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SMITH MICRO SOFTWARE INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes and other financial information appearing elsewhere in this Annual Report. Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made in Item 1A of Part I of this Annual Report under the caption "Risk Factors." Risk factors that could cause actual results to differ from those contained in the forward-looking statements include but are not limited to: deriving revenues from a small number of products; our dependence upon the large carrier customers for a significant portion of our revenues; potential fluctuations in quarterly results; potential further impairments of long-lived assets; our failure to successfully compete; changes in technology; our entry into new markets; failure of our customers to adopt new technologies; loss of key personnel; failure to maintain strategic relationships with device manufacturers; failure of our products to achieve broad acceptance; uncertainty and volatility of current global economic conditions; our failure to successfully integrate acquisitions; undetected software defects; our failure to protect intellectual property; exposure to intellectual property claims; security and privacy breaches in our systems or interruptions or delays in the services we provide which could damage client relations; our inability to raise more funds to meet our capital needs; being delisted from NASDAQ; and doing business internationally. Introduction and Overview Smith Micro Software, Inc. provides software and services that simplify, secure and enhance the mobile experience. The Company's portfolio of wireless solutions includes a wide range of client and server applications that manage voice, data, video and connectivity over mobile broadband networks. Our primary customers are the world's leading mobile network operators, mobile device manufacturers and enterprise businesses. In addition to our wireless and mobility software, Smith Micro offers personal productivity and graphics products distributed through a variety of consumer channels worldwide. The proliferation of mobile broadband technology continues to provide new opportunities for Smith Micro on a global basis. Over the last decade, the Company has developed extensive expertise in embedded software for networked devices (both wireless and wired), and we have leveraged that expertise to solve an unending tide of connectivity and mobile service challenges for our customers. As network operators and businesses struggle to reduce costs and complexity in a market that is characterized by rapid evolution and fragmentation, Smith Micro answers with innovative solutions that increase reliability, security, performance, efficiency, and usability of wireless services over a wide variety of networks and device platforms. The underlying philosophy driving our products and services is our desire to improve the user experience and optimize resources for our customers. These objectives are delivered through the combination of rigorous market analysis and planning, technology innovation that leverages substantial intellectual property, leadership in industry standards, quality engineering, and extensive commercial deployment experience gained over 30 years. As technology, market dynamics and consumer demands change, Smith Micro has proven its ability to evolve and meet those demands again and again. 24-------------------------------------------------------------------------------- Table of Contents During fiscal year 2011, we experienced a significant decrease in our revenues. This was primarily due to the introduction and market acceptance of mobile hotspot devices, Tablets and Smartphones capable of functioning as a WWAN hotspot, resulting in lower demand in our North American marketplace for our core connection management products. While we launched new wireless products that addressed this technology shift, they are new to the market and their rate of adoption and deployment is unknown at this time causing material uncertainty regarding the timing of our future wireless revenues. As a result of our decreased revenues, slow adoption of our new products, operating losses and depressed stock prices, we recorded a goodwill and other long-lived asset impairment charge of $112.9 million in fiscal year 2011. All goodwill and intangible assets have been written off as of December 31, 2011. For the year ended December 31, 2012, revenues to two customers and their respective affiliates in the Wireless business segment accounted for 40.7% and 20.5% of the Company's total revenues and 78% of accounts receivable. For the year ended December 31, 2011, revenues to three customers and their respective affiliates in the Wireless business segment accounted for 24.8%, 18.4% and 11.7% of the Company's total revenues and 63% of accounts receivable. For the year ended December 31, 2010, revenues to three customers and their respective affiliates in the Wireless business segment accounted for 40.1%, 13.9% and 12.3% of the Company's total revenues and 78% of accounts receivable. Results of Operations The following table sets forth certain consolidated statement of comprehensive income data as a percentage of total revenues for the periods indicated: Year Ended December 31, 2012 2011 2010 Revenues 100.0 % 100.0 % 100.0 % Cost of revenues 19.5 23.8 11.9 Gross profit 80.5 76.2 88.1 Operating expenses: Selling and marketing 38.5 46.0 22.8 Research and development 57.2 72.2 32.8 General and administrative 46.6 43.8 18.4 Restructuring expenses 0.5 5.5 - Goodwill and long-lived asset impairment - 195.5 - Total operating expenses 142.8 363.0 74.0 Operating income (loss) (62.3 ) (286.8 ) 14.1 Non-operating income: Change in fair value of contingent liability 2.8 - - Interest and other income, net 0.2 0.2 0.1 Income (loss) before provision for income taxes (59.3 ) (286.6 ) 14.2 Provision for income tax expense (benefit) (0.5 ) (10.3 ) 4.7 Net income (loss) (58.8 )% (276.3 )% 9.5 % 25 -------------------------------------------------------------------------------- Table of Contents Revenues and Expense Components The following is a description of the primary components of our revenues and expenses: Revenues. Revenues are net of sales returns and allowances. Our operations are organized into two business segments: • Wireless, which includes our QuickLink, NetWise and CommSuite family of products; and • Productivity & Graphics, which includes ourconsumer-based products: Poser, Anime Studio, Manga Studio, MotionArtist and StuffIt. The following table shows the revenues generated by each business segment (in thousands): Year Ended December 31, 2012 2011 2010 Wireless $ 36,963 $ 48,711 $ 118,684 Productivity & Graphics 6,175 8,816 11,399 Corporate/Other 191 240 418 Total revenues 43,329 57,767 130,501 Cost of revenues 8,448 13,761 15,507 Gross profit $ 34,881 $ 44,006 $ 114,994 "Corporate/Other" refers to the consulting portion of our services sector which has been de-emphasized and is not considered a strategic element of our future plans. Cost of revenues. Cost of revenues consists of direct product costs, royalties, and the amortization of purchased intangibles and capitalized software. Selling and marketing. Selling and marketing expenses consist primarily of personnel costs, advertising costs, sales commissions, trade show expenses, and the amortization of certain purchased intangibles. These expenses vary significantly from quarter to quarter based on the timing of trade shows and product introductions. Research and development. Research and development expenses consist primarily of personnel and equipment costs required to conduct our software development efforts and the amortization of certain acquired intangibles. General and administrative. General and administrative expenses consist primarily of personnel costs, professional services and fees paid for external service providers, space and occupancy costs, and legal and other public company costs. Restructuring expenses. Restructuring expenses consist primarily of one-time employee termination benefits, lease and other contract terminations and costs to consolidate facilities and relocate employees. Goodwill and long-lived asset impairment. Goodwill and long-lived asset impairment charges are a result of determining that the recoverability of the carrying value of goodwill, intangible assets, and fixed assets will not be realized. Change in fair value of contingent liability. This is the return-to-profit of a milestone payment accrual that we did not have to pay. Interest and other income, net. Interest and other income, net is primarily related to our average cash and short term investment balances during the period and vary among periods. Our other excess cash is invested in short term marketable equity and debt securities classified as cash equivalents. Provision for income tax expense (benefit). The Company accounts for income taxes as required by Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic No. 740, Income Taxes. This statement requires the recognition of deferred tax assets and liabilities for the future consequences of events that have been recognized in the Company's financial statements or tax returns. Measurement of the deferred items is based on enacted tax laws. In the event the future 26-------------------------------------------------------------------------------- Table of Contents consequences of differences between financial reporting bases and tax bases of the Company's assets and liabilities result in a deferred tax asset, we are required to evaluate the probability of being able to realize the future benefits indicated by such asset. The deferred tax assets are reduced by a valuation allowance if, based upon all available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Establishing, reducing or increasing a valuation allowance in an accounting period generally results in an increase or decrease in tax expense in the statement of operations. We must make significant judgments to determine the provision for income taxes, deferred tax assets and liabilities, unrecognized tax benefits and any valuation allowance to be recorded against deferred tax assets. After consideration of the Company's three year cumulative loss position as of December 31, 2011 and sources of taxable income, the Company recorded a valuation allowance related to its U.S.-based deferred tax amounts, with a corresponding charge to income tax expense, of $53.2 million for the year ended December 31, 2011. Year Ended December 31, 2012 Compared to the Year Ended December 31, 2011 Revenues. Revenues of $43.3 million for fiscal year 2012 decreased $14.5 million, or 25.0%, from $57.8 million for fiscal year 2011. Wireless revenues of $36.9 million decreased $11.8 million, or 24.1%, primarily due to lower sales of our base business connection manager products to our carrier customers of $15.5 million and PC OEM customers of $3.2 million, partially offset by higher sales of our CommSuite products of $3.9 million and NetWise products of $3.0 million. Productivity & Graphics sales decreased $2.6 million, or 30.0%, primarily due to lower sell through at large retailers and lower overall demand. Corporate/Other sales decreased $0.1 million as we continue to de-emphasize this business. Due to the introduction and market acceptance of mobile hotspot devices, Tablets and Smartphones capable of functioning as a WWAN hotspot, our core connection management products continue to experience lower demand in our North American marketplace. We have launched new wireless products and services, but they are new to the market and their rate of adoption and deployment is unknown at this time causing material uncertainty regarding the timing of our future wireless revenues. Cost of revenues. Cost of revenues of $8.4 million for fiscal year 2012 decreased $5.4 million, or 38.6%, from $13.8 million for fiscal year 2011. Amortization of intangibles decreased $3.8 million due to the impairment charge we recorded for these assets in fiscal year 2011. There was no amortization of intangibles in fiscal year 2012. Direct product costs decreased $1.6 million primarily due to cost reductions. Gross profit. Gross profit of $34.9 million or 80.5% of revenues for fiscal year 2012 decreased $9.1 million, or 20.7%, from $44.0 million, or 76.2% of revenues for fiscal year 2011. The 4.3 percentage point increase in gross profit was primarily due to no amortization of intangibles in fiscal year 2012 of 6.5 points, partially offset by lower product margins of 2.2 points as a result of the lower revenues not absorbing our fixed overhead costs. Selling and marketing. Selling and marketing expenses of $16.7 million for fiscal year 2012 decreased $9.9 million, or 37.3%, from $26.6 million for fiscal year 2011. This decrease was primarily due to lower personnel related expenses of $5.8 million and lower third party commissions and advertising costs of $0.8 million. Amortization of intangibles decreased $2.1 million due to the impairment charge we recorded for these assets in fiscal year 2011. There was no amortization of intangibles in fiscal year 2012. Stock-based compensation decreased from $2.1 million to $0.9 million. Research and development. Research and development expenses of $24.8 million for fiscal year 2012 decreased $16.9 million, or 40.6%, from $41.7 million for fiscal year 2011. Personnel related, travel and supplies and equipment expenses decreased $16.1 million. Stock-based compensation decreased from $1.4 million to $0.8 million, or $0.6 million. Amortization of purchased technologies decreased $0.2 million due to the impairment charge we recorded for these assets in fiscal year 2011. There was no amortization of purchased technologies in fiscal year 2012. 27 -------------------------------------------------------------------------------- Table of Contents General and administrative. General and administrative expenses of $20.2 million for fiscal year 2012 decreased $5.0 million, or 20.0%, from $25.2 million for fiscal year 2011. This decrease was primarily due to personnel related expenses of $1.8 million, lower outside legal and accounting fees of $0.7 million, and other cost reductions of $0.6 million. Stock-based compensation expense decreased from $4.3 million to $2.4 million, or $1.9 million. Restructuring expenses. Restructuring expenses of $0.2 million for fiscal year 2012 were related to one-time employee termination and other costs as a result of headcount reductions. Restructuring expenses of $3.2 million for fiscal year 2011 were related to the Chicago facility shutdown of $0.8 million, the Sweden facility shutdown of $0.8 million and other one-time employee termination and other costs in the U.S. of $1.6 million Goodwill and long-lived asset impairment. There were no impairment charges in fiscal year 2012. Goodwill and long-lived asset impairment charges of $112.9 million for fiscal year 2011 were related to goodwill of $94.2 million, intangible assets of $13.4 million, and fixed assets of $5.3 million. Change in fair value of contingent liability. When we acquired Core Mobility in October 2009, we established a pre-acquisition contingency made up of two milestone payments that were part of the purchase price of the business. The first milestone was met and $0.6 million was paid in March 2010. The second milestone was not met and therefore not paid. The Core Mobility shareholders disputed the second milestone in a lawsuit which was found in our favor in August 2012. The plaintiffs chose not to appeal the decision. As a result, we have reduced the contingent liability of $1.2 million to its fair value of $0 at December 31, 2012. Interest and other income, net. Interest and other income, net was $0.1 million for both fiscal year 2012 and 2011. Provision for income tax expense (benefit). We recorded an income tax benefit of $0.2 million for fiscal year 2012 related to state R&D tax credits of $0.7 million, partially offset by state and foreign income taxes of $0.5 million. We recorded an income tax benefit of $5.9 million for fiscal year 2011. The effective tax rate for fiscal year 2011 was impacted by the valuation allowance and carryback of losses to offset taxable income in prior years. Year Ended December 31, 2011 Compared to the Year Ended December 31, 2010 Revenues. Revenues of $57.8 million for fiscal year 2011 decreased $72.7 million, or 55.7%, from $130.5 million for fiscal year 2010. Wireless revenues of $48.7 million decreased $70.0 million, or 59.0%, primarily due to lower sales of our base business connection manager products to our carrier customers of $58.3 million and PC OEM customers of $8.3 million and large device solutions sales in fiscal 2010 that were not repeated in fiscal 2011 of $3.4 million. Productivity & Graphics sales decreased $2.6 million, or 22.7%, primarily due to low consumer spending and moving toward a more internal distribution model. Corporate/Other sales decreased $0.1 million as we continue to de-emphasize this business. Due to the introduction and market acceptance of mobile hotspot devices, Tablets and Smartphones capable of functioning as a WWAN hotspot, our core connection management products experienced lower demand in our North American marketplace. While we have launched new wireless products that address this technology shift, they are new to the market and their rate of adoption and deployment is unknown at this time causing material uncertainty regarding the timing of our future wireless revenues. Cost of revenues. Cost of revenues of $13.8 million for fiscal year 2011 decreased $1.7 million, or 11.3%, from $15.5 million for fiscal year 2010. Direct product costs increased $0.4 million primarily due to costs associated with the start-up of our new backup and messaging services. Amortization of intangibles decreased from $5.9 million to $3.8 million, or $2.1 million, primarily due to the impairment charge we recorded for these assets in fiscal year 2011. No future amortization of intangibles is anticipated as these assets have been fully impaired. 28 -------------------------------------------------------------------------------- Table of Contents Gross profit. Gross profit of $44.0 million or 76.2% of revenues for fiscal year 2011 decreased $71.0 million, or 61.7%, from $115.0 million, or 88.1% of revenues for fiscal year 2010. The 11.9 percentage point decrease in gross profit was primarily due to lower product margins of 9.9 points as a result of the lower revenues not absorbing our fixed costs and our datacenter and start-up costs associated with our backup and messaging products. Amortization of intangibles as a percentage of revenues decreased 2.0 points primarily due to the lower revenues and the impairment charge we recorded in fiscal 2011. Selling and marketing. Selling and marketing expenses of $26.6 million for fiscal year 2011 decreased $3.1 million, or 10.5%, from $29.7 million for fiscal year 2010. This decrease was primarily due to lower personnel related expenses of $0.9 million, lower advertising costs of $0.2 million and lower travel costs of $0.1 million. Stock-based compensation decreased from $3.1 million to $2.1 million, or $1.0 million. Amortization of intangibles decreased from $3.0 million to $2.1 million, or $0.9 million. No future amortization of intangibles is anticipated as these assets have been fully impaired. Research and development. Research and development expenses of $41.7 million for fiscal year 2011 decreased $1.0 million, or 2.5%, from $42.7 million for fiscal year 2010. Personnel, recruiting and travel expenses decreased $0.4 million as a result of implementing our restructuring plans. This decrease was offset by increases in software maintenance and other small equipment of $0.6 million related to our new products. Stock-based compensation decreased from $2.7 million to $1.4 million, or $1.3 million. Amortization of purchased technologies increased from $0.1 million to $0.2 million, or $0.1 million. No future amortization of purchased technologies is anticipated as these assets have been fully impaired. General and administrative. General and administrative expenses of $25.2 million for fiscal year 2011 increased $1.1 million, or 4.7%, from $24.1 million for fiscal year 2010. This increase was primarily due to increased space and occupancy costs and depreciation/amortization associated with facility and datacenter expansions in Aliso Viejo and Pittsburgh of $2.7 million and legal expenses of $0.8 million, partially offset by lower personnel related costs of $0.8 million and other cost decreases of $0.2 million. Stock-based compensation expense decreased from $5.7 million to $4.3 million, or $1.4 million. Restructuring expenses. Restructuring expenses of $3.2 million for fiscal year 2011 were related to the Chicago facility shutdown of $0.8 million, the Sweden facility shutdown of $0.8 million and other one-time employee termination and other costs in the U.S. of $1.6 million. There were no restructuring expenses in 2010. Goodwill and long-lived asset impairment. Goodwill and long-lived asset impairment charges of $112.9 million for fiscal year 2011 were related to goodwill of $94.2 million, intangible assets of $13.4 million, and fixed assets of $5.3 million. There were no impairment charges in 2010. Interest and other income, net. Interest and other income, net was $0.1 million for both fiscal year 2011 and 2010. Provision for income tax expense (benefit). We recorded an income tax benefit of $5.9 million for fiscal year 2011 and a tax provision of $6.2 million for fiscal year 2010. The effective tax rate for fiscal year 2011 was impacted by the valuation allowance and carryback of losses to offset taxable income in prior years. Liquidity and Capital Resources At December 31, 2012, we had $32.2 million in cash and cash equivalents and short-term investments and $34.8 million of working capital. In November 2011, the Company announced that its Board of Directors had approved a program authorizing the repurchase of up to five million shares of the Company's common stock over a period of up to two years. Under this program, stock repurchases may be made from time to time and the actual amount 29-------------------------------------------------------------------------------- Table of Contents expended will depend on a variety of factors including market conditions, regulatory and legal requirements, corporate cash generation and other factors. The stock repurchases may be made in both open market and privately negotiated transactions, and may include the use of Rule 10b5-1 trading plans. The program does not obligate Smith Micro to repurchase any particular amount of common stock during any period and the program may be modified or suspended at any time at the Company's discretion. During the fiscal year 2012 we repurchased 375,000 shares at a cost of $0.8 million. Capital expenditures were only $0.3 million for the fiscal year 2012 versus $13.4 million for the fiscal year 2011 as we expanded our Aliso Viejo datacenter and built out our new Pittsburgh facility in 2011. We believe that our existing cash, cash equivalents and short-term investment balances will be sufficient to finance our working capital and capital expenditure requirements through at least the next twelve months. We are hopeful that our new products will gain market acceptance in order to increase our revenues in upcoming quarters. If our new products do not gain market acceptance, or market acceptance is slower than anticipated, then we anticipate that it will be necessary to undertake additional restructuring to lower costs to bring them more in line with actual revenues, thus slowing the use of cash. We may require additional funds to support our working capital requirements or for other purposes and may seek to raise additional funds through public or private equity or debt financing or from other sources. If additional financing is needed, we cannot assure that such financing will be available to us at commercially reasonable terms or at all. Operating Activities In 2012, net cash used in operations was $12.8 million primarily due to our net loss adjusted for depreciation, amortization, non-cash stock-based compensation, and inventory and accounts receivable reserves of $17.0 million, a decrease of accounts payable and accrued liabilities of $2.2 million, and an increase in accounts receivable of $1.5 million. This usage was partially offset by a decrease of income taxes receivable of $7.6 million and a decrease in prepaid and other assets of $0.3 million. In 2011, net cash used in operations was $13.5 million primarily due to our net loss adjusted for goodwill and long-lived asset impairments, depreciation, amortization, non-cash stock-based compensation, deferred income taxes and inventory and accounts receivable reserves of $28.0 million, an increase of income taxes receivable of $5.4 million and a decrease in accounts payable and accrued liabilities of $2.3 million. This usage was partially offset by a decrease in accounts receivable of $20.0 million and lease incentives of $2.2 million. In 2010, net cash provided by operations was $24.7 million primarily due to our net income adjusted for depreciation, amortization, non-cash stock-based compensation, deferred income taxes and inventory and accounts receivable reserves of $34.0 million and a decrease in prepaid expenses of $0.3 million. These increases were partially offset by an increase of accounts receivable due to our increased revenue of $6.5 million, an increase in income tax receivable of $1.9 million and an increase of all other net assets of $1.2 million. Investing Activities In 2012, cash provided by investing activities of $24.9 million was due to the sale of short-term investments of $25.2 million, partially offset by capital expenditures of $0.3 million. In 2011, cash provided by investing activities of $2.7 million was due to the sale of short-term investments of $16.1 million, partially offset by capital expenditures of $13.4 million which were primarily for leasehold improvements and to expand our datacenters. In 2010, we used cash of $30.3 million for investing activities to purchase short-term investments of $23.4 million, capital expenditures which primarily were for leasehold improvements and to expand our datacenter of $6.3 million, and for the acquisition of Avot Media of $0.6 million. 30-------------------------------------------------------------------------------- Table of Contents Financing Activities In 2012, cash used in financing activities of $0.7 million was due to the repurchase of our common stock of $0.8 million which was partially offset by cash received from the sale of stock for our employee stock purchase plan of $0.1 million. In 2011, cash provided by financing activities of $0.4 million was from the sale of stock for our employee stock purchase plan. In 2010, cash provided by financing activities of $8.8 million was related to the exercise of stock options of $7.3 million and tax benefits associated with stock-based compensation of $1.5 million. Contractual Obligations and Commercial Commitments As of December 31, 2012, we had no debt. The following table summarizes our contractual obligations as of December 31, 2012 (in thousands): Payments due by period Less than More than Contractual obligations: Total 1 year 1-3 years 3-5 years 5 years Operating lease obligations $ 17,870 $ 2,611 $ 5,030 $ 3,915 $ 6,314 Purchase obligations 778 778 - - - Total $ 18,648 $ 3,389 $ 5,030 $ 3,915 $ 6,314 During our normal course of business, we have made certain indemnities, commitments and guarantees under which we may be required to make payments in relation to certain transactions. These include: intellectual property indemnities to our customers and licensees in connection with the use, sale and/or license of our products; indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease; indemnities to vendors and service providers pertaining to claims based on the negligence or willful misconduct; indemnities involving the accuracy of representations and warranties in certain contracts; and indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of Delaware. We may also issue a guarantee in the form of a standby letter of credit as security for contingent liabilities under certain customer contracts. The duration of these indemnities, commitments and guarantees varies, and in certain cases, may be indefinite. The majority of these indemnities, commitments and guarantees may not provide for any limitation of the maximum potential for future payments we could be obligated to make. We have not recorded any liability for these indemnities, commitments and guarantees in the accompanying consolidated balance sheets. Real Property Leases Our corporate headquarters, including our principal administrative, sales and marketing, customer support and research and development facility, is located in Aliso Viejo, California, where we currently lease and occupy approximately 52,700 square feet of space pursuant to leases that expire on May 31, 2016 and January 31, 2022. We lease approximately 55,600 square feet in Pittsburgh, Pennsylvania under a lease that expires December 31, 2021. We lease approximately 16,000 square feet in Sunnyvale, California under a lease that expires February 28, 2015. We lease approximately 15,300 square feet in Watsonville, California under a lease that expires September 30, 2018. Internationally, we lease space in Belgrade, Serbia that expires December 30, 2016 and Vancouver, Canada that expires March 31, 2014. Off-Balance Sheet Arrangements As of December 31, 2012, we did not have any off-balance sheet arrangements. 31 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates Our discussion and analysis of results of operations, financial condition and liquidity are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may materially differ from these estimates under different assumptions or conditions. On an on-going basis, we review our estimates to ensure that they appropriately reflect changes in our business or new information as it becomes available. We believe the following critical accounting policies affect our more significant estimates and assumptions used in the preparation of our consolidated financial statements: Revenue Recognition We currently report our net revenues under two operating groups: Wireless and Productivity & Graphics. Within each of these groups software revenue is recognized based on the customer and contract type. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed and determinable, and collectability is probable as required by FASB ASC Topic No. 985-605, Software-Revenue Recognition. We recognize revenues from sales of our software to our customers or end users as completed products are shipped and title passes; or from royalties generated as authorized customers duplicate our software, if the other requirements are met. If the requirements are not met at the date of shipment, revenue is not recognized until these elements are known or resolved. For Wireless sales, returns from customers are limited to defective goods or goods shipped in error. Historically, customer returns have not exceeded the very nominal estimates and reserves. We also provide some technical support to our customers. Such costs have historically been insignificant. We have a few multiple element agreements for which we have contracted to provide a perpetual license for use of proprietary software, to provide non-recurring engineering, and in some cases to provide software maintenance (post contract support). For these software and software-related multiple element arrangements, we must: (1) determine whether and when each element has been delivered; (2) determine whether undelivered products or services are essential to the functionality of the delivered products and services; (3) determine the fair value of each undelivered element using vendor-specific objective evidence ("VSOE"), and (4) allocate the total price among the various elements. VSOE of fair value is used to allocate a portion of the price to the undelivered elements and the residual method is used to allocate the remaining portion to the delivered elements. Absent VSOE, revenue is deferred until the earlier of the point at which VSOE of fair value exists for any undelivered element or until all elements of the arrangement have been delivered. However, if the only undelivered element is post contract support, the entire arrangement fee is recognized ratably over the performance period. We determine VSOE for each element based on historical stand-alone sales to third parties or from the stated renewal rate for the elements contained in the initial arrangement. In determining VSOE, we require that a substantial majority of the selling prices for a product or service fall within a reasonably narrow pricing range. We have established VSOE for our post contract support services and non-recurring engineering. For Productivity & Graphics sales, management reviews available retail channel information and makes a determination of a return provision for sales made to distributors and retailers based on current channel inventory levels and historical return patterns. Certain sales to distributors or retailers are made on a consignment basis. Revenue for consignment sales are not recognized until sell through to the final customer is established. Certain revenues are booked net of revenue sharing payments. Sales directly to end-users are recognized upon shipment. End users have a thirty day right of return, but such returns are reasonably estimable and have historically been immaterial. We also provide technical support to our customers. Such costs have historically been insignificant. 32 -------------------------------------------------------------------------------- Table of Contents Sales Incentives For our Productivity & Graphics sales, the cost of sales incentives the Company offers without charge to customers that can be used in, or that are exercisable by a customer as a result of, a single exchange transaction is accounted for as a reduction of revenue as required by FASB ASC Topic No. 985-605, Software-Revenue Recognition. We use historical redemption rates to estimate the cost of customer incentives. Total sales incentives were $0.9 million, $1.2 million, and $2.0 million for the years ended December 31, 2012, 2011 and 2010, respectively. Accounts Receivable and Allowance for Doubtful Accounts We sell our products worldwide. We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history, the customer's current credit worthiness and various other factors, as determined by our review of their current credit information. We continuously monitor collections and payments from our customers. We estimate credit losses and maintain an allowance for doubtful accounts reserve based upon these estimates. While such credit losses have historically been within our estimated reserves, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. If not, this could have an adverse effect on our consolidated financial statements. Internal Software Development Costs Development costs incurred in the research and development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility has been established. The Company considers technological feasibility to be established when all planning, designing, coding and testing has been completed according to design specifications. After technological feasibility is established, any additional costs are capitalized. Through December 31, 2012, software has been substantially completed concurrently with the establishment of technological feasibility; accordingly, no costs have been capitalized to date. Impairment of Goodwill and Long-Lived Assets During the period ended September 30, 2011, the Company concluded that a decline in its stock price and market capitalization was representative of the fair value of the reporting unit as a whole. The triggering events that led us to this conclusion were: • Revenues - declined for the third consecutive quarter. • New product launches - although we were in trials for several of our new products, as of September 30, 2011 we had not realized any revenues from these new products. • Profitability - declined for the third consecutive quarter. • Stock price - remained at depressed prices. As such, the Company performed Step 1 of the goodwill impairment test which failed, triggering Step 2. As a result of this analysis, the excess of the carrying value of goodwill was compared to the implied fair value of goodwill and resulted in an impairment loss of $94.2 million in the fiscal quarter ended September 30, 2011. As a result of the triggering events described above in our goodwill impairment analysis, the Company reviewed its long-lived assets for recoverability. As a result of this analysis, the Company recognized a long-lived asset impairment charge of $18.7 million in the fiscal quarter ended September 30, 2011 which was allocated pro-rata to the intangible assets of $13.4 million and $5.3 million to equipment and improvements, primarily related to our leasehold improvements. As a result of the $112.9 million goodwill and long-lived asset impairment charge recorded in the fiscal quarter ended September 30, 2011, there were no more goodwill or intangible assets on the balance sheet as of that date. 33-------------------------------------------------------------------------------- Table of Contents Income Taxes We account for income taxes as required by FASB ASC Topic No. 740, Income Taxes. This Topic clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Topic also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. In the event the future consequences of differences between financial reporting bases and the tax bases of the Company's assets and liabilities result in a deferred tax asset, we are required to evaluate the probability of being able to realize the future benefits indicated by such asset. The Company records a valuation allowance to reduce any deferred tax assets by the amount of any tax benefits that, based on available evidence and judgment, are not expected to be realized. The Company assesses whether a valuation allowance should be recorded against its deferred tax assets based on the consideration of all available evidence, using a "more likely than not" realization standard. The four sources of taxable income that must be considered in determining whether deferred tax assets will be realized are: (1) future reversals of existing taxable temporary differences (i.e., offset of gross deferred tax assets against gross deferred tax liabilities); (2) taxable income in prior carryback years, if carryback is permitted under the applicable tax law; (3) tax planning strategies and (4) future taxable income exclusive of reversing temporary differences and carryforwards. In assessing whether a valuation allowance is required, significant weight is to be given to evidence that can be objectively verified. A significant factor in the Company's assessment is that the Company was in a three-year historical cumulative loss as of the end of fiscal 2011. This fact, combined with uncertain near-term market and economic conditions, reduced the Company's ability to rely on projections of future taxable income in assessing the realizability of its deferred tax assets. After a review of the four sources of taxable income as of December 31, 2011 (as described above), and after consideration of the Company's three-year cumulative loss position as of December 31, 2011, the Company recorded a valuation allowance related to its U.S.-based deferred tax amounts, with a corresponding charge to income tax expense, of $53.2 million during the year ended December 31, 2011. Stock-Based Compensation The Company accounts for all stock-based payment awards made to employees and directors based on their fair values and recognized as compensation expense over the vesting period using the straight-line method over the requisite service period for each award as required by FASB ASC Topic No. 718, Compensation-Stock Compensation. Recent Accounting Pronouncements In December 2011, the FASB issued Accounting Standards Update ("ASU") No. 2011-12, Comprehensive Income (Topic 220). The amendments in this Update supersede certain pending paragraphs in ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, to effectively defer only those changes in Update 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive income. The amendments will be temporary to allow the Board time to redeliberate the presentation requirements for reclassifications out of accumulated other comprehensive income for annual and interim financial statements for public, private, and non-profit entities. 34-------------------------------------------------------------------------------- Table of Contents In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. Under the amendments to this Update, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The Company has implemented this guidance. In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurements and Disclosures (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this Update result in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs. Consequently, the amendments change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. The Company has implemented this guidance and its adoption has not had an impact on its consolidated results of operations and financial condition. |