in this report. Our actual results and actual events could differ materially from those anticipated in any forward-looking statement. Readers should not place undue reliance on any forward-looking statement. OVERVIEW The Company Applied Micro Circuits Corporation ("AppliedMicro", "APM", "AMCC", the "Company", "we" or "our") is a leader in semiconductor solutions for the data center, enterprise, telecom and consumer/small medium business ("SMB") markets. We design, develop, market, sell and support high-performance low power ICs, which are essential for the processing, transporting and storing of information worldwide. In the telecom and enterprise markets, we utilize a combination of design expertise coupled with system-level knowledge and multiple technologies to offer IC products for wireline and wireless communications equipment such as wireless access points, wireless base stations, multi-function printers, enterprise and edge switches, blade servers, storage systems, gateways, core switches, routers, metro, long-haul, and ultra-long-haul transport platforms. In the consumer/SMB markets, we combine optimized software and system-level expertise with highly integrated semiconductors to deliver comprehensive reference designs and stand-alone semiconductor solutions for wireline and wireless communications equipment such as wireless access points, network attached storage, and residential and smart energy gateways. We are committed to our strategy to focus on the transition to converge computing and connectivity into the Data Center which will create optimized total-cost-of-ownership solutions for cloud server workloads and position us towards the large growth data center market. Our corporate headquarters are located in Sunnyvale, California. Sales and engineering offices are located throughout the world. We are a semiconductor company that possesses fundamental and differentiated intellectual property for high speed signal processing, packet based communications processors and telecommunications transport protocols. This intellectual property enables us to be a key player in the data center, enterprise and telecommunications applications. Our customer focus is on the OEMs and telecommunications companies that build and connect to data centers. As of December 31, 2012, our business had two reporting units, Computing and Connectivity. 21 -------------------------------------------------------------------------------- Since the start of fiscal 2011, we have invested a total of $436.3 million in the R&D of new products, including higher-speed, lower-power and lower-cost products, products that combine the functions of multiple existing products into single highly-integrated solutions, and other products to expand and complete our portfolio of communications solutions including our ARM 64-bit based server product development. These products, and our customers' products for which they are intended, are highly complex. Due to this complexity, it often takes several years to complete the development and qualification of a product before it enters into volume production. Accordingly, we have not yet generated significant revenues from some of the products developed during this time period. In addition, downturns in the telecommunications market can severely impact our customers' business and often result in significantly less demand for our products than was expected when the development work commenced. We implemented a restructuring program during the three months ended December 31, 2012 to reorganize our operations and reduce our workforce and related operating expenses. The plan includes eliminating job redundancies and reducing our current workforce by approximately 70 employees. As a result, we recorded a charge of $1.5 million for employee severances and $4.7 million for an asset impairment. The asset impairment related to the impairment of the unamortized value of a software intellectual property license, which the Company no longer intends to use to develop new products. We expect to incur cash expenditures of approximately $1.2 million to $1.4 million during the current fiscal year ending March 31, 2013 for employee severances and anticipate that the restructuring plan will reduce ongoing headcount expenses by approximately $8.0 million to $9.0 million annually and other additional operational expenses by $4.0 million to $5.0 million annually. We expect the restructuring program to be completed by the end of its current fiscal year ending March 31, 2013. Acquisition of Veloce On June 20, 2012 (the "Closing Date"), the Company completed its acquisition of Veloce pursuant to the terms of the Agreement and Plan of Merger, entered into as of May 17, 2009 (the "Initial Agreement"), as amended by Amendment No. 1 to Agreement and Plan of Merger, entered into as of November 8, 2010 (the "First Amendment"), and Amendment No. 2 to Agreement and Plan of Merger, entered into as of April 5, 2012 (the "Second Amendment" and, collectively with the Initial Agreement and the First Amendment, the "Merger Agreement"). The First Amendment was amended, restated and replaced in its entirety by the Second Amendment. The Merger is treated as a "reorganization" under Section 368 of the Internal Revenue Code. The terms of the Merger Agreement include the payment of initial consideration of up to $60.4 million, payable in shares of Company common stock and/or cash (at the Company's election) to holders of Veloce common stock, Veloce stock options that were vested on the Closing Date, and holders of Veloce stock equivalents (collectively, "Veloce Equity Holders"). During the three and nine months ended December 31, 2012, as part of the above arrangement, the Company issued 0.2 million shares valued at $1.1 million and 2.9 million shares valued at $16.0 million, respectively, and paid approximately $1.1 million and $15.9 million in cash, respectively. Of the $60.4 million that relates to the initial consideration, $31.9 million has been paid to date. To the extent payments of the $60.4 million are paid in the Company's common stock and relate to shares of Veloce stock that were outstanding at the date of the closing of the Merger, the value of the Company's common stock is fixed at $5.546 per share ("fixed shares"). The balance of the $60.4 million or approximately $28.5 million will be paid over multiple quarters and will include approximately 1.2 million fixed shares and at least $10.2 million in cash for a total value of $16.9 million. The remaining $11.6 million of the $28.5 million will be paid in a combination of cash and shares of the Company's common stock valued at the then-current market price. For accounting purposes, the consideration payable for the acquisition of Veloce is considered compensatory and is recognized as research and development expense when incurred. Recognition of these costs will occur when the specific development and performance milestones become probable of achievement and the amount of expense will be based upon the estimated stage of product development to date. As of March 31, 2012, the first development and performance milestone set forth under the Merger Agreement was considered probable of achievement and the Company recognized $60.4 million of expense. The total estimated value to the Veloce Equity Holders is based on the Company achieving certain performance benchmarks defined under the Merger Agreement within a certain time period. The Company performed various simulations during the three months ended December 31, 2012. The results of the simulations exceeded expectations for certain of the benchmarks defined under the Merger Agreement, and as a result the estimated maximum value to the Veloce Equity Holders was increased from approximately $135 million to the contractual maximum of $178.5 million, based on the Company's current expectations regarding the achievement of such product development milestones. As such, the total estimated value to the Veloce Equity Holders has been updated to be in the range of $117 million to $178.5 million, depending upon the achievement of multiple product development milestones and technical performance results. The increase in the estimated value to the Veloce Equity Holders also resulted in an increase of the estimated value of the first performance milestone. Research and Development expense recognized during the three months ended December 31, 2012 relating to the first performance milestone 22 -------------------------------------------------------------------------------- was based upon the estimated stage of the development of the first milestone as of December 31, 2012 and the estimated value tied to the first performance milestone. The remaining costs associated with the first performance milestone, estimated value of the first milestone less expense recognized through December 31, 2012, will be recognized on a straight line basis, subject to adjustment for actual progress towards the milestones, over the remaining period of expected development which is currently estimated not to exceed the next three fiscal quarters. Additionally, during the three months ended December 31, 2012, the second development and performance milestone set forth under the Merger Agreement was considered probable of achievement. The Company recognized research and development expenses that were based upon the estimated stage of development and estimated value tied to the second performance milestone. The remaining costs associated with the second performance milestone will be recognized on a straight line basis, subject to adjustment for actual progress towards the milestones, over the remaining period of expected development which is currently estimated not to exceed the next three fiscal quarters. The third and last development and performance milestone set forth under the Merger Agreement was not yet considered probable of achievement as of December 31, 2012. Total research and development expenses expected to be recognized upon completion of the first and second performance milestones is approximately $142.8 million (including the initial consideration of $60.4 million), of which approximately $117 million has been recognized through December 31, 2012. During the three and nine months ended December 31, 2012, expenses recognized in connection with first and second performance milestones were $51.9 million and $56.6 million, respectively. The amount and timing of expense recognition is determined based upon the probability of the respective performance milestone being achieved, the estimated progress of development, and estimated date of the milestone attainment. Timing of payments will be based upon actual attainment of the development and performance milestones, and upon vesting, if any, associated with outstanding Veloce' stock equivalents. Of the total of approximately $142.8 million which is expected to be due to Veloce upon the attainment of the first two development and performance milestones and expected to be paid over multiple quarters, $31.9 million has been paid to date and the Company expects that approximately another $77 million will be paid in cash and stock by September 30, 2013. Summary Financials The following tables present a summary of our results of operations for the three and nine months ended December 31, 2012 and 2011 (dollars in thousands): Three Months Ended December 31, 2012 2011 % of Net % of Net Increase % Amount Revenue Amount Revenue (Decrease) Change Net revenues $ 51,698 100.0 % $ 56,347 100.0 % $ (4,649 ) (8.3 )% Cost of revenues 22,958 44.4 23,795 42.2 (837 ) (3.5 ) Gross profit 28,740 55.6 32,552 57.8 (3,812 ) (11.7 ) Total operating expenses 101,942 197.2 40,337 71.6 61,605 152.7 Operating loss (73,202 ) (141.6 ) (7,785 ) (13.8 ) 65,417 840.3 Interest and other income, net 2,258 4.4 914 1.6 1,344 147.0 Loss before income taxes (70,944 ) (137.2 ) (6,871 ) (12.2 ) 64,073 932.5 Income tax expense 618 1.2 206 0.4 412 200.0 Net loss $ (71,562 ) (138.4 )% $ (7,077 ) (12.6 )% $ 64,485 911.2 23-------------------------------------------------------------------------------- Nine Months Ended December 31, 2012 2011 % of Net % of Net Increase % Amount Revenue Amount Revenue (Decrease) Change Net revenues $ 139,316 100.0 % $ 182,120 100.0 % $ (42,804 ) (23.5 )% Cost of revenues 61,874 44.4 77,830 42.7 (15,956 ) (20.5 ) Gross profit 77,442 55.6 104,290 57.3 (26,848 ) (25.7 ) Total operating expenses 198,348 142.4 122,586 67.3 75,762 61.8 Operating loss (120,906 ) (86.8 ) (18,296 ) (10.0 ) 102,610 560.8 Interest and other income, net 4,855 3.5 3,787 2.1 1,068 28.2 Loss before income taxes (116,051 ) (83.3 ) (14,509 ) (8.0 ) 101,542 699.9 Income tax expense 458 0.3 597 0.3 (139 ) (23.3 ) Net loss $ (116,509 ) (83.6 )% $ (15,106 ) (8.3 )% $ 101,403 671.3 Net Revenues. We generate revenues primarily through sales of our IC products, embedded processors and printed circuit board assemblies to OEMs, such as Alcatel-Lucent, Ciena, Cisco, Brocade, Fujitsu, Hitachi, Huawei, Juniper, Ericsson, NEC, Nokia Siemens Networks, and Tellabs, who in turn supply their equipment principally to communications service providers. On a sell-through basis, we had approximately 61 days of inventory in the distributor channel at December 31, 2012 as compared to 65 days at December 31, 2011. The decrease in inventory days was due to a further decline in amounts sold into the distributor channel than the amounts sold through during the quarter ended December 31, 2012 as compared to the quarter ended December 31, 2011. The gross margins for our solutions have historically declined over time. Some factors that we expect to cause downward pressure on the gross margins for our products include competitive pricing pressures, unfavorable product mix, the cost sensitivity of our customers particularly in the higher-volume markets, new product introductions by us or our competitors, and capacity constraints in our supply chain. From time to time, for strategic reasons, we may accept orders at less than optimal gross margins in order to facilitate the introduction of, or, market penetration of our new or existing products. To maintain acceptable operating results, we will need to offset any reduction in gross margins of our products by reducing costs, increasing sales volume, developing and introducing new products and developing new generations and versions of existing products on a timely basis. We classify our revenues into two categories based on the markets that the underlying products serve. The categories are Computing and Connectivity. We use this information to analyze our performance and success in these markets including our strategy to focus on the transition to the large growth data center market. We are continuing to focus our current connectivity investments on high growth 10G and faster Ethernet solutions, data center, Optical Transport Network ("OTN") and enterprise market opportunities while continuing to service the Telecom (SONET/SDH) market. Over time, we believe customers will transition from the SONET/SDH standard to higher speed, lower power products that utilize the OTN standard in order to support the increasing demand for transmission of data over networks. However, the timing and extent of this transition is uncertain due to the significant investment that is needed to convert networks to the OTN standard. As such, the rate of conversion to the OTN standard is, in part, greatly influenced by global economic market conditions. Recessionary type market conditions will result in a slower transition of networks to the OTN standard. Additionally, there can be no assurance that our revenues will increase as the OTN standard is adopted. The portion of our business represented by connectivity revenues attributable to our OTN and 10 gigabit or faster Ethernet products and that attributable to our SONET/SDH and Legacy Switch products for the year ended March 31, 2012 was 59% and 41%, respectively. 24 -------------------------------------------------------------------------------- The following table presents the portion of our business represented by connectivity revenues attributable to our OTN and 10 gigabit or faster Ethernet products and that attributable to our SONET/SDH and Legacy Switch products for the three and nine months ended December 31, 2012 and 2011: Three Months Ended Nine Months Ended December 31, December 31, 2012 2011 2012 2011 OTN and 10G Ethernet products 80 % 75 % 77 % 57 % SONET, SDH (including Switch) products 20 % 25 % 23 % 43 % 100 % 100 % 100 % 100 % The demand for our products has been affected in the past, and may continue to be affected in the future, by various factors, including, but not limited to, the following: • the timing, rescheduling or cancellation of significant customer orders and our ability, as well as the ability of our customers, to manage inventory corrections; • the qualification, availability and pricing of competing products and technologies and the resulting effects on the sales, pricing and gross margins of our products; • our ability to specify, develop or acquire, complete, introduce, and market new products and technologies in a cost effective and timely manner; • the rate at which our present and future customers and end-users adopt our products and technologies in our target markets; • general economic and market conditions in the semiconductor industry and communications markets; • combinations of companies in our customer base, resulting in the combined company choosing our competitor's IC standardization rather than our supported product platforms; • the gain or loss of one or more key customers, or their key customers, or significant changes in the financial condition of one or more of our key customers or their key customers; • our expectation of a market ramp for our products could be incorrect and such ramp could get pushed out or not happen at all; • our ability to meet customer demand due to capacityconstraints at our suppliers; and • natural disasters that could affect our supply chain or our customer's supply chain which would affect their requirements of our products. For these and other reasons, our net revenue and results of operations for the three and nine months ended December 31, 2012 may not necessarily be indicative of future net revenue and results of operations. Based on direct shipments, net revenues to customers that were equal to or greater than 10% of total net revenues were as follows (in thousands): Three Months Ended Nine Months Ended December 31, December 31, 2012 2011 2012 2011 Wintec (global logistics provider) 21 % 19 % 20 % 21 % Avnet (distributor) 27 % 23 % 28 % 19 % Flextronics (sub-contract manufacturer) * * * 11 % * Less than 10% of total net revenues. We expect that our largest customers will continue to account for a substantial portion of our net revenue for the foreseeable future. 25 --------------------------------------------------------------------------------Net revenues by geographic region were as follows (in thousands): Three Months Ended December 31, Nine Months Ended December 31, 2012 2011 2012 2011 % of Net % of Net % of Net % of Net Amount Revenue Amount Revenue Amount Revenue Amount Revenue United States of America* $ 22,910 44.3 % $ 24,044 42.7 % $ 56,337 40.4 % $ 82,455 45.3 % Taiwan 6,513 12.6 5,997 10.6 16,579 11.9 15,462 8.5 Hong Kong 4,487 8.7 5,094 9.0 16,405 11.8 17,601 9.7 China 290 0.6 1,062 1.9 1,879 1.4 4,152 2.3 Europe* 9,556 18.5 9,220 16.4 26,345 18.9 31,895 17.5 Japan 2,142 4.1 3,803 6.7 6,180 4.4 7,643 4.2 Malaysia 1,413 2.7 1,685 3.0 3,758 2.7 6,541 3.6 Singapore 2,773 5.4 3,555 6.3 7,835 5.6 10,440 5.7 Other Asia 1,346 2.6 1,659 2.9 3,276 2.4 5,227 2.9 Other 268 0.5 228 0.4 722 0.5 704 0.4 $ 51,698 100.0 % $ 56,347 100.0 % $ 139,316 100.0 % $ 182,120 100.0 % * Change in revenues was primarily due to shift in customer demand and continuing geographic changes to macro-economic conditions. Our revenues are primarily denominated in U.S. dollars, other than revenues that account for less than 10% of our total revenues, which are denominated primarily in the Danish Kroner. Key non-GAAP measurements. We use certain non-GAAP metrics such as Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization ("Adjusted EBITDA") to measure our performance. We define Adjusted EBITDA as net (loss) income, less interest income, income taxes, depreciation and amortization, stock-based compensation, amortization of intangibles and other one-time and/or non-cash items. The following table reconciles Adjusted EBITDA to the accompanying financial statements (in thousands): Three Months Ended Nine Months Ended December 31, December 31, 2012 2011 2012 2011 Net loss $ (71,562 ) $ (7,077 ) $ (116,509 ) $ (15,106 ) Adjustments to net loss: Interest and other income, net (689 ) (853 ) (2,023 ) (3,121 ) Stock-based compensation expense 6,222 4,433 21,545 11,735 Warrant expense - - 1,289 - Amortization of purchased intangibles 1,017 1,329 3,626 5,425 Restructuring charges, net 6,218 2 6,218 875 Veloce accrued liability 51,930 - 56,580 -Impairment of marketable securities* (270 ) (61 ) (1,533 ) (666 ) Acquisition related recoveries - - - (2,267 ) Depreciation and amortization** 3,889 2,539 10,244 7,193 Sale of assets (1,299 ) - (1,299 ) - Other and income tax adjustment 618 204 325 598 Adjusted EBITDA $ (3,926 ) $ 516 $ (21,537 ) $ 4,666 * For non-GAAP purposes, any gain or loss relating to marketable securities is not recognized until the underlying securities are sold and the actual gain or loss is realized. ** For non-GAAP purposes, amortization adjustment is related to certain prepaid software intellectual property licenses. 26-------------------------------------------------------------------------------- We believe that Adjusted EBITDA is a useful supplemental measure of our operation's performance because it helps investors evaluate and compare the results of operations from period to period by removing the accounting impact of the company's financing strategies, tax provisions, depreciation and amortization, restructuring charges, stock based compensation expense, Veloce accrued liability and certain other operating items. We adjust for these excluded items because we believe that, in general, these items possess one or more of the following characteristics: their magnitude and timing is largely outside of the company's control; they are unrelated to the ongoing operations of the business in the ordinary course; they are unusual or infrequent and the company does not expect them to occur in the ordinary course of business; or they are non-cash expenses. Adjusted EBITDA is not a measure determined in accordance with generally accepted accounting principles in the United States, or GAAP, and should not be considered a substitute for operating income, net income or any other measure determined in accordance with GAAP. Adjusted EBITDA should not be considered in isolation or as a substitute for measures of performance prepared in accordance with GAAP. Adjusted EBITDA is used by our management as a measure of operating efficiency and overall financial performance for benchmarking against our peers and competitors and is used as a metric to determine the performance vesting of our three-year RSU grants issued in May 2009 (the "EBITDA Grants") and May 2011 (the "EBITDA2 Grants"). Management believes Adjusted EBITDA provides meaningful supplemental information regarding the underlying operating performance of our business. Management also believes that Adjusted EBITDA is useful to investors because it is frequently used by securities analysts, investors and other interested parties to evaluate the company. The book-to-bill ratio is another metric commonly used by investors to compare and evaluate technology and semiconductor companies. The book-to-bill ratio is a demand-to-supply ratio that compares the total amount of orders received to the total amount of orders filled. This ratio tells whether the company has more orders than it delivered (if greater than 1), has the same amount of orders that it delivered (equals 1), or has less orders than it delivered (under 1). Though the ratio provides an indicator of whether orders are rising or falling, it does not consider the timing of or if the order will result in future revenues and the effect of changing lead times on bookings. Our book-to-bill ratio at December 31, 2012 and 2011 was 1.3 and 0.9, respectively. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenue and expenses in the reporting period. We regularly evaluate our estimates and assumptions related to: inventory valuation and capitalized mask set costs, which affect our cost of sales and gross profit; the valuation of goodwill and purchased intangibles, which has in the past affected, and could in the future affect, our impairment charges to write down the carrying value of purchased intangibles and the amount of related periodic amortization expense recorded for definite-lived intangibles; the valuation of the Veloce consideration which affects operating expenses; and an evaluation of other-than-temporary impairment of our investments, which affects the amount and timing of write-down charges. We also have other key accounting policies, such as our policies for stock-based compensation and revenue recognition. The methods, estimates and judgments we use in applying these critical accounting policies have a significant impact on the results we report in our financial statements. We base our estimates and assumptions on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. The actual results experienced by us may differ materially and adversely from management's estimates. To the extent there are material differences between our estimates and the actual results, our future results of operations will be affected. We believe the following critical accounting policies require us to make significant judgments and estimates in the preparation of our consolidated financial statements. Investments We hold a variety of securities that have varied underlying investments. We review our investment portfolio periodically to assess for other-than-temporary impairment. We assess the existence of impairment of our investments in order to determine the classification of the impairment as "temporary" or "other-than-temporary". The factors used to determine whether an impairment is temporary or other-than-temporary involves considerable judgment. The factors we consider in determining whether any individual impairment is temporary or other-than-temporary are primarily the length of the time and the extent to which the market value has been less than amortized cost, the nature of underlying assets (including the degree of collateralization), the financial condition, credit rating, market liquidity conditions and near-term prospects of the issuer. If the fair value of a debt security is less than its amortized cost basis at the balance sheet date, an assessment would have to be made as to whether the impairment is other-than-temporary. If we decided to sell the security, an other-than-temporary impairment shall be considered to have occurred. However, if we do not intend to sell the debt security, we shall consider available evidence to assess whether it is more likely than not we will be required to sell the security before the recovery of its amortized 27 -------------------------------------------------------------------------------- cost basis due to cash, working capital requirements, contractual or regulatory obligations indicate that the security will be required to be sold before a forecasted recovery occurs. If it is more likely than not that we are required to sell the security before recovery of its amortized cost basis, an other-than-temporary impairment is considered to have occurred. If we do not expect to recover the entire amortized cost basis of the security, we would not be able to assert that we will recover its amortized cost basis even if we do not intend to sell the security. Therefore, in those situations, an other-than-temporary impairment shall be considered to have occurred. We use present value cash flow models to determine whether the entire amortized cost basis of the security will be recovered. We will compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security. An other-than-temporary impairment is said to have occurred if the present value of cash flows expected to be collected is less than the amortized cost basis of the security. During the three and nine months ended December 31, 2012 and fiscal year ended March 31, 2012, we did not record any other-than-temporary impairment charges. As of December 31, 2012, we did not record an impairment charge in connection with securities in a loss position (fair value less than carrying value) with unrealized losses of $1.2 million as we believe that such unrealized losses are temporary. In addition, we also had $7.3 million in unrealized gains. Veloce Consideration We periodically evaluate the progress of the development work that is performed by Veloce, in connection with our contractual arrangement with Veloce. Based on such an evaluation as well as considering various other qualitative factors, we estimate the total value of the development work being performed by Veloce, and assess the timing and probability of attaining contractually defined performance milestones. Upon assessing a performance milestone as probable of achievement, the amount of research and development expense that is recognized is based upon the estimated stage of development of that milestone and the estimated value associated with each performance milestone. The consideration that we will pay for each performance milestone is based upon the timing of when the performance milestone is completed. Significant judgment is required to estimate the total value of the Veloce development work, assess when a performance milestone is probable of achievement and estimating the timing of when the performance milestones will be completed. The estimated total value of the Veloce consideration is currently based upon the benchmarks that were achieved during simulations that were performed during the three months ended December 31, 2012 and correlating the results of the simulations to the contractual terms included in the Merger Agreement. As a result of higher than expected benchmarks achieved during simulations, the total estimated value to the Veloce Equity Holders has been updated from a previous estimated maximum of $135 million to the contractual maximum of $178.5 million. As a result of this increase in value, the estimated value relating to the first performance milestone was also increased. The additional expense recognized as a result of the increased value reflects the estimated stage of development for the first performance milestone as of December 31, 2012. We rely on discussions with internal technical personnel and using various qualitative and quantitative factors, including, but not limited to, overall complexity, stage of development and progress made to date, results of testing, and consideration as to the nature of the remaining development work, to assess probability of attaining the performance milestones defined in the Merger Agreement. If based on our assessment we believe attainment of a performance milestone is probable, we will recognize expenses related to the estimated stage of development for the performance milestone. During the quarter ended December 31, 2012, we assessed the second performance milestone to be probable of achievement. Currently we believe that the first two performance milestones are probable of attainment. Upon completion, the estimated value of these two performance milestone will be $142.8 million. We have expensed as research and development expense, approximately $117 million through December 31, 2012. The third and final performance milestone is currently not yet believed to be probable of attainment. We periodically assess the developmental progress made towards the attainment of the various milestones and rely on internal discussions with technical personnel to assess the stage of development for a particular performance milestone and the estimated time to complete based on the respective work plan. This information is used in determining the amount of expense to recognize for a performance milestone once the performance milestone is deemed probable of achievement. This information is also utilized in determining the period over which to recognize the remaining expenses relating to the specific performance milestone. During the fiscal quarter ended December 31, 2012, the total estimated value of the Veloce consideration increased and we assessed the second performance milestone to be probable of achievement. The total expense recognized was based upon the estimated stage of development and value of the respective performance milestones. As of December 31, 2012, we estimate that the first two performance milestones were deemed probable of completion, and projected to be completed by no later than the next three fiscal quarters. The third and last performance milestone set forth under the Merger Agreement was not yet considered probable of achievement as of December 31, 2012. 28 -------------------------------------------------------------------------------- Total research and development expenses expected to be recognized upon completion of the first and second performance milestones is approximately $142.8 million (including the initial consideration of $60.4 million), of which approximately $117 million has been recognized through December 31, 2012. During the three and nine months ended December 31, 2012, expenses recognized in connection with first and second performance milestones were $51.9 million and $56.6 million, respectively. Inventory Valuation Our policy is to value inventories at the lower of cost or market on a part-by-part basis. This policy requires us to make estimates regarding the market value of our inventories, including an assessment of excess or obsolete inventories. We determine excess and obsolete inventories based on an estimate of the future demand for our products within a specified time horizon, generally 12 months. The estimates we use for future demand are also used for near-term capacity planning and inventory purchasing and are consistent with our revenue forecasts. If our demand forecast is greater than our actual demand we may be required to take additional excess inventory charges, which would decrease gross margin and net operating results. Any impairment charges taken establishes a new cost basis for the underlying inventory and the cost basis for such inventory is not marked-up on changes in circumstances until a gain is realized upon its eventual sale. This accounting is consistent with the guidance provided by SAB Topic 5-BB. To illustrate the sensitivity of inventory valuations to future estimates, as of December 31, 2012, reducing our future demand estimate to six months would decrease our current inventory valuation by approximately $1.4 million and increasing our future demand forecast to 18 months would increase our current inventory valuation by approximately $0.4 million. Purchased Definite-Lived Intangible Assets and Other Long-Lived Assets We evaluate our long-lived assets such as property, plant and equipment and purchased intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate the carrying value of an asset or asset group may not be recoverable. The carrying value of an asset or asset group is not recoverable if the amount of undiscounted future cash flows the assets are expected to generate (including any net proceeds expected from the disposal of the asset) are less than its carrying value. When we identify an impairment has occurred, we reduce the carrying value of the assets to its comparable market value (if available and appropriate) or to its estimated fair value based on a discounted cash flow approach. Revenue Recognition We recognize revenue based on four basic criteria: 1) there is evidence that an arrangement exists; 2) delivery has occurred; 3) the fee is fixed or determinable; and 4) collectability is reasonably assured. We recognize revenue upon determination that all criteria for revenue recognition have been met. In addition, we do not recognize revenue until the applicable customer's acceptance criteria have been met. The criteria are usually met at the time of product shipment. Our standard terms and conditions of sale do not allow for product returns and we generally do not allow product returns other than under warranty or stock rotation agreements. Revenue from shipments to distributors is recognized upon shipment. In addition, we record reductions to revenue for estimated allowances such as returns not pursuant to contractual rights, competitive pricing programs and rebates. These estimates are based on our experience with stock rotations and the contractual terms of the competitive pricing and rebate programs. Royalty revenues are recognized when cash is received, only when royalty amounts cannot be reasonably estimated. Royalty revenues are based upon sales of our customer's products that include our technology. Shipping terms are generally FCA (Free Carrier) shipping point. If actual returns or pricing adjustments exceed our estimates, we would record additional reductions to revenue. From time to time we generate revenue from the sale of our internally developed IP. We generally recognize revenue from the sale of IP when all basic criteria outlined above are met, which is generally when the payments are received. Mask Costs We incur significant costs for the fabrication of masks used by our contract manufacturers to manufacture our products. If we determine, at the time the cost for the fabrication of masks are incurred, that technological feasibility of the product has been achieved, we consider the nature of these costs to be pre-production costs. Accordingly, such costs are capitalized as property and equipment under machinery and equipment and are amortized as cost of sales over approximately three years, representing the estimated production period of the product. We periodically reassess the estimated product production period for specific mask sets capitalized. If we determine, at the time fabrication mask costs are incurred, that either technological feasibility of the product has not occurred or that the mask is not reasonably expected to be used in production manufacturing or that the commercial feasibility of the product is uncertain, the related mask costs are expensed to R&D in the period in which the costs are incurred. We will also periodically assess capitalized mask costs for impairment. During the three and nine 29 -------------------------------------------------------------------------------- months ended December 31, 2012, total mask costs capitalized was zero and $3.1 million, respectively. During the three and nine months ended December 31, 2011, total mask costs capitalized was $0.6 million and $1.8 million, respectively. Stock-Based Compensation Expense All share-based payments, including grants of stock options, restricted stock units and employee stock purchase rights, are required to be recognized in our financial statements based on their respective grant date fair values. The fair value of each employee stock option and employee stock purchase right is estimated on the date of grant using an option pricing model that meets certain requirements. We currently use the Black-Scholes option pricing model to estimate the fair value of our share-based payments, excluding RSUs, which we use the fair market value of our common stock. The fair values generated by the Black-Scholes model may not be indicative of the actual fair values of our stock-based awards as it does not consider certain factors important to stock-based awards, such as continued employment, periodic vesting requirements and limited transferability. The determination of the fair value of share-based payment awards utilizing the Black-Scholes model is affected by our stock price and a number of assumptions, including expected volatility, expected life, risk-free interest rate and expected dividends. We estimate the expected volatility of our stock options at grant date by equally weighting the historical volatility and the implied volatility of our stock over specific periods of time as the expected volatility assumption required in the Black-Scholes model. The expected life of the stock options is based on historical and other data including life of the option and vesting period. The risk-free interest rate assumption is the implied yield currently available on zero-coupon government issues with a remaining term equal to the expected term. The dividend yield assumption is based on our history and expectation of dividend payouts. The fair value of our restricted stock units is based on the fair market value of our common stock on the date of grant. Forfeitures are required to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ significantly from those estimated. We evaluate the assumptions used to value stock-based awards on a quarterly basis. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. We currently estimate when and if performance-based grants will be earned. If the awards are not considered probable of achievement, no amount of stock-based compensation is recognized. If we consider the award to be probable, expense is recorded over the estimated service period. To the extent that our assumptions are incorrect, the amount of stock-based compensation recorded will be increased or decreased. To the extent that we grant additional equity securities to employees or we assume unvested securities in connection with any acquisitions, our stock-based compensation expense will be increased by the additional unearned compensation resulting from those additional grants or acquisitions. RESULTS OF OPERATIONS Comparison of the Three and Nine Months Ended December 31, 2012 to the Three and Nine Months Ended December 31, 2011 Net Revenues. Net revenues for the three and nine months ended December 31, 2012 were $51.7 million and $139.3 million, representing a decrease of 8.3% and 23.5% from net revenues of $56.3 million and $182.1 million for the three and nine months ended December 31, 2011, respectively. We classify our revenues into two categories based on the markets that the underlying products serve. The categories are Computing and Connectivity. We use this information to analyze our performance and success in these markets. See the following tables (dollars in thousands): Three Months Ended December 31, 2012 2011 % of Net % of Net % Amount Revenue Amount Revenue (Decrease) Change Computing $ 29,536 57.1 % $ 33,658 59.7 % $ (4,122 ) (12.2 )% Connectivity 22,162 42.9 22,689 40.3 (527 ) (2.3 ) $ 51,698 100.0 % $ 56,347 100.0 % $ (4,649 ) (8.3 )% Nine Months Ended December 31, 2012 2011 % of Net % of Net % Amount Revenue Amount Revenue (Decrease) Change Computing $ 75,749 54.4 % $ 97,817 53.7 % $ (22,068 ) (22.6 )% Connectivity 63,567 45.6 84,303 46.3 (20,736 ) (24.6 ) $ 139,316 100.0 % $ 182,120 100.0 % $ (42,804 ) (23.5 )% 30-------------------------------------------------------------------------------- During the three and nine months ended December 31, 2012, our Computing revenues declined by 12.2% and 22.6%, respectively, and our Connectivity revenues declined by 2.3% and 24.6%, respectively compared to the same periods last year. The overall revenue decline was spread across both the Computing and Connectivity product families and was as a result of lower demand for our products due to overall softness in the macro conditions and due to the roll-off of legacy products as we continue to focus on the development of our new products. In addition, the revenues for our Connectivity products were lower due to the delay in the overall OTN infrastructure build-out. Gross Profit. The following table presents net revenues, cost of revenues and gross profit for the three and nine months ended December 31, 2012 and 2011 (dollars in thousands): Three months ended December 31, 2012 2011 % of Net % of Net Increase % Amount Revenue Amount Revenue (Decrease) Change Net revenues $ 51,698 100.0 % $ 56,347 100.0 % $ (4,649 ) (8.3 )% Cost of revenues 22,958 44.4 23,795 42.2 837 3.5 $ 28,740 55.6 % $ 32,552 57.8 % $ (3,812 ) (11.7 )% Nine Months Ended December 31, 2012 2011 % of Net % of Net Increase % Amount Revenue Amount Revenue (Decrease) Change Net revenues $ 139,316 100.0 % $ 182,120 100.0 % $ (42,804 ) (23.5 )% Cost of revenues 61,874 44.4 77,830 42.7 15,956 20.5 $ 77,442 55.6 % $ 104,290 57.3 % $ (26,848 ) (25.7 )% The gross profit percentage for each of the three and nine months ended December 31, 2012 was 55.6% compared to 57.8% and 57.3% for the three and nine months ended December 31, 2011, respectively. The decrease in our gross profit percentage, excluding the impact of amortization of purchased intangibles, was 56.9% and 57.0%, and 59.0% and 58.8%, respectively, for the three and nine months ended December 31, 2012 and 2011, respectively. The decrease in our gross profit percentage was primarily due to lower licensing revenues, unfavorable product mix, lower overall revenues that have an impact on the absorption of fixed costs, and declining average selling prices. The amortization of purchased intangible assets included in cost of revenues during the three and nine months ended December 31, 2012 and 2011 was $0.7 million and $2.0 million, and $0.7 million and $2.9 million, respectively. The decrease during the nine months ended December 31, 2012 and 2011 was primarily due to certain purchased intangible assets being fully amortized during the fiscal year ended March 31, 2012 resulting in a lower amortization charge in the three and nine months ended December 31, 2012. Research and Development and Selling, General and Administrative Expenses. The following table presents research and development and selling, general and administrative expenses for the three and nine months ended December 31, 2012 and 2011 (dollars in thousands): Three Months Ended December 31, 2012 2011 % of Net % of Net % Amount Revenue Amount Revenue Increase Change Research and development $ 82,711 160.0 % $ 28,279 50.2 % $ 54,432 192.5 % Selling, general and administrative $ 12,675 24.5 % $ 11,406 20.2 % $ 1,269 11.1 % Nine Months Ended December 31, 2012 2011 % of Net % of Net % Amount Revenue Amount Revenue Increase Change Research and development $ 151,865 109.0 % $ 86,256 47.4 % $ 65,609 76.1 % Selling, general and administrative $ 38,676 27.8 % $ 32,903 18.1 % $ 5,773 17.5 % 31-------------------------------------------------------------------------------- Research and Development. Increases in research and development ("R&D") expenses are primarily driven by the effect of a ramp-up in the costs relating to the ARM 64-bit silicon server development effort, and costs incurred on our developmental effort relating to other new products. Total consolidated R&D expenses consist primarily of salaries and related costs (including stock-based compensation) of employees engaged in research, design and development activities, costs related to engineering design tools, subcontracting costs and facilities expenses. For accounting purposes, the consideration payable for the acquisition of Veloce is considered compensatory and is recognized as research and development expense when incurred. Recognition of these costs will occur when the specific development and performance milestones become probable of achievement and the amount of expense will be based upon the estimated stage of product development to date. As of March 31, 2012, the first development and performance milestone set forth under the Merger Agreement was considered probable of achievement and the Company recognized $60.4 million of expense. The total estimated value to the Veloce Equity Holders is based on the Company achieving certain performance benchmarks defined under the Merger Agreement within a certain time period. The Company performed various simulations during the three months ended December 31, 2012. The results of the simulations exceeded expectations for certain of the benchmarks defined under the Merger Agreement, and as a result the estimated maximum value to the Veloce Equity Holders was increased from approximately $135 million to the contractual maximum of $178.5 million, based on the Company's current expectations regarding the achievement of such product development milestones. As such, the total estimated value to the Veloce Equity Holders has been updated to be in the range of $117 million to $178.5 million, depending upon the achievement of multiple product development milestones and technical performance results. The increase in the estimated value to the Veloce Equity Holders also resulted in an increase of the estimated value of the first performance milestone. Research and Development expense recognized during the three months ended December 31, 2012 relating to the first performance milestone was based upon the estimated stage of the development of the first milestone as of December 31, 2012 and the estimated value tied to the first performance milestone. The remaining costs associated with the first performance milestone, estimated value of the first milestone less expense recognized through December 31, 2012, will be recognized on a straight line basis, subject to adjustment for actual progress towards the milestones, over the remaining period of expected development which is currently estimated not to exceed the next three fiscal quarters. Additionally, during the three months ended December 31, 2012, the second development and performance milestone set forth under the Merger Agreement was considered probable of achievement. The Company recognized research and development expenses that were based upon the estimated stage of development and estimated value tied to the second performance milestone. The remaining costs associated with the second performance milestone will be recognized on a straight line basis, subject to adjustment for actual progress towards the milestones, over the remaining period of expected development which is currently estimated not to exceed the next three fiscal quarters. The third and last development and performance milestone set forth under the Merger Agreement was not yet considered probable of achievement as of December 31, 2012. Total research and development expenses expected to be recognized upon completion of the first and second performance milestones is approximately $142.8 million (including the initial consideration of $60.4 million), of which approximately $117 million has been recognized through December 31, 2012. During the three and nine months ended December 31, 2012, expenses recognized in connection with first and second performance milestones were $51.9 million and $56.6 million, respectively. The amount and timing of expense recognition is determined based upon the probability of the respective performance milestone being achieved, the estimated progress of development, and estimated date of the milestone attainment. Timing of payments will be based upon actual attainment of the development and performance milestones, and upon vesting, if any, associated with outstanding Veloce' stock equivalents. Of the total of approximately $142.8 million which is expected to be due to Veloce upon the attainment of the first two development and performance milestones and expected to be paid over multiple quarters, $31.9 million has been paid to date and the Company expects that approximately another $77 million will be paid in cash and stock by September 30, 2013. The increase in R&D expenses of 192.5% for the three months ended December 31, 2012 compared to the three months ended December 31, 2011 was primarily due to $51.9 million for Veloce merger consideration costs, $1.7 million in third party foundry cost, $0.9 million in new product development costs, $0.7 million in consumable equipment and software cost, $0.3 million in customer funded non-recurring engineering payments and $0.2 million in stock-based compensation charges offset by a decrease of $0.8 million in contractor costs, engineering tools, supplies and other costs, $0.3 million in technology access fees and $0.2 million in printed circuit board costs. The increase in R&D expenses of 76.1% for the nine months ended December 31, 2012 compared to the nine months ended December 31, 2011 was primarily due $57.9 million for Veloce merger consideration costs (which includes approximately $1.3 million of expense related to the acceleration of Veloce warrants), $3.9 32 -------------------------------------------------------------------------------- million in stock-based compensation charges, $2.1 million in consumable equipment and software cost, $1.1 million in third party foundry cost, $1.0 million in customer funded non-recurring engineering payments, $0.8 million each in personnel cost and product development costs and $0.3 million each in packaging cost and other engineering costs offset by a decrease of $1.7 million in technology access fees, $0.5 million in contractor cost and $0.4 million in printed circuit board cost. We believe that a continued commitment to R&D is vital to our goal of maintaining a leadership position with innovative products. In addition to our internal R&D programs, our business strategy includes acquiring products, technologies or businesses from third parties. Future acquisitions of products, technologies or businesses may result in substantial additional on-going R&D costs. Selling, General and Administrative. Selling, general and administrative ("SG&A") expenses consist primarily of personnel related expenses (including stock-based compensation), professional and legal fees, corporate branding and facilities expenses. The increase in SG&A expenses of 11.1% for the three months ended December 31, 2012 compared to the three months ended December 31, 2011, was primarily due to $1.5 million in stock-based compensation charges and $0.6 million in professional and other service fees offset by a decrease of $0.3 million each in provision for doubtful debts and general administration costs and $0.2 million in corporate allocation expenses. The increase in SG&A expenses of 17.5% for the nine months ended December 31, 2012 compared to the nine months ended December 31, 2011, was primarily due to $5.5 million in stock-based compensation charges, $2.1 million relating to the reversal of previously accrued liabilities associated with an acquisition in the nine months ended December 31, 2011 (none in the nine months ended December 31, 2012) and $0.8 million in professional and other service fees offset by a decrease of $0.7 million in corporate allocation expenses, $0.6 million in marketing and travel costs, $0.5 million in provision for doubtful debts and $0.4 million each in personnel cost and sales commission cost. Future acquisitions of products, technologies or businesses may result in substantial additional on-going SG&A costs. Stock-Based Compensation. The following table presents stock-based compensation expense for the three and nine months ended December 31, 2012 and 2011, which was included in the tables above (dollars in thousands): Three Months Ended December 31, 2012 2011 % of Net % of Net % Amount Revenue Amount Revenue Increase Change Costs of revenues $ 158 0.3 % $ 83 0.2 % $ 75 90.4 % Research and development 2,814 5.4 2,647 4.7 167 6.3 Selling, general and administrative 3,250 6.3 1,703 3.0 1,547 90.8 $ 6,222 12.0 % $ 4,433 7.9 % $ 1,789 40.4 % Nine Months Ended December 31, 2012 2011 % of Net % of Net % Amount Revenue Amount Revenue Increase Change Costs of revenues $ 596 0.4 % $ 292 0.1 % $ 304 104.1 % Research and development 10,733 7.7 6,761 3.7 3,972 58.7 Selling, general and administrative 10,216 7.3 4,682 2.6 5,534 118.2 $ 21,545 15.4 % $ 11,735 6.4 % $ 9,810 83.6 % The increase in stock-based compensation of 40.4% and 83.6% during the three and nine months ended December 31, 2012 compared to the three and nine months ended December 31, 2011, respectively, was primarily due to the expense associated with the granting of new performance retention grants and other performance based awards. The stock based compensation expense of approximately $6.2 million and $21.5 million for the three and nine months ended December 31, 2012 does not include approximately $1.3 million of expense related to the acceleration of Veloce warrants. See note 5 of Notes to Condensed Consolidated Financial Statements for further details relating to the Veloce warrants. Stock-based compensation expense will continue to have a significant adverse impact on the Company's reported results of operations, although it will have no impact on its overall financial position. Restructuring Charges. We implemented a restructuring program during the three months ended December 31, 2012 to reorganize our operations and reduce our workforce and related operating expenses. The plan includes eliminating job redundancies and reducing our current workforce by approximately 70 employees. As a result, we recorded a charge of $1.5 33 -------------------------------------------------------------------------------- million for employee severances and $4.7 million for an asset impairment. The asset impairment related to the impairment of the unamortized value of a software intellectual property license, which the Company no longer intends to use to develop new products. We expect to incur cash expenditures of approximately $1.2 million to $1.4 million during the current fiscal year ending March 31, 2013 for employee severances and anticipate that the restructuring plan will reduce ongoing headcount expenses by approximately $8.0 million to $9.0 million annually and other additional operational expenses by $4.0 million to $5.0 million annually. We expect the restructuring program to be completed by the end of its current fiscal year ending March 31, 2013. The restructuring charges recorded during the three and nine months ended December 31, 2011 was primarily for employee severances. Interest and Other Income, net. The following table presents interest and other income (expense), net for the three and nine months ended December 31, 2012 and 2011 (dollars in thousands): Three Months Ended December 31, 2012 2011 % of Net % of Net Increase % Amount Revenue Amount Revenue (Decrease) Change Interest income (expense), net $ 892 1.7 % $ 828 1.5 % $ 64 7.7 % Other income (expense), net $ 1,366 2.6 % $ 86 0.2 % $ 1,280 1,488.4 % Nine Months Ended December 31, 2012 2011 % of Net % of Net % Amount Revenue Amount Revenue (Decrease) Change Interest income (expense), net $ 3,316 2.4 % $ 3,578 2.0 % $ (262 ) (7.3 )% Other income (expense), net $ 1,539 1.1 % $ 209 0.1 % $ 1,330 636.4 % Interest Income (Expense), net. Interest income, net of management fees, reflects interest earned on cash and cash equivalents, short-term investments and marketable securities. The increase in interest income, net for the three months ended December 31, 2012 as compared to the three months ended December 31, 2011 was primarily due to realized gains from the sale of short-term investments and marketable securities which was partially offset by lower interest income due to our lower cash, cash equivalents and short-term investments available-for-sale balances. The decrease in interest income, net for the nine months ended December 31, 2012, compared to the nine months ended December 31, 2011 was primarily due to our lower cash, cash equivalents and short-term investments available-for-sale balances. Other Income (Expense) Income, net. The increase in other income for the three and nine months ended December 31, 2012 as compared to the three and nine months ended December 31, 2011 was due to a gain of $1.3 million arising from the sale of equipment and other assets. Income Taxes. The federal statutory income tax rate was 35% for the fiscal three and nine months ended December 31, 2012 and 2011. The increase in the income tax expense recorded for the three months ended December 31, 2012 compared to December 31, 2011, was primarily related to other comprehensive income. The allocation of the current quarter tax provision included reversing $0.4 million of tax expense that was allocated to other comprehensive income in prior quarters. The decrease in the income tax expense recorded for the nine months ended December 31, 2012 compared to December 31, 2011, was also related to other comprehensive income. The allocation of the current year tax provision included a $0.1 million tax benefit in continuing operations with an offsetting tax expense in other comprehensive income. FINANCIAL CONDITION AND LIQUIDITY As of December 31, 2012, our principal source of liquidity consisted of $84.2 million in cash, cash equivalents and short-term investments which is approximately $1.26 per share of outstanding common stock as compared to $1.84 per share at March 31, 2012. Working capital as of December 31, 2012 was $30.4 million. Total cash, cash equivalents, and short-term investments decreased by $29.6 million during the nine months ended December 31, 2012, primarily due to cash used for operations of $30.9 million, purchase of property and equipment of $8.5 million, the repurchases of our common stock for $0.7 million, a strategic investment of $0.5 million, payment of contingent consideration of $0.5 million, issuance of a notes receivable of $0.5 million and the funding of restricted stock units withheld for taxes of $2.8 million offset by proceeds from 34 -------------------------------------------------------------------------------- stock issuance of $5.8 million, proceeds from sale of a strategic equity investment of $7.1 million and proceeds from the sale of equipment and other assets of $1.8 million. At December 31, 2012, we had contractual obligations not included on our balance sheet totaling $90.7 million, primarily related to facility leases, IP licenses, engineering design software tool licenses, non-cancelable inventory purchase commitments and liability for uncertain tax positions. For the nine months ended December 31, 2012, we used $30.9 million of cash in our operations compared to $3.0 million used for our operations for the nine months ended December 31, 2011. Our net loss of $116.5 million for the nine months ended December 31, 2012 included $93.4 million of non-cash charges consisting of $7.2 million of depreciation, $3.6 million of amortization of purchased intangibles, $22.8 million of stock-based compensation, $56.6 million of additional Veloce compensation cost and $4.7 million of restructuring costs offset by $1.3 million gain on asset disposals, $0.1 million relating to the tax effect on other comprehensive income and $0.1 million in acquisition related adjustment (relating to our TPack acquisition in fiscal 2011). Our net loss of $15.1 million for the nine months ended December 31, 2011 included $20.9 million of non-cash charges consisting of $6.0 million of depreciation, $5.5 million of amortization of purchased intangibles and $11.7 million of stock-based compensation, offset by a $2.3 million reduction to the estimated fair value of our contingent consideration. The remaining change in operating cash flows for the nine months ended December 31, 2012 primarily reflected decreases in accounts receivable, inventories, other assets, accounts payable and deferred revenue and increases in Veloce accrued liability, accrued payroll and related expenses and other accrued liabilities. Our overall quarterly days sales outstanding was 31 days and 50 days for the three months ended December 31, 2012 and 2011, respectively. Decrease in the revenues generated during the last month of the quarter ended December 31, 2012 as compared to the same period for the quarter ended March 31, 2012 was the primary reason for the decrease in our days sales outstanding. We provided $17.0 million in cash from our investing activities during the nine months ended December 31, 2012, compared to using $1.2 million during the nine months ended December 31, 2011. During the nine months ended December 31, 2012, we used $8.5 million for the purchase of property and equipment, $0.5 million for purchase of strategic investment and $0.5 million for the issuance of a note receivable offset by net proceeds of $17.5 million from short-term investment activities, $7.1 million from sales of strategic equity investment and $1.8 million from the sale of equipment and other assets. During the nine months ended December 31, 2011, we generated $15.4 million for net short-term investment activities offset by $11.9 million for the purchase of property and equipment and $4.7 million for purchases of strategic investments. We provided $1.5 million in cash for our financing activities during the nine months ended December 31, 2012, compared to using $30.0 million during the nine months ended December 31, 2011. The major financing use of cash for the nine months ended December 31, 2012 was the $0.7 million for the repurchase of common stock, $0.5 million for the payment of a contingent consideration, restricted stock units withheld for taxes of $2.8 million and other uses of cash of $0.4 million offset by proceeds from the issuance of common stock of $5.8 million. The major financing use of cash for the nine months ended December 31, 2011 was $20.9 million for the repurchase of common stock, $10.0 million for the funding of our structured stock repurchase agreements and $2.7 million for restricted stock units withheld for taxes, offset by $3.9 million in proceeds from the issuance of common stock. Veloce Merger On June 20, 2012 (the "Closing Date"), the Company completed its acquisition of Veloce pursuant to the terms of the Agreement and Plan of Merger, entered into as of May 17, 2009 (the "Initial Agreement"), as amended by Amendment No. 1 to Agreement and Plan of Merger, entered into as of November 8, 2010 (the "First Amendment"), and Amendment No. 2 to Agreement and Plan of Merger, entered into as of April 5, 2012 (the "Second Amendment" and, collectively with the Initial Agreement and the First Amendment, the "Merger Agreement"). The First Amendment was amended, restated and replaced in its entirety by the Second Amendment. The terms of the Merger Agreement include the payment of initial consideration of up to $60.4 million, payable in shares of Company common stock and/or cash (at the Company's election) to holders of Veloce common stock, Veloce stock options that were vested on the Closing Date, and holders of Veloce stock equivalents (collectively, "Veloce Equity Holders"). During the three and nine months ended December 31, 2012, as part of the above arrangement, the Company issued 0.2 million shares valued at $1.1 million and 2.9 million shares valued at $16.0 million, respectively, and paid approximately $1.1 million and $15.9 million in cash, respectively. Of the $60.4 million that relates to the initial consideration, $31.9 million has been paid to date. To the extent payments of the $60.4 million are paid in the Company's common stock and relate to shares of Veloce stock that were outstanding at the date of the closing of the Merger, the value of the Company's common stock is fixed at $5.546 per share ("fixed shares"). The balance of the $60.4 million or approximately $28.5 million will be paid over multiple quarters and will include approximately 1.2 million fixed shares and at least $10.2 million in cash for a total value of $16.9 million. The remaining $11.6 million of the $28.5 million will be paid in a combination of cash and shares of the Company's common stock valued at the then-current market price. 35 -------------------------------------------------------------------------------- For accounting purposes, the consideration payable for the acquisition of Veloce is considered compensatory and is recognized as research and development expense when incurred. Recognition of these costs will occur when the specific development and performance milestones become probable of achievement and the amount of expense will be based upon the estimated stage of product development to date. As of March 31, 2012, the first development and performance milestone set forth under the Merger Agreement was considered probable of achievement and the Company recognized $60.4 million of expense. The total estimated value to the Veloce Equity Holders is based on the Company achieving certain performance benchmarks defined under the Merger Agreement within a certain time period. The Company performed various simulations during the three months ended December 31, 2012. The results of the simulations exceeded expectations for certain of the benchmarks defined under the Merger Agreement, and as a result the estimated maximum value to the Veloce Equity Holders was increased from approximately $135 million to the contractual maximum of $178.5 million, based on the Company's current expectations regarding the achievement of such product development milestones. As such, the total estimated value to the Veloce Equity Holders has been updated to be in the range of $117 million to $178.5 million, depending upon the achievement of multiple product development milestones and technical performance results. The increase in the estimated value to the Veloce Equity Holders also resulted in an increase of the estimated value of the first performance milestone. Research and Development expense recognized during the three months ended December 31, 2012 relating to the first performance milestone was based upon the estimated stage of the development of the first milestone as of December 31, 2012 and the estimated value tied to the first performance milestone. The remaining costs associated with the first performance milestone, estimated value of the first milestone less expense recognized through December 31, 2012, will be recognized on a straight line basis, subject to adjustment for actual progress towards the milestones, over the remaining period of expected development which is currently estimated not to exceed the next three fiscal quarters. Additionally, during the three months ended December 31, 2012, the second development and performance milestone set forth under the Merger Agreement was considered probable of achievement. The Company recognized research and development expenses that were based upon the estimated stage of development and estimated value tied to the second performance milestone. The remaining costs associated with the second performance milestone will be recognized on a straight line basis, subject to adjustment for actual progress towards the milestones, over the remaining period of expected development which is currently estimated not to exceed the next three fiscal quarters. The third and last development and performance milestone set forth under the Merger Agreement was not yet considered probable of achievement as of December 31, 2012. Total research and development expenses expected to be recognized upon completion of the first and second performance milestones is approximately $142.8 million (including the initial consideration of $60.4 million), of which approximately $117 million has been recognized through December 31, 2012. During the three and nine months ended December 31, 2012, research and development expenses recognized in connection with first and second performance milestones were $51.9 million and $56.6 million, respectively. The amount and timing of expense recognition is determined based upon the probability of the respective performance milestone being achieved, the estimated progress of development, and estimated date of the milestone attainment. Timing of payments will be based upon actual attainment of the development and performance milestones, and upon vesting, if any, associated with outstanding Veloce' stock equivalents. Of the total of approximately $142.8 million which is expected to be due to Veloce upon the attainment of the first two development and performance milestones and expected to be paid over multiple quarters, $31.9 million has been paid to date and the Company expects that approximately another $77 million will be paid in cash and stock by September 30, 2013. Liquidity We currently believe that our available cash, cash equivalents and short-term investments will be sufficient to meet our capital requirements and fund our operations for at least the next 12 months. We expect to satisfy the Veloce-related payment obligations using a combination of cash and the issuance of shares of common stock. We expect our resources to be sufficient to make the above described Veloce-related payments while maintaining adequate cash to run our operations. Our available liquidity could be adversely affected, however, if we decide to satisfy the Veloce liability using a greater proportion of cash rather than our common stock, or if our normal operations require us to expend more cash than currently expected. If our stock price declines, it could result in a higher dilution to our stockholders. As a result of any of the above, we could elect or be required to pursue various options to raise additional capital or generate cash. There can be no assurance that any of the options that we currently believe to be available will be viable in the future on commercially reasonable terms or at all. 36 -------------------------------------------------------------------------------- Stock Repurchase Program In August 2004, our Board of Directors authorized a stock repurchase program for the repurchase of up to $200.0 million of our common stock. Under the program, we are authorized to make purchases in the open market or enter into structured agreements. In October 2008, our Board of Directors increased the stock repurchase program by $100.0 million. During the nine months ended December 31, 2012, approximately 0.1 million shares were repurchased on the open market at a weighted average price of $5.18 per share. During the nine months ended December 31, 2011, approximately 3.5 million shares were repurchased on the open market at a weighted average price of $5.98 per share. All repurchased shares were retired upon delivery to us. As of December 31, 2012, we had $15.8 million available in our stock repurchase program. We also utilize structured stock repurchase agreements to buy back shares which are prepaid written put options on our common stock. We pay a fixed sum of cash upon execution of each agreement in exchange for the right to receive either a pre-determined amount of cash or stock depending on the closing market price of our common stock on the expiration date of the agreement. Upon expiration of each agreement, if the closing market price of our common stock is above the pre-determined price, we will have our cash investment returned with a premium. If the closing market price is at or below the pre-determined price, we will receive the number of shares specified at the agreement inception. Any cash received, including the premium, is treated as additional paid in capital on the balance sheet. We did not enter into any structured stock repurchase agreements during the nine months ended December 31, 2012. During the nine months ended December 31, 2011, we entered into structured stock repurchase agreements totaling $10.0 million. For those agreements that settled during the nine months ended December 31, 2011, we received 1.0 million in shares of our common stock at an effective purchase price of $9.74 per share from the settled structured stock repurchase agreements. At December 31, 2011, we had no outstanding structured stock repurchase agreements. Other Our aggregate fixed commitments payable over the next five years for licensing fees relating to our R&D efforts, including our licensed IP, technology, product design, test and verification tools, are approximately $27.3 million. These amounts are also included in the table below. The following table summarizes our contractual operating leases and other purchase commitments as of December 31, 2012 (in thousands): Other Operating Purchase Leases Commitments Total Fiscal Years Ending March 31, 2013 $ 511 $ 66,451 * $ 66,962 2014 1,767 12,748 14,515 2015 871 7,841 8,712 2016 278 240 518 Total minimum payments $ 3,427 $ 87,280 $ 90,707 * Includes liability for uncertain tax positions of $43.4 million including interest and penalties. Due to the high degree of uncertainty regarding the timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements as at December 31, 2012. |