[March 04, 2013] NOVATEL WIRELESS INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) The following discussion of our consolidated financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. This report contains certain forward-looking statements relating to future events or our future financial performance. These statements are subject to risks and uncertainties which could cause actual results to differ materially from those discussed in this report. You are cautioned not to place undue reliance on this information which speaks only as of the date of this report. We are not obligated to update this information, whether as a result of new information, future events or otherwise, except to the extent we are required to by law. For a discussion of the important risks related to our business and future operating performance, see the discussion under the caption "Item 1A. Risk Factors" and under the caption "Factors Which May Influence Future Results of Operations" below. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur. Overview and Background We are a provider of intelligent wireless solutions for the worldwide mobile communications market. Our broad range of products principally includes intelligent mobile hotspots, USB modems, embedded PCI and wireless PC-card modems, and communications and applications software. In addition, our Enfora division provides asset-management solutions utilizing intelligent platforms, customized service-delivery software, and machine-to-machine, or M2M, communications devices. Our products currently operate on every major cellular wireless technology platform. Our mobile hotspots, embedded modules, and modems provide subscribers with secure and convenient high-speed access to corporate, public and personal information through the Internet and enterprise networks. Our M2M products enable devices to communicate with each other and with server- or cloud-based application infrastructure. Our mobile-hotspot and modem customer base is comprised of wireless operators, including AT&T, Sprint, and Verizon Wireless; laptop PC and other original equipment manufacturers, or OEMs, including Dell and Hewlett-Packard; as well as distributors and various companies in other vertical markets. Our M2M customer base is comprised of transportation companies, industrial companies, manufacturers of medical devices and geographical-location devices and providers of security systems. We have strategic relationships with several of these customers for technology development and marketing. We sell our wireless broadband solutions primarily to wireless operators either directly or through strategic relationships, as well as to OEM partners and distributors located worldwide. Most of our mobile-computing product sales to wireless operators and OEM partners are sold directly by our sales force, or to a lesser degree, through distributors. We sell our M2M solutions primarily to enterprises in the following industries: transportation; energy and industrial automation; security and safety; and medical monitoring. We sell our M2M solutions through our direct sales force and through distributors. We intend to continue to identify and respond to our customers' needs by introducing new product designs with an emphasis on supporting cutting edge wide area network, or WAN, technology, ease-of-use, performance, size, weight, cost and power consumption. We manage our products through a structured life cycle process, from identifying initial customer requirements through development and commercial introduction to eventual phase-out. During product development, emphasis is placed on innovation, time-to-market, performance, meeting industry standards and customer product specifications, ease of integration, cost reduction, manufacturability, quality and reliability. The hardware used in our solutions is produced by contract manufacturers. Their services include component procurement, assembly, testing, quality control, and fulfillment. We have agreements with Inventec Appliances Corporation, or IAC; Hon Hai Precision Industry co., LTD; and Benchmark Electronics for the 24-------------------------------------------------------------------------------- Table of Contents outsourced manufacturing of our products. Under our manufacturing agreements, contract manufacturers provide us with services including component procurement, product manufacturing, final assembly, testing, quality control, and fulfillment. In addition, we have an agreement with Mobiltron for certain distribution, fulfillment and repair services related to our business in Europe, the Middle East and Africa, or EMEA. Factors Which May Influence Future Results of Operations Net Revenues. We believe that our future net revenues will be influenced largely by the speed and breadth of the demand for wireless access to data through the use of next generation networks including demand for 3G and 4G products, 3G and 4G data access services, particularly in North America, Europe and Asia; customer acceptance for our new products that address these markets, including our MiFi line of Intelligent Mobile Hotspots; and our ability to meet customer demand. Factors that could potentially affect customer demand for our products include the following: • economic environment and related market conditions; • increased competition from other wireless data modem suppliers as well as suppliers of emerging devices that contain a wireless data access feature; • demand for broadband access services and networks; • rate of change to new products; • timing of deployment of 4G networks by wireless operators; • decreased demand for EV-DO and HSPA products; and • changes in technologies. We anticipate introducing additional products during the next twelve months, including 4G broadband-access products, M2M solutions and software applications and platforms. We continue to develop and maintain strategic relationships with wireless and computing industry leaders like QUALCOMM, Sprint, Verizon Wireless, AT&T, Texas Instruments, and major software vendors. Through strategic relationships, we have been able to increase market penetration by leveraging the resources of our channel partners, including their access to distribution resources, increased sales opportunities and market opportunities. As a result of the extremely competitive market for wireless devices, we have experienced significant downward pressure on the average selling prices of our products. This pressure has the potential to materially adversely affect our results of operations and financial condition in future periods and we cannot predict the magnitude or timing of future reductions in the average selling prices of our products. Cost of Net Revenues. All costs associated with our contract manufacturers, as well as distribution, fulfillment and repair services are included in our cost of net revenues. Cost of net revenues also includes warranty costs, amortization of intangible assets, royalties, operations overhead, costs associated with the Company's cancellation of purchase orders, costs related to outside services and costs related to inventory adjustments, including write downs for excess and obsolete inventory. Inventory adjustments are impacted primarily by demand for our products, which is influenced by the factors discussed above. Operating Costs and Expenses. Many of our products target wireless operators and other customers in North America, Europe, and Asia. We will likely develop new products to serve these markets, resulting in increased research and development expenses. We have incurred these expenses in the past and expect to continue to incur these expenses in future periods prior to recognizing net revenues from sales of these products. Our operating costs consist of four primary categories: research and development costs; sales and marketing; general and administrative costs; and amortization of purchased intangibles. 25 -------------------------------------------------------------------------------- Table of Contents Research and development are at the core of our ability to produce innovative, leading-edge products. This category consists primarily of engineers and technicians who design and test our highly complex products. As we work to expand our portfolio of products and remain competitive, it may be necessary to increase our research and development costs in the future. Sales and marketing expense consists primarily of our sales force and product-marketing professionals. In order to maintain strong sales relationships, we provide co-marketing, trade show support, product training and demo units for merchandising. We are also engaged in a wide variety of activities, such as awareness and lead generation programs as well as product marketing. Other marketing initiatives include public relations, seminars and co-branding with partners. General and administrative expenses include primarily corporate functions such as accounting, human resources, professional legal fees, administrative support, and professional fees. This category also includes the expenses needed to operate as a publicly-traded company, including Sarbanes-Oxley compliance, SEC filings, stock-exchange fees, and investor-relations expense. Although general and administrative expenses have been relatively stable and are not directly related to revenue levels, certain expenses such as litigation settlements and provisions for bad debts may impact future general and administrative expenses. Amortization of purchased intangibles includes the amortization of customer relationships, covenant-not-to-compete agreements and trade name intangible assets purchased through the acquisition of Enfora. We also subject our intangible assets and goodwill to impairment assessments when required which can result in charges when impairment occurs. As part of our business strategy, we review, and intend to continue to review, acquisition opportunities that we believe would be advantageous or complementary to the development of our business. If we make any acquisitions, we may incur substantial expenditures in conjunction with the acquisition process and the subsequent assimilation of any acquired business, products, technologies or personnel. Merger & Acquisition Activities Acquisition of Enfora On November 30, 2010, the Company completed its acquisition of Enfora, a provider of intelligent asset-management solutions utilizing wireless technology and M2M communications. The acquisition of Enfora diversifies the Company's customer base and product lines into adjacent markets and advances the Company's strategy of providing intelligent devices to more end markets-enterprise, consumer and vertical applications. Enfora's results of operations and estimated fair value of assets acquired and liabilities assumed are included in the Company's consolidated financial statements from the date of acquisition. Under the terms of the acquisition agreement, the Company paid cash consideration of $64.5 million and additional cash consideration of $13.0 million in exchange for an agreed upon amount of Enfora working capital. The Company also agreed to pay additional cash consideration, or contingent consideration, of up to $6.0 million based on the operating results of Enfora for the 15 month period from October 1, 2010 to December 31, 2011. At December 31, 2010, the estimated fair value of this contingent consideration at the acquisition date was $0.9 million, resulting in total estimated cash to be paid of $78.4 million. During the quarter ended March 31, 2011, the Company revised its estimate of contingent consideration to $0 and accordingly reflected this change as a benefit to general and administrative expenses for the quarter ended March 31, 2011. At December 31, 2011, the operating results necessary to receive payment of the contingent consideration were not achieved. 26-------------------------------------------------------------------------------- Table of Contents Cinterion In June 2010, the Company submitted a bid to purchase certain assets of Cinterion Wireless Modules, a company in the cellular machine-to-machine communications industry. The Company was not the successful bidder at the conclusion of the process on June 28, 2010. In June 2010, the Company borrowed $30.0 million, net of $2.2 million in lender fees, under a bridge loan facility in connection with its bid. In accordance with bidding procedures, during June 2010, the Company deposited into escrow an amount in Euros equal to its bid price using cash and cash equivalents, proceeds from the sale of marketable securities, and borrowings under the $30.0 million bridge loan facility. The escrowed funds are reflected as a deposit of restricted funds in the accompanying consolidated statement of cash flows for the year ended December 31, 2010. The escrowed funds were returned to the Company in July 2010. While the Company's Euro funds were held in escrow, the Company engaged in hedging transactions to address foreign currency risk at a cost of $1.2 million, which amount was recorded in other income (expense), net, in the consolidated statement of operations during the year ended December 31, 2010. During the second quarter ended June 30, 2010, the Company recorded a foreign currency gain of $2.9 million, which was recorded in other income (expense), net, in connection with the conversion of its Euro-denominated escrowed funds into U.S. dollars following completion of the auction on June 28, 2010. Pursuant to authoritative accounting guidance, the $2.2 million in lender fees on the $30.0 million bridge loan facility were recorded as a discount to amounts outstanding under the facility and amortized over the stated term of the facility which was scheduled to mature on September 8, 2010. During June 2010, the Company also incurred $660,000 in professional fees attributable to the bridge facility, which were capitalized and amortized over the stated term of the facility. During the second quarter ended June 30, 2010, the Company recognized $687,000 in interest expense related to this facility, which primarily consisted of the amortization of lender and professional fees. In connection with its bid, the Company estimated that during the second quarter of 2010, it had incurred $2.0 million in legal, advisory and professional fees unrelated to the bridge loan facility, which were recorded as accrued expenses and classified as general and administrative expenses in the consolidated statement of operations. During the third quarter of 2010, the Company reduced its estimate of professional fees by approximately $700,000 based upon information we received during the third quarter of 2010 that indicated the reduction to the original estimated liability was appropriate. In July 2010, the Company repaid all amounts outstanding under the bridge loan facility. 27 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth our consolidated statements of operations expressed as a percentage of net revenues for the periods indicated. Year Ended December 31, 2012 2011 2010 (as a percent of net revenues) Net revenues 100.0 % 100.0 % 100.0 % Cost of net revenues 79.0 79.0 80.4 Gross margin 21.0 21.0 19.6 Operating costs and expenses: Research and development 17.5 15.2 14.4 Sales and marketing 8.0 7.4 6.2 General and administrative 6.6 5.4 6.3 Goodwill and intangible assets impairment 14.4 0.8 0.0 Amortization of purchased intangible assets 0.3 0.6 0.1 Total operating costs and expenses 46.8 29.4 27.0 Operating loss (25.8 ) (8.4 ) (7.4 ) Interest income (expense), net 0.1 0.1 (0.7 ) Other income (expense), net (0.1 ) (0.3 ) 0.6 Loss before income taxes (25.8 ) (8.6 ) (7.5 ) Income tax expense (benefit) 0.2 (2.4 ) 2.3 Net loss (25.9 )% (6.2 )% (9.8 )% Year Ended December 31, 2012 Compared to Year Ended December 31, 2011 Net revenues. Net revenues were approximately $344.3 million during 2012, a decrease of approximately $58.6 million or 14.5% compared to 2011. The following table summarizes net revenues by reportable segment and product categories during the years ended December 31, 2012 and 2011 (in thousands): Year Ended December 31, 2012 2011 Net revenues by reportable segment: Mobile Computing Products $ 312,508 $ 358,106 M2M Products and Solutions 31,780 44,756 Total $ 344,288 $ 402,862 Year Ended December 31, 2012 2011 Net revenues by product categories: Mobile Broadband Devices $ 287,572 $ 336,730 Embedded Solutions 29,960 39,793 Asset Management Solutions & Services 26,756 26,339 Total $ 344,288 $ 402,862 28 -------------------------------------------------------------------------------- Table of Contents Mobile Computing Products. Net revenues from our Mobile Computing Products segment for the year ended December 31, 2012 were $312.5 million, a decrease of $45.6 million or 12.7% compared to the same period in 2011. The decrease is primarily attributable to lower sales of Mobile Broadband devices caused by increased market competition at our largest customer. M2M Products and Solutions. Net revenues from our M2M Products and Solutions segment for the year ended December 31, 2012 were $31.8 million, a decrease of $13.0 million compared with $44.8 million in net revenues for the previous year. The decrease is primarily due to the reduced sales volume and pricing of our 2G GPRS M2M modules in the North American market as it transitions away from 2G GSM networks, and the loss of one of our larger customers for the M2M segment. We continue to develop CDMA and 3G GSM modules and integrated solutions to address this market. We launched a CDMA module in the fourth quarter of 2012 and expect to launch other products in 2013. Product Categories. We have categorized the combined product portfolios of the mobile computing and M2M businesses into three categories (1) Mobile Broadband Devices, (2) Embedded Solutions and (3) Asset Management Solutions and Services. These categories were established due to the different markets and sales channels served. We believe this product categorization facilitates the analysis of our operating trends and enhances our segment disclosures. The Mobile Broadband Devices category includes all external data modems including MiFi intelligent hotspots, USB modems and PC cards. These devices are sold primarily through wireless operator enterprise and retail channels, telecom equipment distributors and consumer retail chains. Embedded Solutions products include wireless-broadband modules and related software and services sold to manufacturers of laptop computers, tablets, and other wireless computer devices. This product category also includes M2M modules sold to manufacturers of various asset tracking and monitoring products. Our products are sold directly to OEMs or through distributor channels. Asset Management Solutions and Services are mobile intelligent wireless broadband terminal devices and communication management software, or CMS, that transmit information about the assets into which these products are integrated. These hardware and software products can be bundled or sold separately. The CMS software activates the terminal device onto the wireless network and manages its functionality. Net revenues from our Mobile Broadband Devices category for the year ended December 31, 2012 were $287.6 million, a decrease of $49.2 million or 14.6% compared to the same period in 2011. The decrease is primarily attributable to increased market competition at our largest customer. The Embedded Solutions category accounted for $30.0 million, or 8.7% of total net revenues for the year ended December 31, 2012, a decrease of $9.8 million compared to the same period in 2011. This included $13.7 million in sales of M2M modules and $16.3 million of embedded modules for OEM computing devices. Net revenues from Asset Management Solutions & Services were $26.8 million and accounted for approximately 7.8% of total net revenues for the year ended December 31, 2012, an increase of $ 417,000 compared to the same period in 2011. These sales were predominantly comprised of integrated product hardware sales. Sales of CMS software were not significant for the years ended December 31, 2012 and 2011. Cost of net revenues. Cost of net revenues for the year ended December 31, 2012 was approximately $271.8 million, or 79.0% of net revenues, as compared to approximately $318.3 million, or 79.0% of net revenues in 2011. The cost of net revenues as a percentage of net revenues remained flat compared to the same period in 2011. The reduction of average sales prices of 4G products in our Mobile Computing Products segment compared to the same period in 2011 was offset by lower amortization costs associated with purchased intangible assets. Cost of net revenues as a percentage of net revenues is expected to fluctuate in future quarters depending on revenue levels, the mix of products sold, competitive pricing, new product introduction costs and other factors. 29-------------------------------------------------------------------------------- Table of Contents Increased competitive pressures may continue to negatively impact the average sales prices of our products. This may require us in future periods to record inventory write downs to reflect lower of cost or market adjustments and revalue certain assets that may become impaired. Gross profit. Gross profit for the year ended December 31, 2012 was approximately $72.4 million, or 21.0% of net revenues, as compared to approximately $84.6 million, or 21.0% of net revenues in 2011. The gross profit percentage remained flat as compared to the same period in 2011. We expect that our gross profit percentage will continue to fluctuate from quarter to quarter depending on product mix, competitive selling prices, our ability to reduce product costs and changes in unit volume. Research and development expenses. Research and development expenses for the year ended December 31, 2012 were approximately $60.4 million, or 17.5% of net revenues, compared to approximately $61.4 million, or 15.2% of net revenues in 2011. Research and development expenses for the year ended December 31, 2012 were lower as compared to the same period in 2011 due to reduced labor cost attributed to headcount reductions, lower software amortization costs, and lower engineering build materials and outside testing services. This decrease was partially offset by an increase in share based compensation expenses primarily related to the termination of our 2000 Employee Stock Purchase Plan in the fourth quarter of 2012. We believe that focused investments in research and development are critical to our future growth and competitive position in the marketplace and are directly related to timely development of new and enhanced products that are central to our core business strategy. As such, we expect to make further investments in research and development to remain competitive. Research and development expenses as a percentage of net revenues are expected to fluctuate in future periods depending on the amount of revenue recognized, and potential variation in the costs associated with the development of our products, including the number and complexity of the products under development and the progress of the development activities with respect to those products. We may increase our investment in research and development to continue to provide innovative products and services. Sales and marketing expenses. Sales and marketing expenses for the year ended December 31, 2012 were approximately $27.5 million, or 8.0% of net revenues, compared to approximately $29.8 million or 7.4% of net revenues in 2011. The dollar decrease was due primarily to lower labor cost as a result of reductions in headcount and decreased cooperative advertising and joint marketing expenses compared to the same period in 2011. While managing sales and marketing expenses relative to net revenues, we expect to continue to make selected investments in sales and marketing as we introduce new products, market existing products, expand our distribution channels and focus on key customers around the world. General and administrative expenses. General and administrative expenses for the year ended December 31, 2012 were approximately $22.7 million, or 6.6% of net revenues, compared to approximately $21.6 million, or 5.4% of net revenues in 2011. The increase was due primarily to legal expenses related to IP defense and litigation settlements, and an increase in bad debt reserve compared to the same period in 2011. Goodwill and intangible assets impairments. During the first and third quarters of 2012, based on actual operating results, and reductions in management's estimates of forecasted operating results of the M2M Products and Solutions reporting unit principally due to an updated view of competitive pressures impacting average selling prices and forecasted sales volumes, customer product and technology selections, and the loss of certain customers, the Company determined there were sufficient indicators of impairment present to require an interim impairment analysis. Based on the fair value tests performed during the first quarter of 2012, the Company recorded a pre-tax goodwill impairment charge of $6.5 million and a purchased intangible asset charge of $22.8 million. Based on the fair value tests performed during the third quarter of 2012, the Company recorded a 30 -------------------------------------------------------------------------------- Table of Contents preliminary pre-tax goodwill impairment charge of $13.2 million and a preliminary purchased intangible asset charge of $7.3 million. During the fourth quarter of 2012, the Company completed the third quarter impairment analysis and reduced the purchased intangible asset impairment by $300,000. During the third quarter of 2011, we performed an interim assessment of impairment for goodwill and recorded an impairment charge of $3.5 million. During the fourth quarter of 2011, we completed the impairment analysis and reduced the impairment by $237,000. Amortization of purchased intangible assets. The amortization of purchased intangible assets for the year ended December 31, 2012 was approximately $1.1 million, compared to approximately $2.2 million in 2011. The decrease in amortization expense was due to the lower net asset value of the intangible assets resulting from impairment charges in the first and third quarters of 2012. Interest income, net. Interest income, net, for the year ended December 31, 2012 was $291,000 as compared to $384,000 for the same period in 2011. Our net interest income during 2012 and 2011 was primarily related to interest earned on our marketable securities. Other expense, net. Other expense, net for the year ended December 31, 2012 was $203,000 as compared to $1.1 million for the same period in 2011. The net other expenses for 2011 were primarily related to foreign currency losses on South Korean Won denominated trade payables, foreign exchange currency losses on our foreign denominated bank accounts and trade receivables, and other-than-temporary loss recognized on our marketable equity securities. Income tax expense (benefit). Income tax expense was approximately $611,000 for fiscal 2012, compared to a benefit of $9.5 million in 2011. The difference between the federal and state statutory combined benefit rate of 35% and our effective tax rate for 2012 is primarily due to a full valuation allowance on the U.S.-based deferred tax assets generated in 2012, and a $0.4 million expense related to an increase in the Company's valuation allowance on the Canadian-based deferred tax assets. The income tax benefit for 2011 was primarily due to an $11.8 million income tax benefit related to the recognition of uncertain tax positions. U.S.-based deferred tax assets generated in 2011 resulting from the Company's operating losses did not result in a net tax benefit due to an offsetting full valuation allowance on the deferred tax assets. Net loss. For the year ended December 31, 2012, we reported a net loss of approximately $89.3 million, as compared to net loss of approximately $24.9 million in 2011. Net income was significantly impacted due to the impairment charges recognized in 2012. Year Ended December 31, 2011 Compared to Year Ended December 31, 2010 Net revenues. Net revenues were approximately $402.9 million during 2011, an increase of approximately $63.9 million or 18.9% compared to 2010. The following table summarizes net revenues by reportable segment and product categories during the years ended December 31, 2011 and 2010 (in thousands): Year Ended December 31, 2011 2010 Net revenues by reportable segment: Mobile Computing Products $ 358,106 $ 332,464 M2M Products and Solutions 44,756 6,478 Total $ 402,862 $ 338,942 31 -------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2011 2010 Net revenues by product categories: Mobile Broadband Devices $ 336,730 $324,740 Embedded Solutions 39,793 7,724 Asset Management Solutions & Services 26,339 6,478 Total $ 402,862 $ 338,942 Mobile Computing Products. Net revenues from our Mobile Computing Products segment for the year ended December 31, 2011 were $358.1 million, an increase of $25.6 million or 7.7% compared to the same period in 2010. The increase was primarily attributable to new product rollouts of our next generation 4G MiFi Intelligent Mobile Hotspot. M2M Products and Solutions. Net revenues from our M2M Products and Solutions segment for the year ended December 31, 2011 were $44.8 million, an increase of $38.3 million compared with $6.5 million in revenues for the previous year. Our acquisition of Enfora occurred during the fourth quarter of 2010 and we recognized revenues from the date of acquisition. Net revenues from M2M Products and Solutions during 2011 were also constrained by supply disruptions that affected a component manufacturer in Japan and our contract manufacturer in Thailand due to natural disasters in those countries in 2011. Net revenues from our Mobile Broadband Devices category for the year ended December 31, 2011 were $336.7 million, an increase of $12.0 million or 3.7% compared to the same period in 2010. The increase in net revenues was primarily driven by higher sales of our next generation 4G MiFi products. The Embedded Solutions category accounted for $39.8 million, or 9.9% of total net revenues for the year ended December 31, 2011, an increase of $32.1 million compared to the same period in 2010. This included $22.2 million in sales of M2M modules and $17.6 million of embedded modules for OEM computing devices. Net revenues from Asset Management Solutions & Services were $26.3 million and accounted for approximately 6.5% of total net revenues for the year ended December 31, 2011, an increase of $19.9 million compared to the same period in 2010. These sales were predominantly comprised of integrated product hardware sales. Sales of CMS software were not significant for the year ended December 31, 2011. The increase in net revenues in Embedded Solutions and Asset Management Solutions and Services compared to the same period in 2010 were related to the Enfora acquisition and increased sales to OEM customers in the Mobile Computing Products segment. Cost of net revenues. Cost of net revenues for the year ended December 31, 2011 was approximately $318.3 million, or 79.0% of net revenues, as compared to approximately $272.6 million, or 80.4% of net revenues in 2010. The primary driver of the dollar increase in cost of net revenues was the increase in units sold compared to the same period in 2010. Cost of net revenues as a percentage of net revenues decreased compared to the same period last year due to higher margins on sales of 4G MiFi devices. Cost of net revenues also included approximately $39.9 million in 2011 from our M2M Products and Solutions segment, including amortization costs of $4.1 million related to purchased intangibles and a fair value inventory valuation increase of $1.8 million in connection with our Enfora acquisition. Gross profit. Gross profit for the year ended December 31, 2011 was approximately $84.6 million, or 21.0% of net revenues, as compared to approximately $66.3 million, or 19.6% of net revenues in 2010. The increase was primarily attributable to the increase in net revenues as discussed above. 32-------------------------------------------------------------------------------- Table of Contents Research and development expenses. Research and development expenses for the year ended December 31, 2011 were approximately $61.4 million, or 15.2% of net revenues, compared to approximately $48.9 million, or 14.4% of net revenues in 2010. This increase was primarily due to an increase in salaries and related expenses due to the acquisition of Enfora, and an increase in product testing and certification costs in the current year to support expanded research and development activities. Research and development expenses included approximately $8.5 million in 2011 from our M2M Products and Solutions segment, compared to $837,000 in 2010. Sales and marketing expenses. Sales and marketing expenses for the year ended December 31, 2011 were approximately $29.8 million, or 7.4% of net revenues, compared to approximately $21.0 million or 6.2% of net revenues in 2010. The increase was due primarily to an increase in salaries and related expenses due to the acquisition of Enfora, an increase in travel and related expenses, and an increase in consulting and marketing expenses to support marketing efforts for our various product launches in 2011. Sales and marketing expenses also included approximately $8.2 million in 2011 from our M2M Products and Solutions segment related to our Enfora acquisition, compared to $825,000 in 2010. General and administrative expenses. General and administrative expenses for the year ended December 31, 2011 were approximately $21.6 million, or 5.4% of net revenues, compared to approximately $21.2 million, or 6.3% of net revenues in 2010. Although general and administrative expenses remained relatively flat in dollar spending for the year ended December 31, 2011 compared to the same period in 2010, general and administrative expenses decreased as a percentage of net revenues due to the increase in net revenues in 2011 as compared to 2010. General and administrative expenses also included approximately $2.7 million in 2011 from our M2M Products and Solutions segment, compared to $350,000 in 2010. Amortization of purchased intangible assets. The increase in amortization expense for the year ended December 31, 2011 was due to the full year 2011 amortization of purchased intangible assets from the Enfora acquisition completed during the fourth quarter of 2010. Goodwill impairment. During the third quarter of 2011, we performed an interim assessment of impairment for goodwill and recorded an impairment charge of $3.5 million. During the fourth quarter of 2011, we completed the impairment analysis and reduced the impairment by $237,000. As a result of this assessment, we recorded a goodwill impairment of $3.3 million related to the M2M reporting unit for the year ended December 31, 2011. Interest income (expense), net.Interest income (expense), net, for the year ended December 31, 2011 was approximately $384,000 of income, net as compared to net interest expense of approximately $2.5 million in 2010. Our net interest income during 2011 is primarily related to interest earned on our marketable securities. Our net interest expense during 2010 is primarily related to interest charges, and debt issuance costs associated with our bridge loan facility in connection with our bid acquisition to acquire Cinterion. Other income (expense), net. Other income (expense), net, for the year ended December 31, 2011 decreased by approximately $3.0 million, to approximately $1.1 million of net expense, compared to approximately $2.0 million of other income, net in 2010. The net other expenses for 2011 were related to foreign currency losses on South Korean Won denominated trade payables, foreign exchange currency losses on our foreign denominated bank accounts and trade receivables, and other-than-temporary loss recognized on our marketable equity securities. The other income, net for 2010 was primarily driven by a $2.9 million foreign exchange gain realized upon conversion of the Euro-denominated bid funds into U.S. dollars in July 2010 at the conclusion of the bidding process for Cinterion. The gain was offset by $1.2 million in premiums paid for protective put options 33 -------------------------------------------------------------------------------- Table of Contents we utilized to hedge our Euro exposure during the bidding process for Cinterion in the second quarter of 2010. These puts expired unexercised on June 25, 2010. Income tax expense (benefit). Income tax benefit was approximately $9.5 million for fiscal 2011, compared to an expense of $7.9 million in 2010. The company's annual effective tax benefit rate in 2011 was 28%. The difference between the federal and state statutory combined benefit rate of 36% and our effective tax benefit rate for 2011 is primarily due to a full valuation allowance on the U.S.-based deferred tax assets generated in 2011, a $1.4 million expense related to an increase in the Company's valuation allowance on the Canadian-based deferred tax assets and an $11.8 million income tax benefit related to uncertain tax positions. During 2010, the Company had income tax expense of $7.9 million, predominantly relating to the full valuation allowance incurred against the Company's U.S. based deferred tax assets created in years prior to 2010. Net loss. For the year ended December 31, 2011, we reported a net loss of approximately $24.9 million, as compared to net loss of approximately $33.4 million in 2010. As discussed above, the increase in gross profit was exceeded by an increase in operating expenses, a full year of amortization from acquired intangibles and the impairment of goodwill. However, the Company recorded a $9.5 million benefit in income taxes during 2011 as compared to a $7.9 income tax expense in 2010. Liquidity and Capital Resources Our principal sources of liquidity are our existing cash, cash equivalents and marketable securities and cash generated from operations. To address short term liquidity requirements resulting from working capital changes the Company entered into a margin credit facility with a bank in 2011. The use of this margin credit facility allows the Company to meet short-term cash requirements and avoid selling cash equivalents and marketable securities. Borrowings under this facility are collateralized by Company cash and cash equivalents and marketable securities on deposit at the bank. During the three months ended September 30, 2011, the Company borrowed approximately $12.0 million and repaid the entire amount during the same period. During the three months ended September 30, 2012, the Company borrowed $5.0 million and repaid the entire amount during the same period. During three months ended December 31, 2012, the Company borrowed $9.0 million against the facility and repaid the entire amount during the same period. The Company had no outstanding borrowings under this facility at December 31, 2012, and the Company's borrowing limit at December 31, 2012 under the credit facility was $6.8 million. In September 2009, we filed a shelf registration statement with the Securities and Exchange Commission, or the SEC, that will allow us to sell up to $125 million of equity, debt or other securities described in the registration statement in one or more offerings by us from time to time. As set forth in the shelf registration statement, the net proceeds from the sale of our securities may be used for general corporate purposes, including working capital, capital expenditures and acquisitions. As of the date of this report, we had not issued any securities under this registration statement. 34-------------------------------------------------------------------------------- Table of Contents Working Capital, Cash and Cash Equivalents and Marketable Securities The following table presents working capital, cash and cash equivalents and marketable securities: Year Ended December 31, (in thousands) Increase / 2012 2011 (Decrease) Working capital $ 67,199 $ 81,113 $ (13,914 ) Cash and cash equivalents (1) $ 16,044 $ 47,069 $ (31,025 ) Short-term marketable securities (1) 38,064 28,267 9,797 Long-term marketable securities 1,201 13,495 (12,294 ) Total cash and cash equivalents and marketable securities $ 55,309 $ 88,831 $ (33,522 ) (1) Included in working capital. Our decrease in working capital as of December 31, 2012 compared to the prior year was primarily due to losses incurred and capital expenditures in 2012. As of December 31, 2012, our cash, cash equivalents and marketable securities decreased $33.5 million as compared to December 31, 2011, primarily due to $29.9 million of cash used in operating activities and capital expenditures of $4.6 million. See the discussion of market risk in Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Historical Cash Flows The following table summarizes our consolidated statements of cash flows for the periods indicated: Year Ended December 31, (in thousands) 2012 2011 Net cash used in operating activities $ (29,879 ) $ (1,531 ) Net cash provided by (used in) investing activities (2,203 ) 31,659 Net cash provided by (used in) financing activities 1,120 (305 ) Effect of exchange rates on cash and cash equivalents (63 ) (129 ) Net increase (decrease) in cash and cash equivalents (31,025 ) 29,694 Cash and cash equivalents, beginning of period 47,069 17,375 Cash and cash equivalents, end of period $ 16,044 $ 47,069 Operating activities. Net cash used in operating activities was $29.9 million for 2012 compared to $1.5 million of net cash used in 2011. Net cash used in operating activities for the year ended December 31, 2012 was primarily attributable to the loss incurred in 2012 and the unfavorable working capital impacts of a $10.4 million reduction in accounts payable and a $6.2 million increase in accounts receivable. The unfavorable working capital impacts during the year ended December 31, 2012 were partially offset by non-cash charges including depreciation and amortization, goodwill and intangible assets impairment and share-based compensation. During 2011, the difference between our net loss of $24.9 million and our net cash used in operating activities of $1.5 million was primarily due to the favorable impact of non-cash charges, including depreciation, amortization and share-based compensation, partially offset by our non-cash tax benefit. 35 -------------------------------------------------------------------------------- Table of Contents Investing activities. Net cash used in investing activities for 2012 was approximately $2.2 million compared to $31.7 million provided by investing activities in 2011. The net cash used in 2012 was primarily related to purchases of property and equipment of $4.6 million, partially offset by the net sales and maturities of our marketable securities of $2.5 million. The net cash provided by investing activities in 2011 was primarily related to the net sales and maturities of our marketable securities of $37.9 million, partially offset by purchases of property and equipment of $6.0 million. Financing activities. Net cash provided by financing activities for 2012 was $1.1 million, compared to net cash used in financing activities of $305,000 for 2011. Net cash provided by financing activities in 2012 was primarily related to proceeds from stock option exercises and stock purchases through our employee stock purchase plan. Net financing activities for 2012 also included cash borrowings and repayment of $5.0 million and $9.0 million from our credit facility during the third and fourth quarters of 2012, respectively. Net cash used in financing activities in 2011 was primarily due to net taxes paid on vested restricted stock units, and payments of capital lease obligations. Net financing activities for 2011 also included cash borrowings and repayment of $12.0 million from our credit facility during the third quarter of 2011. Contractual Obligations and Commercial Commitments The following table summarizes our contractual obligations and commercial commitments at December 31, 2012, and the effect such obligations could have on our liquidity and cash flow in future periods (in thousands): Payments Due by Fiscal Year 2013 2014 2015 2016 2017 Total Operating leases $ 3,613 $ 3,664 $ 2,930 $ 2,899 $ 356 $ 13,462 Committed purchase orders 103,273 0 0 0 0 103,273 Total contractual obligations $ 106,886 $ 3,664 $ 2,930 $ 2,899 $ 356 $ 116,735 Our liability for uncertain tax benefits, including interest, as of December 31, 2012 was approximately $367,000, compared to approximately $413,000 as of December 31, 2011. The decrease was primarily due to the expiration of the applicable statutes of limitations for certain tax years. Our tax liability for uncertain tax benefits is not included in our table of contractual obligations and commercial commitments. We do not believe that we will pay such amount within one year from December 31, 2012; however, we cannot reasonably estimate the timing of future payments with respect to this liability. Other Liquidity Needs We expect to incur ongoing professional fees and expenses to defend litigation filed against us or related to our products, which litigation is discussed in Note 11 to our consolidated financial statements included in this report. These costs cannot be estimated at this time. During the year ending December 31, 2013, we plan to incur approximately $5.4 million for discretionary capital expenditures, including the acquisition of additional software licenses. We believe our cash resources from cash and cash equivalents and marketable securities, together with anticipated cash flows from operations will be sufficient to meet our working capital needs for the next twelve months. Our liquidity could be impaired if there is any interruption in our business operations, a material failure to satisfy our contractual commitments or a failure to generate revenue from new or existing products. 36-------------------------------------------------------------------------------- Table of Contents We may raise additional funds to accelerate development of new and existing services and products, to respond to competitive pressures or to acquire complementary products, businesses or technologies. There can be no assurance that any required additional financing will be available on terms favorable to us, or at all. If additional funds are raised by the issuance of equity securities, our shareholders could experience dilution of their ownership interests and securities issued may have rights senior to those of the holders of our common stock. If additional funds are raised by the issuance of debt securities, we may be subject to certain limitations on our operations. If adequate funds are not available or not available on acceptable terms, we may be unable to take advantage of acquisition opportunities, develop or enhance products or respond to competitive pressures, any of which could have a material adverse effect on our business, financial condition and results of operations. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that are material to our results of operations, financial conditions or liquidity. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues, expenses and disclosures of contingent assets and liabilities. Actual results could differ from these estimates. Critical accounting policies and significant estimates include revenue recognition, allowance for doubtful accounts receivable, provision for excess and obsolete inventory, valuation of intangible and long-lived assets including acquired intangibles and goodwill resulting from the acquisition of Enfora, valuation of contingent consideration, provision for warranty costs, litigation, income taxes, foreign exchange forward contracts, and share-based compensation expense. Revenue Recognition. The Company's revenue is principally generated from the sale of wireless modems to wireless operators, OEM customers and value added resellers and distributors. In addition, the Company generates revenue from the sale of asset-management solutions utilizing wireless technology and M2M communication devices to transportation and industrial companies, medical device manufacturers and security system providers. Revenue from product sales is generally recognized upon the later of transfer of title or delivery of the product to the customer. Where the transfer of title or risk of loss is contingent on the customer's acceptance of the product, we will not recognize revenue until both title and risk of loss have transferred to the customer. We record deferred revenue for cash payments received from customers in advance of when revenue recognition criteria are met. We have granted price protection to certain customers in accordance with the provisions of the respective contracts and track pricing and other terms offered to customers buying similar products to assess compliance with these provisions. We estimate the amount of price protection for current period product sales utilizing historical experience and information regarding customer inventory levels. To date, we have not incurred material price protection obligations. Revenues from sales to certain customers are subject to cooperative advertising allowances. Cooperative advertising allowances are recorded as an operating expense to the extent that the advertising benefit is separable from the revenue transaction and the fair value of that advertising benefit is determinable. To the extent that such allowances either do not provide a separable benefit to us, or the fair value of the advertising benefit cannot be reliably estimated, such amounts are recorded as a reduction of revenue. We establish reserves for estimated product returns allowances in the period in which revenue is recognized. In estimating future product returns, we consider various factors, including our stated return policies and practices and historical trends. Predominantly all of the revenues represent the sale of hardware with accompanied software that is essential to the functionality of the hardware. The Company records revenue associated with the agreed upon price on hardware sales, and accrues any estimated costs of post-delivery performance obligations, such as warranty 37 -------------------------------------------------------------------------------- Table of Contents obligations. The Company considers the four basic revenue recognition criteria discussed under Staff Accounting Bulletin #104 when assessing appropriate revenue recognition as follows: Criterion #1 - Persuasive evidence of an arrangement must exist; Criterion #2 - Delivery has occurred; Criterion #3 - The Company's price to the buyer must be fixed or determinable; and, Criterion #4 - Collectibility is reasonably assured. Under ASU 2009-13, in multiple element arrangements, the total consideration received from customers must be allocated to the elements based on a relative selling price. The accounting guidance establishes a hierarchy to determine the selling price to be used for allocating revenue to deliverables as follows: (i) vendors specific objective evidence (VSOE), (ii) third party evidence (TPE), and (iii) best estimate of selling price (ESP). Because the Company has neither VSOE nor TPE, revenue has been based on the Company's ESP. Amounts allocated to the delivered hardware and the related essential software are recognized at the time of the sale provided all other revenue recognition criteria have been met. Amounts allocated to other deliverables based upon ESP are recognized in the period the revenue recognition criteria have been met. Our process for determining its ESP for deliverables without VSOE or TPE considers multiple factors that may vary depending upon the unique facts and circumstances related to each deliverable. Our prices are determined based upon cost to produce our products, expected order quantities and acceptance in the marketplace. In addition, when developing ESPs for products we may consider other factors as appropriate including the pricing of competitive alternatives if they exist, and product-specific business objectives. We account for multiple element arrangements that primarily consist of software licenses and post contract support (PCS) by recognizing revenue for such arrangements ratably over the term of the PCS as we have not established VSOE for the PCS element. For the years ended December 31, 2012, 2011, and 2010, we have not recorded any significant revenues from multiple element or software arrangements. Allowance for Doubtful Accounts Receivable. We provide an allowance for our accounts receivable for estimated losses that may result from our customers' inability to pay. We determine the amount of the allowance by analyzing known uncollectible accounts, aged receivables, economic conditions, historical losses, and changes in customer payment cycles and our customers' credit-worthiness. Amounts later determined and specifically identified to be uncollectible are charged or written off against this allowance. To minimize the likelihood of uncollectibility, we review our customers' credit-worthiness periodically based on credit scores generated by independent credit reporting services, our experience with our customers and the economic condition of our customers' industries. Material differences may result in the amount and timing of expense for any period if we were to make different judgments or utilize different estimates. If the financial condition of our customers deteriorates resulting in an impairment of their ability to make payments, additional allowances may be required. Provision for Excess and Obsolete Inventory. Inventories are stated at the lower of cost (first-in, first-out method) or market. We review the components of our inventory and our inventory purchase commitments on a regular basis for excess and obsolete inventory based on estimated future usage and sales. Write-downs in inventory value or losses on inventory purchase commitments depend on various items, including factors related to customer demand, economic and competitive conditions, technological advances or new product introductions by us or our customers that vary from our current expectations. Whenever inventory is written down, a new cost basis is established and the inventory is not subsequently written up if market conditions improve. We believe that, when made, the estimates we use in calculating the inventory provision are reasonable and properly reflect the risk of excess and obsolete inventory. If customer demand for our inventory is substantially less than our estimates, inventory write-downs may be required, which could have a material adverse effect on our consolidated financial statements. 38-------------------------------------------------------------------------------- Table of Contents Valuation of Acquired Intangible Assets. In determining the Enfora purchase price allocation, the Company considered, among other factors, its intention to use the acquired assets and the historical and estimated future demand for Enfora products and services. The estimated fair value of intangible assets was based upon the income approach. The income approach relies on an estimation of the present value of the future monetary benefits expected to flow to the owner of an asset during its remaining economic life. This approach requires a projection of the cash flow that the asset is expected to generate in the future. The projected cash flow is discounted to its present value using a rate of return, or discount rate that accounts for the time value of money and the degree of risks inherent in the asset. The expected future cash flow that is projected should include all of the economic benefits attributable to the asset, including the tax savings associated with the amortization of the intangible asset value over the tax life of the asset. The income approach may take the form of a "relief from royalty" methodology, a cost savings methodology, a "with and without" methodology, or excess earnings methodology, depending on the specific asset under consideration. The relief-from-royalty method was used to value the trade name acquired from Enfora. The relief-from-royalty method estimates the cost savings that accrue to the owner of an intangible asset that would otherwise be required to pay royalties or license fees on revenues earned through the use of the asset. The royalty rate used was based on an analysis of empirical, market-derived royalty rates for guideline intangible assets. Typically, revenue is projected over the expected remaining useful life of the intangible asset. The royalty rate is then applied to estimate the royalty savings. The key assumptions used in valuing the existing trade name acquired were as follows: royalty rate of 2%, discount rate of 20.5%, tax rate of 40% and an economic life of approximately 10.0 years. The developed technologies, customer relationships and backlog were valued using a form of the income approach known as the multi-period excess earnings method. Inherent in the multi-period excess earnings method is the recognition that, in most cases, all of the assets of the business, both tangible and intangible, contribute to the generation of the cash flow of the business and the net cash flows attributable to the subject asset must recognize the support of the other assets which contribute to the realization of the cash flows. The contributory asset charges are based on the fair value of the contributory assets and either pre-tax or after-tax cash flows are assessed charges representing "returns on" the contributory assets. A contributory asset charge for the use of the technology was assessed on pre-tax cash flows, while contributory asset charges for the use of the working capital, fixed assets, and assembled work force have been deducted from the after-tax cash flow in each year to determine the net future cash flow attributable to the relationships. This future cash flow was then discounted using an estimated required rate of return for the asset to determine the present value of the future cash flows attributable to the asset. The key assumptions used in valuing the developed technologies acquired were as follows: discount rate of 18.5%, tax rate of 40% and estimated average economic life of 5-10 years. The key assumptions used in valuing the customer relationships acquired are as follows: discount rate of 19.5%, tax rate of 40% and estimated average economic life of 10 years. The key assumptions used in valuing the backlog acquired are as follows: discount rate of 14.5%, tax rate of 40% and estimated average economic life of 5 months. The covenant-not-to-compete agreements were valued using the "with or without" method. The "with or without" method measures the value of an asset as the difference between two scenarios. One scenario measures the value of a business "with" the asset. The other scenario measures the value "without" the asset. The method treats the difference between the two scenarios (with certain valuation adjustments) as the value of the asset. The key assumptions used in valuing the covenant not to compete agreements were as follows: discount rate of 20.5% and estimated average economic life of 1-2 years. Valuation of Intangible and Long-Lived Assets. We periodically assess the valuation of intangible and long-lived assets, which requires us to make assumptions and judgments regarding the carrying value of these assets. We consider assets to be impaired if the carrying value may not be recoverable based upon our assessment of the following events or changes in circumstances: the asset's ability to continue to generate income from operations and positive cash flow in future periods; loss of legal ownership or title to the asset; significant changes in our strategic business objectives and utilization of the asset; or significant negative industry or economic trends. 39-------------------------------------------------------------------------------- Table of Contents Our assessment includes comparing the carrying amounts of intangible and long-lived assets to their associated undiscounted expected future cash flows, which are determined using an expected cash flow model. This model requires estimates of our future revenues, profits, capital expenditures, working capital and other relevant factors. We estimate these amounts by evaluating our historical trends, current budgets, operating plans and other industry data. If the assets are considered to be impaired, the impairment charge recognized is the amount by which the asset's carrying value exceeds its estimated fair value. The timing and frequency of our impairment test is based on an ongoing assessment of triggering events that could reduce the fair value of our long-lived assets below their carrying value. We monitor our intangible and long-lived asset balances and conduct formal tests on at least an annual basis or earlier when impairment indicators are present. We believe that the assumptions and estimates we used to value intangible and long-lived assets were appropriate based on the information available to management. The majority of our long-lived assets are being amortized or depreciated over two to four years. As most of these assets are associated with technology or trade conditions that may change rapidly; such changes could have an immediate impact on our impairment analysis. During the first and third quarters of 2012, based on actual operating results, and reductions in management's then estimates of forecasted operating results of the M2M Products and Solutions reporting unit principally due to updated views of competitive pressures impacting average selling prices, customer product and technology selections, and the loss of certain customers, the Company determined there were sufficient indicators of impairment present to require an interim impairment analysis during the respective impacted quarters. The Company performed fair value tests with the assistance of third party independent appraisals, for each of the Company's purchased intangible assets. The existing trade name acquired was valued using royalty rates ranging from 1% to 2% and discount rates ranging from 23.0% to 24.0%. The developed technologies were valued using discount rates ranging from 20.0% to 21.0%. The backlog was valued using discount rates ranging from 17.0% to 18.0%. Customer relationships were valued using discount rates ranging from 21.0% to 22.0%. All key assumptions assumed tax rates of 40%, and the assets were assumed to have economic lives ranging from 6 months to 10 years depending on the asset. Goodwill. Our goodwill resulted from the acquisition of Enfora (M2M Products and Solutions) in the fourth quarter of 2010. In accordance with the (FASB) Accounting Standards Codification ("ASC") Topic 350, Intangibles-Goodwill and Other ("ASC Topic 350"), we reviewed goodwill for impairment at least annually at the beginning of the fourth quarter of each year, and more frequently when events or changes in circumstances occurred that indicated a potential reduction in the fair value of the reporting unit below its carrying value. ASC Topic 350 requires that goodwill and certain intangible assets be assessed for impairment using fair value measurement techniques. The goodwill impairment test compares the implied fair value of the reporting unit's goodwill with the carrying amount of that goodwill to measure the amount of the impairment loss, if any. The implied fair value of goodwill is determined in the same manner as in a business combination. Determining the fair value of the implied goodwill is judgmental in nature and often involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the magnitude of any such charge. In order to perform the annual goodwill impairment analysis, we are required to estimate the fair value of our M2M Products reporting unit. The fair value is calculated as though the M2M Products and Solutions reporting unit were to be sold in its entirety in an orderly transaction between market participants, using an estimate of fair value based on a blended sum resulting from the use of two valuation methods. First, we use the guideline public company method utilizing a multiple of the reporting unit's revenue. Second, we perform a discounted cash flow analysis using forward looking projections of an estimate of our future operating results. These approaches use significant estimates and assumptions, including the size and timing of product deployments by our customers and related projections and timing of future cash flows, discount rates reflecting 40 -------------------------------------------------------------------------------- Table of Contents the risk inherent in future cash flows, perpetual growth rates, stage of products in development, determination of appropriate market comparables and determination of whether a premium or discount should be applied to comparables. The resultant estimated fair value of our M2M Products and Solutions reporting unit is compared to the net book value of the reporting unit to assess whether any impairment exists. Contingent Consideration. Contingent consideration is recorded at the acquisition date estimated fair value of the contingent payment for all acquisitions. The fair value of the contingent consideration is remeasured at each reporting period with any adjustments in fair value included in the Company's consolidated statement of operations. Provision for Warranty Costs. We accrue warranty costs based on estimates of future warranty related replacement, repairs or rework of products. Our warranty policy generally provides one to three years of coverage for products following the date of purchase. Our policy is to accrue the estimated cost of warranty coverage as a component of cost of revenue in the consolidated statements of operations at the time revenue is recognized. In estimating our future warranty obligations we consider various relevant factors, including the historical frequency and volume of claims, and the cost to replace or repair products under warranty. The warranty provision for our products is determined by using a financial model to estimate future warranty costs. Our financial model takes into consideration actual product failure rates; estimated replacement over the contractual warranty period, repair or rework expenses; and potential risks associated with our different products. The risk levels, warranty cost information, and failure rates used within this model are reviewed throughout the year and updated, if and when, these inputs change. We actively engage in product improvement programs and processes to limit our warranty costs, but our warranty obligation is affected by the complexity of our product, product failure rates and costs incurred to correct those product failures. The industry in which we operate is subject to rapid technological change, and as a result, we periodically introduce newer, more complex products. Depending on the quality of our product design and manufacturing, actual product failure rates or actual warranty costs could be materially greater than our estimates, which could harm our financial condition and results of operations. Income Taxes. We recognize federal, state and foreign current tax liabilities or assets based on our estimate of taxes payable to or refundable by tax authorities in the current fiscal year. We also recognize federal, state and foreign deferred tax liabilities or assets based on our estimate of future tax effects attributable to temporary differences and carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by valuation allowances if, based on the consideration of all available evidence, it is more-likely-than-not that some portion of the deferred tax asset will not be realized. We evaluate deferred income taxes on a quarterly basis to determine if valuation allowances are required by considering available evidence. If we are unable to generate sufficient future taxable income in certain tax jurisdictions, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, we could be required to increase our valuation allowance against our deferred tax assets which could result in a decrease in our effective tax rate and an adverse impact on operating results. We will continue to evaluate the level of valuation allowance required based on the remaining deferred tax assets. The American Taxpayer Relief Act of 2012, which reinstated the United States federal research and development tax credit retroactively from January 1, 2012 through December 31, 2013, was not enacted into law until the first quarter of 2013. Therefore, the expected tax benefit resulting from such reinstatement for 2012 will not be reflected in the Company's estimated annual effective tax rate until 2013. The Company recognizes the impact of uncertain income tax positions on the income tax return at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Uncertain tax positions are recognized in the first subsequent financial reporting period in which that threshold is met or from changes in circumstances such as the expiration of applicable statutes of limitations. 41-------------------------------------------------------------------------------- Table of Contents Litigation. The Company is currently involved in certain legal proceedings. The Company will record a loss when the Company determines information available prior to the issuance of the financial statements indicates the loss is both probable and estimable. Where a liability is probable and there is a range of estimated loss with no best estimate in the range, the Company records the minimum estimated liability related to the claim. As additional information becomes available, the Company assesses the potential liability related to the Company's pending litigation and revises its estimates, if necessary. The Company's policy is to expense litigation costs as incurred. Share-based Compensation Expense. We have stock incentive plans under which incentive stock options and restricted stock units have been granted to employees and non-employee members of our Board of Directors. We also had an employee stock purchase plan for all eligible employees. Share-based payments to employees, including grants of employee stock options, restricted stock units and employee stock purchase rights, are recognized in the financial statements based upon their respective grant date fair values. We estimate the fair value of stock option awards and stock purchase rights on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is principally recognized as expense ratably over the requisite service periods. We have estimated the fair value of stock options and stock purchase rights as of the date of grant or assumption using the Black-Scholes option pricing model, which was developed for use in estimating the value of traded options that have no vesting restrictions and that are freely transferable. The Black-Scholes model considers, among other factors, the expected life of the award and the expected volatility of our stock price. We evaluate the assumptions used to value stock options and stock purchase rights on a quarterly basis. Although the Black-Scholes model is an acceptable model, the fair values generated by the model may not be indicative of the actual fair values of our equity awards, as it does not consider other factors important to those awards to employees, such as continued employment, periodic vesting requirements and limited transferability. Compensation cost associated with grants of restricted stock units are measured at fair value, which has historically been the closing price of the Company's stock on the date of the grant. [ Back To TMCnet.com's Homepage ]