[April 25, 2013] ENVIVIO 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 and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and elsewhere in this Annual Report on Form 10-K, including those discussed in "Risk Factors." OVERVIEW We are a leading provider of software-based IP video processing and distribution solutions that enable the delivery of high-quality video to consumers. Based on our unique video compression and advanced IP video networking technologies, our solution is designed to enable service providers and content providers to offer high-quality video anytime, anywhere across a broad array of video formats, networks, consumer devices and operating systems. Our software-based solution runs on industry-standard hardware and includes encoders, transcoders, network media processors and video gateways, all controlled through our network management system. We were founded in January 2000 by a small group of talented software and electrical engineers from France Telecom. Since our inception, we have been focused on developing a software-based architecture for processing and distributing IP video to video-enabled devices at the highest video quality possible. At that time, our software-based approach was a novel strategy for addressing video processing and distribution as most existing technologies processed and distributed video by designing hardware products for the transfer of video over a fixed format to standard TVs. These hardware products generally focused on improving quality of video, but did not attempt to address multiple formats or the challenges created by multiple devices and different networks. Because of our founding team's software expertise and the challenge of delivering video to mobile devices, which utilizes multiple formats and has multiple delivery requirements, our solution was designed from the beginning to provide a flexible solution that could adapt quickly and cost-effectively to the rapidly changing landscape of technologies, formats and capabilities of mobile devices. While attempting to address the challenges of processing and distributing video across a rapidly changing landscape of formats, networks, devices and operating systems, we have maintained our focus on improving the quality of the video delivered by our solution. We originally focused on developing technologies supported by the MPEG-4 standard, which is an industry standard for a group of audio and video coding formats and related technology that is capable of providing the highest quality video in the marketplace today. When we initially developed this technology, the standard in the marketplace was MPEG-2, a previous similar standard available since 1992. Throughout our history, we believe we have made valuable contributions to the ISO/IEC Moving Picture Experts Group, or MPEG, including having several of our employees sit on the governing standards body and by contributing several technologies to the video community that fostered the development of MPEG-4 as an industry standard. We believe these contributions demonstrate our innovation and thought leadership in the video processing and distribution industry. Our software-based approach to developing a flexible solution while delivering high-quality video has led to the development of several key products throughout our history. In 2001, we completed our first product based on the MPEG-4 standard. In 2002, we developed our first MPEG-4 webcasting system, which allowed us to address the enterprise market. In 2003, we deployed a news video contribution system in MPEG-4, which allowed us to address the need to transmit low bitrate video for real-time news gathering. In 2004, our first H.264 live transmission over satellite was successful, which allowed us to address the needs of satellite providers looking to deliver low bitrate video over satellite. We focused on our expansion into Asia in 2005 by providing the IPTV system for a service provider in China and a mobile digital TV service provider in Japan. In 2007, we developed our first all IP-based headend, an innovative and cost-reducing design for consumer video distribution, 42-------------------------------------------------------------------------------- Table of Contents and our first AVS encoder, which allowed us to address the expanding video services market in China. In 2008, we introduced the world's first three-screen convergence encoder, which enabled operators to deliver video to three screens (mobile, PC and TV) from a single product. In 2010, we introduced 3D TV support with multi-video encoding standard on our C4 encoder, as well as support for the expanding set of mobile and web streaming formats. In November 2010, we launched a new class of product, a network media processor, which we call Halo, which enables the optimization of networks for distribution of multi-screen, multi-format video. In December 2011, we released Muse, our new multi-screen software designed for live or file-based video transcoding and distribution to any device. In September 2012, we introduced the 4Caster G4 encoding appliance for the Muse software-based encoder family which offers more density compared to the previous platform, with the potential for further density improvements. As a result of our close relationship with France Telecom, we initially focused on the telecommunications market both for broadband IPTV delivery and delivery of video to mobile devices. However, as consumer demands have evolved over time, our solution has become attractive to a larger set of customers. In reaction to telecommunications companies providing video content and services to multiple devices with IPTV as well as mobile video services, traditional cable TV service providers have launched innovative services that deliver video content to PCs and mobile devices. Most recently over-the-top, or OTT, providers have also gained market share by offering innovative and cost-effective video services to mobile devices, PCs and even TVs for consumers through the open Internet. This set of competing service offerings, when combined with increased consumer demand for video on multiple screens, led us to design a single solution that addresses the needs of a broader customer base of service providers and content providers. For example, one of our first major end-customers purchased our IPTV solution in 2008 to enable delivery of video to TVs over broadband networks. This same customer began providing OTT services in 2009, and purchased our OTT solution to enable its OTT services. Finally, in 2010, this customer began to offer mobile video content and purchased our solution to address this video delivery mode as well. We target several different types of video service providers and content providers, including telecommunications companies and cable, satellite and OTT providers. These target customers have unique characteristics, including their infrastructure, target consumer demands, scale, delivery models and business models. We focus on providing video delivery solutions to these customers that allow them to better target their growth markets, such as mobile TV, Pay-TV, IPTV and OTT. To date, our solution has been deployed by over 300 end-customers worldwide in over 50 different countries. We outsource the manufacturing of our products to a single manufacturer in California. In some cases, we rely on our manufacturer to procure the components for our equipment. For certain components, we contract directly with the supplier. We ship our solutions directly from our manufacturer. Our products and support services are sold worldwide, primarily through systems integrators, which serve as our channel partners. Our channel partners assist us with the sales process, systems integration, deployment and support. We employ a sales force that is responsible for managing our relationships with our channel partners within each geographic territory in which we market and sell our products. To a lesser extent, we also sell our products and support services directly to end-customers. In many cases, even when we sell our products through channel partners, we market and work directly with the end-customer to promote our products. Since inception, we have expended significant resources on our research and development operations. Our research and development activities are exclusively conducted in the metropolitan area of Rennes, France, which we believe provides us access to highly qualified engineers on a cost-effective basis located in what has traditionally been viewed as a top broadcast center of Europe. 43-------------------------------------------------------------------------------- Table of Contents FACTORS AFFECTING OUR RESULTS OF OPERATIONS The following are key factors that impact our results of operations: Consumer Demand and Infrastructure Capacity Most of our products are installed into networks operated by telecommunications, cable, satellite and OTT providers to deliver high-quality video to a consumer. The demand for our products is significantly impacted by the end consumer of video services and the demands these end consumers place on service providers and content providers to deliver high-quality video across disparate networks and to multiple devices. As this consumer demand increases, service providers respond by expanding or enhancing their infrastructure and equipment to address these needs. As the infrastructure capacity increases, high-quality video can be made available to more consumers over broadband and wireless IP networks, which we believe will also increase the number of global broadband users. Our solution is designed to address the infrastructure challenge of delivering massive amounts of content over different types of networks to consumers who are increasingly viewing video on a growing variety of devices, such as tablets, smartphones, laptops, and Internet-enabled TVs and media players. As consumer expectations of video delivery increase, the demand from telecommunications, cable, satellite and OTT providers for the type of video delivery solutions that we provide increases. Accordingly, we measure consumer demand for video services by monitoring a collection of key market metrics, including the introduction of new mobile devices, such as tablets, new access mediums that are emerging in the digital home, such as Internet-enabled TVs and new video applications, and enhanced product offerings, such as bundling on-demand video services with other traditional service offerings. We believe the combination of increased availability of video-enabled connected devices combined with the evolution of the network infrastructure will, in turn, drive service providers and content providers to seek flexible solutions to deliver video to consumers that can continue to adapt to changing formats, networks and devices while maintaining the highest possible video quality. Competitive Environment and Geographic Mix The market for our products is competitive and our gross margin is impacted by the level of competition we face and the geographic mix of product sales worldwide. We face significant competition in selling our solution. In any given sales opportunity, the level of competition we face could impact our gross margin. In addition, our gross margin may be impacted by the location of our target customer as different geographic regions have different pricing environments based on customer expectation, business models and our customers' revenue opportunity from the services we enable. For example, we typically experience lower average sales prices in the Asia-Pacific region. We anticipate that our geographic mix will continue to fluctuate in the future from quarter to quarter, which could impact our future gross margin. The geographic mix of our revenues during the year ended January 31, 2013 reflects a general slowdown in spending by our service provider customers, particularly in North America, Western Europe and Asia, which we attribute to the current global economic environment. We anticipate that our revenues will continue to be impacted by the economic environment, both globally and regionally, and our ability to improve our sales execution, particularly in North America. Average Sales Prices We may experience a decline in average sales prices as new competitive products are introduced into the marketplace. Changes in average sales prices cannot always be predicted with certainty. The average sales prices of our products may decline faster than we expect. Competitors may also anticipate our entry into a market and begin to lower their sales prices even before we introduce our product. Under certain circumstances, lower prices may increase our sales volume and thus our revenue, but a lower average sales price typically reduces our gross 44 -------------------------------------------------------------------------------- Table of Contents margin percentage. We expect to continue to face price pressure on our products as average sales prices may decline over time, and there is no assurance that our gross margins will not decline in the future. As we continue to innovate our software-based solution, we may be able to offset a decline in the average sales prices of the prior generation of our solution. Evolution of Hardware Platform We utilize industry-standard hardware, and therefore, are able to leverage the evolutionary increase in computing power in each new generation of hardware. In the past, this has allowed us to increase the number of video streams at a given resolution with each new hardware platform, and we expect this to continue. This increase in performance may offset any potential decline in the average sales prices of the prior generation of our solution. Components of Revenue, Cost of Revenue and Operating Expenses Revenue Our revenue is derived primarily from the sale of our IP video processing and distribution solutions, which consists of both hardware and software. Our proprietary software is an essential component in the products we sell and provides a key differentiator between us and our competitors. Our hardware generally consists of industry-standard components, which are readily available from third-party providers. To a lesser extent, we derive revenue from professional services as well as support and maintenance of our products. Our maintenance contracts may include future software upgrades depending on the level of maintenance purchased. Our support contracts typically include telephone and email access to technical support personnel. When we sell an enhanced support offering we provide our customers with rights to software upgrades as well as maintenance releases and patches released during the term of the support period. Cost of Revenue Our cost of revenue consists primarily of third-party manufacturing costs and component costs. Our cost of revenue also includes shipping costs, third-party logistics costs, personnel costs associated with our technical support and professional services teams and write-offs for excess and obsolete inventory. To a lesser extent, our cost of revenue includes personnel costs associated with our operations and logistics. Operating Expenses Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of salaries and benefits for our employees. We expect to manage our operating expenses in both the near and long term to ensure that our expenses are in-line with our operating plan. However, our operating expenses may fluctuate as a percentage of revenue. Research and Development Expenses Research and development expenses primarily consist of personnel, engineering, testing and compliance, facilities and professional services costs. We expense research and development costs as incurred. Research and development expenses are presented net of French government research tax credits. We continue to closely manage our existing research and development resources as well as strategically invest in additional resources to add more functionality to our existing products and develop new products that support our overall company strategy. Sales and Marketing Expenses Sales and marketing expenses primarily consist of personnel costs, sales commissions, travel costs, costs for marketing programs and facilities costs. We continue to closely monitor sales and marketing expenses and augment our sales force in key areas to further expand our strategic relationships with current and future channel partners and direct customers. 45-------------------------------------------------------------------------------- Table of Contents General and Administrative Expenses General and administrative expenses primarily consist of personnel, professional services and facilities costs related to our executive, finance, human resource and information technology functions. Professional services costs consist of outside legal, accounting and information technology consulting costs. As a public company, we expect to incur additional costs related to compliance with rules and regulations enacted by the SEC. Such additional costs include additional professional services costs, additional insurance, investor relations and similar costs associated with being a public company. Interest Income (Expense), net Interest income (expense), net, consists primarily of interest expense related to our line of credit and interest income from our cash, cash equivalent and short term investment balances. Other Income (Expense), net Other income (expense), net, consists primarily of charges due to fluctuations in foreign exchange rates on receivables and payables denominated in currencies other than the U.S. dollar. The foreign currency transaction gains and losses relate to transactions that are exercised in a different currency than the respective functional currency of the Company and its subsidiaries. CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period-to-period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management's judgments and estimates. Revenue Recognition We derive revenue from the sale of our IP video processing and distribution solutions which consist of hardware and integrated software that is essential to the functionality of the equipment we sell, and stand-alone software. We also derive revenue from related professional services and support and maintenance agreements. We recognize revenue only when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collectability is probable. We evaluate each of these criteria as follows: • Evidence of an arrangement - We generally use contracts and customer purchase orders to determine the existence of an arrangement. • Delivery - We consider delivery to occur when title has been transferred, except in instances where final acceptance of the product, system or solution is specified by the customer. In these instances, we defer revenue until all acceptance criteria have been met. In the case of electronic delivery of the licensed software, title transfers when the customer is given access to download the software. 46 -------------------------------------------------------------------------------- Table of Contents • Fixed or determinable fee - We assess whether fees are fixed or determinable at the time of sale. We only consider the fee to be fixed or determinable if the fee is not subject to refund or adjustment. Our payment terms may vary based on the country in which the agreement is executed and the credit standing of the individual customer, among other factors. If the arrangement fee is not fixed or determinable, we recognize revenue as amounts become due and payable. • Collection is deemed probable - We deem collection to be probable if we expect that the customer will be able to pay amounts under the arrangement as payments become due. If we determine that collection is not probable, we defer the recognition of revenue until we actually collect cash from the customer. In October 2009, the Financial Accounting Standards Board, or FASB, amended the accounting standards for revenue recognition to remove from the scope of industry-specific software revenue recognition guidance any tangible products containing software components and non-software components that operate together to deliver the product's essential functionality. In addition, the FASB amended the accounting standards for certain multiple element revenue arrangements to: • Provide updated guidance on whether multiple elements exist, how the elements in an arrangement should be separated, and how the arrangement consideration should be allocated to the separate elements; • Provide for price hierarchy, where the selling price for an element is based on vendor specific objective evidence, or VSOE, if available; third-party evidence, or TPE, if available and VSOE is not available; or the best estimate of selling price, or BESP, if neither VSOE or TPE is available; and • Eliminate the use of the residual method and require an entity to allocate arrangement consideration using the selling price hierarchy. We adopted the new accounting guidance on a prospective basis at the beginning of the fiscal year ending January 31, 2012 for all transactions, except for stand-alone sales of software, entered into or materially modified on or after February 1, 2011. We enter into multiple element revenue arrangements in which a customer may purchase a combination of hardware, software, software upgrades, hardware and software maintenance and professional services. We account for multiple agreements with a single customer as one arrangement if the contractual terms or substance of those agreements indicate that they may be so closely related that they are, in effect, parts of a single arrangement. For transactions entered into prior to February 1, 2011, the adoption date of the amended revenue standards, we allocate revenue for arrangements with multiple deliverables, such as sales of our solution with software that include support, training or other professional services, to the delivered elements of the arrangement using the residual value method based on VSOE of fair value of the undelivered items. VSOE of fair value for undelivered elements is determined based upon prices paid by the customers for the separate renewal or sales of such services. For transactions, other than stand-alone sales of software, entered into or materially modified on or after February 1, 2011, we allocate the arrangement fee to each element based upon the relative selling price of such element and, if software and software-related elements, such as maintenance for the software elements, are also included in the arrangement, we allocate the arrangement fee to each of those software and software-related elements as a group based on its BESP for those elements. After such allocations are made, the amount of the arrangement fee allocated to the software and software-related elements is accounted for using the residual method. When applying the relative selling price method, we determine the selling price for each element using VSOE of selling price, if it exists, or if not, TPE of selling price, if it exists. If neither VSOE nor TPE of selling 47-------------------------------------------------------------------------------- Table of Contents price exist for an element, we use BESP for that element. The revenue allocated to each element is then recognized when the basic revenue recognition criteria are met for that element. The manner in which we account for multiple element arrangements that contain only software and software-related elements remains unchanged. Consistent with our methodology under previous accounting guidance, we determine VSOE for each element based on historical stand-alone sales to third parties. For hardware and software maintenance and professional services, we determine VSOE of fair value based on our history of stand-alone sales demonstrating that a substantial majority of transactions fall within a narrow range for each service offering. The Company is presently not able to determine VSOE of fair value for its professional services due to lack of stand-alone sales of such services. We presently are not able to determine TPE for our products, maintenance or professional services. TPE is determined based on competitor prices for similar elements when sold separately. Generally, our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, our go-to-market strategy differs from that of our peers and we are unable to reliably determine what similar competitor products' selling prices are on a stand-alone basis. When we are unable to establish the selling price of an element using VSOE or TPE, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine BESP for a product or service by considering multiple factors including, but not limited to, historical pricing practices by geography, customer class and distribution channel and gross margin objectives. We regularly review VSOE and BESP data provided by actual transactions to update these estimates and the relative selling prices allocated to each element. If the transactions entered into or materially modified after February 1, 2011 were subject to previous accounting guidance, our total pro forma revenues would have been $45.1 million during the year ended January 31, 2012. Similarly, our pro forma deferred revenue would have been $14.2 million as of January 31, 2012 if the transactions entered into or materially modified after February 1, 2011 were subject to previous accounting guidance. The impact of the revised accounting guidance to total revenue for the year ended January 31, 2012 was attributable to our ability to assign BESP to undelivered elements which previously required VSOE, the recognition of hardware revenue associated with maintenance contracts previously accounted for ratably over the contract period, and the reallocation of discounts to revenue deliverables. Revenue from support and maintenance agreements is recognized ratably over the term of the maintenance agreement, which is typically one year, and we defer the unrecognized revenue portion of the maintenance agreements. We recognize revenue from professional services upon performance of the services and recognize costs associated with services as incurred. For stand-alone sales of software with professional services, we do not recognize revenue until all professional services have been delivered to the customer as we do not have VSOE for these services. Deferred Revenue A portion of our deferred revenue represents customer payments made in advance for our support and maintenance contracts because we typically bill our support contracts on an annual basis in advance and recognize the associated revenue ratably over the support period, which typically is a one-year term, but was as long as five years for certain arrangements entered into during fiscal years 2008 and 2009. For transactions entered into before February 1, 2011, and for stand-alone sales of software that are subject to software accounting, when we do not have VSOE for our support services, we recognize revenue from the entire arrangement ratably over the support period. 48-------------------------------------------------------------------------------- Table of Contents For transactions entered into before February 1, 2011 and for stand-alone sales of software, we also record deferred revenue for arrangements that include our professional services because we had not established VSOE for these services. In these arrangements, we deferred the revenue from the entire arrangement until the professional services were delivered, which typically ranges from approximately two weeks to three months after delivery of the products. For transactions, other than stand-alone sales of software, entered into or materially modified on or after February 1, 2011, revenue will only be deferred for the portion of the arrangement relating to undelivered services and support and maintenance. Our deferred revenue also includes arrangements where final acceptance of the product, system or solution is specified by the customer, and the recognition of revenue for these arrangements is deferred until all acceptance criteria are met. Stock-Based Compensation We recognize compensation costs related to stock options, share purchase rights and restricted stock units granted to employees based on the estimated fair value of the awards on the date of grant, net of estimated forfeitures. We estimate the grant date fair value of stock options and share purchase rights, and the resulting stock-based compensation expense, using the Black-Scholes option-pricing model. We use a modified binary option pricing model (European, call option) to establish the expected value of restricted stock awards with market and performance vesting conditions. The fair value of the restricted stock units is the fair value of our common stock on the date of grant. The grant date fair value of the stock-based awards is generally recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective awards. We account for stock options issued to non-employees based on the estimated fair value of the awards determined using the Black-Scholes option-pricing model. The fair value of the equity awards granted to nonemployees is remeasured as the awards vest, and the resulting increase in value, if any, is recognized as expense during the period the related services are rendered. The determination of fair value of stock options and share purchase rights on the date of grant, using an option-pricing model, is affected by our stock price, as well as assumptions regarding a number of highly complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rates, and expected dividends. For option grants that are considered to be "plain vanilla," we used the simplified method to determine the expected term as provided by the SEC. The simplified method calculates the expected term as the average of the time-to-vesting and the contractual life of the options. For option grants that are not considered "plain vanilla," the expected term is based on historical option exercise behavior and post-vesting cancellations of options by employees. The risk-free interest rate assumption is based upon observed interest rates appropriate for the expected term of the awards. We do not currently pay cash dividends on our common stock and do not anticipate doing so in the foreseeable future. Accordingly, our expected dividend yield is zero. Stock-based compensation expense recognized in the consolidated statement of operations is based on awards ultimately expected to vest and therefore has been reduced for estimated forfeitures. The stock-based compensation guidance requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience. We will continue to use judgment in evaluating the expected volatility, expected terms and forfeiture rates utilized for our stock-based compensation calculations on a prospective basis. As we continue to accumulate additional data related to our common stock, we may have refinements to the estimates of our expected volatility, expected terms and forfeiture rates, which could materially impact our future stock based compensation expense. Our stock-based compensation expense for our stock-based awards was $0.8 million, $1.7 million and $2.8 million for the years ended January 31, 2011, 2012 and 2013, respectively. 49 -------------------------------------------------------------------------------- Table of Contents See Note 8 of our consolidated financial statements for additional information. Allowance for Doubtful Accounts We record a provision for doubtful accounts based on historical experience and a detailed assessment of the collectability of our accounts receivable. To assist with the estimate, our management considers, among other factors, the aging of the accounts receivable, including trends within the age of the accounts receivable, our historical write-offs, the credit-worthiness of each customer, the economic conditions of the customer's industry and general economic conditions. In cases where we become aware of circumstances that may impair a specific customer's ability to meet their financial obligations to us, we record a specific allowance against amounts due from the customer, and thereby reduce the net recognized receivable to the amount we reasonably believe will be collected. There is significant judgment involved in estimating the allowance for doubtful accounts. Income Taxes Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We make these estimates and judgments about our future taxable income that are based on assumptions that are consistent with our future plans. As of January 31, 2013, we had recorded a full valuation allowance on our net deferred tax assets due to uncertainties related to our ability to utilize our deferred tax assets in the foreseeable future. These deferred tax assets primarily consist of net operating loss carry-forwards. Should the actual amounts differ from our estimates, the amount of our valuation allowance could be materially impacted. With the exception of fiscal 2012, we have incurred operating losses since inception, and, accordingly, we have not recorded significant provisions for income taxes for any of the periods presented. Accordingly, there have not been significant changes to our provision for income taxes and we do not expect any significant changes until we are no longer incurring losses. As of January 31, 2013, we had federal net operating loss carry-forwards of $67.3 million and state net operating loss carry-forwards of $56.7 million. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance. If not utilized, the federal net operating loss carry-forwards will begin to expire in 2021 and the state net operating loss carry-forwards will begin to expire in 2013. Utilization of these net operating loss carry-forwards may be subject to an annual limitation due to applicable provisions of the Internal Revenue Code, and state and local tax laws if we have experienced an "ownership change" in the past, or if an ownership change occurs in the future, including, for example, as a result of the shares issued in this offering aggregated with certain other sales of our stock before or after this offering. We regularly review our tax positions and for benefits to be realized, a tax position must be more likely than not to be sustained upon examination. The amount recognized is measured as the largest amount of benefit that is more likely than not to be realized upon settlement. Our policy is to recognize interest and penalties related to income tax matters as income tax expense. Through January 31, 2013, approximately $35,000 of interest and penalties associated with unrecognized tax benefits has been recognized. 50-------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONS Fiscal Year Ended January 31, 2013 Compared to the Fiscal Year Ended January 31, 2012 The following table presents our historical operating results and the changes in these results in dollars (in thousands) and as a percentage for the periods presented: Year Ended January 31, 2012 2013 $ Change % Change (in thousands, except for percentages) Revenue: Product $ 46,113 $ 32,022 $ (14,091 ) (31 )% Professional services and support 4,533 7,077 2,544 56 Total revenue 50,646 39,099 (11,547 ) (23 ) Cost of revenue: Product 16,989 13,510 (3,479 ) (20 ) Professional services and support 1,503 1,483 (20 ) 0 Total cost of revenue 18,492 14,993 (3,499 ) (19 ) Gross profit 32,154 24,106 (8,048 ) (25 ) Gross margin 63 % 62 % Operating expenses: Research and development 6,728 7,589 861 13 Sales and marketing 16,206 21,359 5,153 32 General and administrative 8,561 11,730 3,169 37 Total operating expenses 31,495 40,678 9,183 29 Income (loss) from operations 659 (16,572 ) (17,231 ) (2,615 ) Interest income (expense), net (134 ) 84 218 (163 ) Other income (expense), net 237 (72 ) (309 ) (130 ) Income (loss) before provision for income taxes 762 (16,560 ) (17,322 ) (2,273 ) Provision for income taxes 624 375 (249 ) (40 ) Net income (loss) $ 138 $ (16,935 ) $ (17,073 ) (12,372 )% Revenue Our total revenue decreased by $11.5 million, or 23%, to $39.1 million for the year ended January 31, 2013 from $50.6 million for the year ended January 31, 2012, primarily due to a decrease of $14.1 million in product revenue, slightly offset by an increase of $2.5 million in our professional services and support revenue. The decrease in product revenue was primarily due to decreased spending from our existing service provider customers for multi-screen video services, with a majority of the decline coming from the Americas and Western Europe. We attribute the slowdown in spending by our service provider customers to the weakening global economic environment for the year ended January 31, 2013, continued lengthening of our sales cycle and the fact that the video industry continues to transition to a multi-screen video delivery model. Because many of our large target service provider customers purchase our products in connection with constructing and upgrading their architecture and systems, demand for our products depends on the magnitude and timing of capital spending by our customers. We believe the weak global environment, particularly in the Americas and Western Europe, where a large portion of our products have historically been sold, has contributed to a lengthening of our sales cycle with these customers, thereby causing a decline in our revenue. Our decline in revenue was also due, in part, to challenges in our sales execution, primarily in North America. To address these challenges, we have restructured our sales force, which includes the appointment of our new senior vice president of global sales and service and vice president of sales for North and Latin America, are focusing resources on the broader Pay TV video processing market and strategically investing in our multi-screen technology for long-term growth. We believe that our future revenue will continue to be impacted by consumer demand for multi-screen video 51-------------------------------------------------------------------------------- Table of Contents services, which in turn impacts the level of capital expenditures by our target end customers looking to upgrade their IP video processing and distribution capabilities to enable the delivery of these video services to consumers. The slight increase in our professional services and support revenue reflects a higher volume of professional services sales, timing of completion of customer projects and an overall increase in our support renewals business. Cost of Revenue and Gross Profit Our total cost of revenue overall decreased by $3.5 million, or 19%, to $15.0 million for the year ended January 31, 2013 from $18.5 million for the year ended January 31, 2012, primarily due to the corresponding decline in product revenue. Our total gross margin percentage slightly decreased from 63% during the year ended January 31, 2012 to 62% during the year ended January 31, 2013 primarily due to higher costs from shifts to a slightly lower proportion of software sales and product sales in North America which typically have higher gross margins than product sales in other regions. Cost of revenue for professional services and support, despite the increase in corresponding revenue, remained the same at $1.5 million compared to the same prior year period as headcount remained largely unchanged within our professional services organization. Operating Expenses Our operating expenses increased by $9.2 million, or 29%, to $40.7 million for the year ended January 31, 2013 from $31.5 million for the year ended January 31, 2012. Research and Development Expenses Research and development expenses increased by $0.9 million, or 13%, to $7.6 million for the year ended January 31, 2013 from $6.7 million for the year ended January 31, 2012. Research and development expenses increased primarily due to an increase of $1.3 million in personnel-related expenses for additional engineering contractors to supplement and support existing headcount for certain research and development activities as well as an increase of $0.3 million in rent and $0.2 million in depreciation relating to our new facility in Rennes, France. These increases were partially offset by a $0.6 million increase in the French government research tax credit. Research and development expenses are presented net of French research tax credits, which amounted to $1.6 million and $1.2 million for the years ended January 31, 2013 and 2012, respectively. Although we are devoting substantial resources to the development of additional functionality for our existing products and the development of new products, we are focusing on only deploying resources to activities that align with our overall corporate strategy. We expect research and development expenses for the year ended January 31, 2014 to remain even with the year ended January 31, 2013. Sales and Marketing Expenses Sales and marketing expenses increased by $5.2 million, or 32%, to $21.4 million for the year ended January 31, 2013 from $16.2 million for the year ended January 31, 2012, primarily due to increased headcount which led to an increase of $2.2 million in personnel-related expenses, such as payroll, payroll taxes, benefits and commissions. In addition, travel expenses increased by $0.9 million and marketing expenses increased by $0.4 million as we made efforts to increase our brand awareness and global footprint through tradeshows, enhancing our web and social media presence and participating in co-marketing campaigns. Our consulting costs increased by $0.7 million as we added additional sales resources worldwide. Depreciation and amortization increased by $1.0 million due to an increase in demo pool inventory and additional equipment purchased to support increased headcount. We expect an increase in sales and marketing expenses for the year ended January 31, 2014 compared to the year ended January 31, 2013. 52 -------------------------------------------------------------------------------- Table of Contents General and Administrative Expenses General and administrative expenses increased by $3.2 million, or 37%, to $11.7 million for the year ended January 31, 2013 from $8.6 million for the year ended January 31, 2012, primarily due to an increase of $1.3 million in professional services related to our use of outside finance, accounting, investor relations, and legal resources, including consultants, and other costs associated with being a public company, such as additional insurance and maintaining compliance with rules and regulations enacted by the SEC. In addition, bad debt expense increased by $0.5 million as more of our accounts receivable originated from regions with more payment risk such as East Asia, India and the Middle East. Stock-based compensation expense also increased by $0.8 million primarily due to grants to outside directors, executive management and current employees. We expect a decrease in general and administrative expenses for the year ended January 31, 2014 compared to the year ended January 31, 2013. Interest Income (Expense), net Interest income (expense), net, changed by $0.2 million, or 163%, from an expense of $0.1 million in fiscal 2012 to income of $0.1 million in fiscal 2013. The change was primarily due to interest income generated from the short-term investment account we established using existing cash and proceeds from our IPO in April 2012 during the year ended January 31, 2013. Other Income (Expense), net Other income (expense), net, changed by $0.3 million, or 130%, from an income of $0.2 million in 2012 to an expense of $0.1 million in 2013. This change was primarily due to a change in our foreign currency gain or loss from a gain of $237,000 during the year ended January 31, 2012 to a loss of $72,000 during the year ended January 31, 2013. 53 -------------------------------------------------------------------------------- Table of Contents Fiscal Year Ended January 31, 2012 Compared to the Fiscal Year Ended January 31, 2011 The following table presents our historical operating results and the changes in these results in dollars and as a percentage for the periods presented: Year Ended January 31, 2011 2012 $ Change % Change (in thousands, except for percentages) Revenue: Product $ 27,504 $ 46,113 $ 18,609 68 % Professional services and support 2,500 4,533 2,033 81 Total revenue 30,004 50,646 20,642 69 Cost of revenue: Product 10,306 16,989 6,683 65 Professional services and support 1,198 1,503 305 25 Total cost of revenue 11,504 18,492 6,988 61 Gross profit 18,500 32,154 13,654 74 Gross margin 62 % 63 % Operating expenses: Research and development 5,152 6,728 1,576 31 Sales and marketing 8,886 16,206 7,320 82 General and administrative 6,449 8,561 2,112 33 Total operating expenses 20,487 31,495 11,008 54 Income (loss) from operations (1,987 ) 659 2,646 (133 ) Interest expense, net (270 ) (134 ) 136 (50 ) Other income (expense), net (61 ) 237 298 (489 ) Income (loss) before provision for income taxes (2,318 ) 762 3,080 (133 ) Provision for income taxes 167 624 457 274 Net income (loss) $ (2,485 ) $ 138 $ 2,623 (106 )% Revenue Our total revenue increased by $20.6 million, or 69%, to $50.6 million in fiscal 2012 from $30.0 million in fiscal 2011, primarily due to increases of $18.6 million and $2.0 million in product revenue and professional services and support revenue, respectively. The increase in product revenue reflected the significant increase in sales of our IP video processing and distribution solution in the fiscal year ended January 31, 2012, which was primarily the result of increased consumer demand for multi-screen video services, and our continued growth into the North American telecommunications and cable services market. In addition, we prospectively adopted new accounting guidance for multiple element revenue arrangements entered into or materially modified on or subsequent to February 1, 2011, which had a positive impact on our revenue during the period when compared to the fiscal year ended January 31, 2011 as discussed further in Note 1 of our consolidated financial statements. The increase in our professional services and support revenue reflects a higher volume of professional services sales, timing of completion of customer projects and an overall increase in our support renewals business. Cost of Revenue and Gross Profit Our total cost of revenue overall increased by $7.0 million, or 61%, to $18.5 million in fiscal 2012 from $11.5 million in fiscal 2011, primarily due to a corresponding increase in product revenue. Our product cost of revenue increased due to larger unit volume during the year ended January 31, 2012 compared to the prior fiscal 54 -------------------------------------------------------------------------------- Table of Contents year in order to meet increasing demand for our solution. Our total gross margin increased from 62% in fiscal 2011 to 63% in fiscal 2012, primarily due to increased unit sales volume while our manufacturing and other fixed costs remained relatively consistent across these periods. In addition, our total gross margin was positively impacted by an increase in higher margin software-only transactions. Cost of revenue for professional services and support increased by $0.3 million compared to the same prior year period as headcount slightly increased within our professional services organization. Operating Expenses Our operating expenses increased by $11.0 million, or 54%, to $31.5 million in fiscal 2012 from $20.5 million in fiscal 2011. Research and Development Expenses Research and development expenses increased by $1.6 million, or 31%, to $6.7 million in fiscal 2012 from $5.2 million in fiscal 2011. Research and development expenses increased primarily as a result of increases of $1.2 million in personnel-related expenses and $1.1 million in professional services related to our use of consultants for certain research and development activities. Research and development expenses are presented net of French research tax credits, which amounted to $1.2 million for each of the years ended January 31, 2011 and 2012. Sales and Marketing Expenses Sales and marketing expenses increased by $7.3 million, or 82%, to $16.2 million in fiscal 2012 from $8.9 million in fiscal 2011, primarily as a result of increases of $3.2 million in personnel-related expenses, $1.9 million in commissions and bonuses associated with increased sales, $1.1 million in travel expenses due to increases in sales and marketing personnel and $0.4 million in marketing expenses to increase our brand and global footprint. General and Administrative Expenses General and administrative expenses increased by $2.1 million, or 33%, to $8.6 million in fiscal 2012 from $6.4 million in fiscal 2011, primarily due to increases of $1.7 million in personnel-related expenses and $0.3 million in professional services related to our use of consultants for accounting and other administrative activities. Interest Expense, net Interest expense, net, decreased by approximately $0.2 million, or 66%, to $0.1 million in fiscal 2012 from $0.3 million in fiscal 2011. The decrease was primarily a result of a decrease in the average outstanding principal amount of borrowings under our credit facilities in the year ended January 31, 2012 compared to the same prior year period, due to our repayment of outstanding notes payable. Other Income (Expense), net Other income (expense), net, changed by $0.3 million in fiscal 2012 from an expense of $0.1 million in fiscal 2011 to income of $0.2 million in fiscal 2012. This change was due primarily to a change in our foreign currency gain or loss from a gain of $103,000 in the year ended January 31, 2012 compared to a gain of $52,000 during the year ended January 31, 2011. The difference is also due to the decrease in the fair value of our convertible preferred stock warrants which resulted in a gain of $0.1 million for the year ended January 31, 2012 compared to a loss of $0.1 million for the year ended January 31, 2011. LIQUIDITY AND CAPITAL RESOURCES On April 24, 2012, we sold 6,500,000 shares of common stock at a price to the public of $9.00 per share in an initial public offering, or IPO. The shares began trading on the NASDAQ Global Market on April 25, 2012. The $54.4 million in proceeds from the IPO, net of underwriters' discounts and commissions, but before 55 -------------------------------------------------------------------------------- Table of Contents deducting offering-related expenses payable by us of $5.8 million, were received on April 30, 2012, which was the closing date of the IPO. Immediately prior to the closing of the offering, all outstanding shares of convertible preferred stock converted into common stock on a one-for-one basis and we have blank check preferred stock authorized. The convertible preferred stock converted into 6,988,120 shares of common stock and the 1,006,206 shares of Series 1 common stock and the 12,909,470 shares of Series 2 common stock converted into one class of common stock. In addition to the 6,500,000 shares of common stock sold in the IPO, our existing stockholders sold 1,255,000 shares of common stock in the IPO. The shares sold by the selling stockholders consisted of 503,496 shares of convertible preferred stock and 751,504 shares of Series 1 and Series 2 common stock, which were converted to common stock immediately prior to the closing of the IPO. Prior to the IPO, we funded our operations primarily with proceeds from issuances of convertible preferred stock and borrowings under our credit facilities. We raised an aggregate of $95.1 million, net of issuance cost, from the sale of our convertible preferred stock, including the conversion of convertible promissory notes. We also funded purchases of equipment and other general corporate services with proceeds from our borrowings under our credit facilities. We believe that our existing cash and cash equivalents as of January 31, 2013 will be sufficient to fund our operations and capital expenditures for at least the next 12 months. However, management may in the future elect to finance operations by utilizing our credit facilities or selling equity securities. If additional funding is required, there can be no assurance that additional funds will be available to us on acceptable terms on a timely basis, if at all, or that we will generate sufficient cash from operations to adequately fund our operating needs or sustain profitability. If we are unable to raise additional capital or generate sufficient cash from operations to adequately fund our operations, we will need to curtail planned activities to reduce costs. Doing so will likely have an unfavorable effect on our ability to execute on our business plan. Cash Requirements As of January 31, 2013, our cash, cash equivalents and short term investments totaled $54.9 million. We had not drawn on our revolving credit facility as of January 31, 2013 and the availability under this facility was $10.0 million subject to a borrowing base. Financial Condition (Sources and Uses of Cash) Our cash and cash equivalents consisted of cash deposits and money market funds with a total amount of $51.3 million as of January 31, 2013. Our cash flows for fiscal 2011, fiscal 2012 and fiscal 2013 are summarized as follows: Year Ended January 31, 2011 2012 2013 (in thousands) Net cash provided by (used in) operating activities $ 3,657 $ 2,381 $ (17,370 ) Net cash used in investing activities (1,310 ) (2,847 ) (7,664 ) Net cash provided by financing activities 3,489 17,973 49,016 Cash Flows from Operating Activities Our primary uses of cash from operating activities have been for personnel costs, purchases of inventory and costs related to our facilities. In the past, we experienced negative cash flows from operating activities as we expanded our business and generated operating losses. Our cash flows from operating activities will continue to be affected principally by our working capital requirements and the extent to which we spend on personnel and sales and marketing activities as our business requires. 56-------------------------------------------------------------------------------- Table of Contents Cash used in operating activities of $17.4 million during the year ended January 31, 2013 reflected a net loss of $16.9 million, non-cash charges of $2.6 million for depreciation and amortization, $2.8 million for stock-based compensation and $0.7 million in bad debt expense. The change in net operating assets primarily consisted of cash uses of $0.6 million in accounts receivable, $0.6 million in inventory, $3.0 million in accounts payable and accrued liabilities and $4.0 million in deferred revenue. The decrease in operating cash relating to accounts receivable was primarily due to a higher concentration of sales in regions where customary payment terms are often longer such as East Asia, India and the Middle East, and a corresponding increase in our allowance for doubtful accounts. The decrease in operating cash relating to accounts payable and accrued liabilities primarily resulted from lower revenue and thus, less amounts due to our third-party contract manufacturer, while the decrease in operating cash relating to inventory resulted from equipment purchases for future sales transactions, and consists primarily of components and finished goods used in our industry-standard server platforms. Cash sources from changes in net operating liabilities primarily consisted of $1.4 million in both other non-current liabilities and deferred rent relating to our new research and development facility in Rennes and $1.3 million in deferred inventory costs. Operating cash relating to deferred revenue decreased while deferred inventory costs increased during the year ended January 31, 2013 primarily due to timing of revenue recognition as we had fewer transactions subject to deferral as a result of the new revenue recognition rules adopted for the year ended January 31, 2012. Cash provided by operating activities of $2.4 million in the year ended January 31, 2012 reflected net income of $0.1 million, non-cash charges of $1.6 million for depreciation and amortization and $1.7 million for stock-based compensation. Our net operating liabilities, excluding cash and cash equivalents, decreased from $9.1 million as of January 31, 2011 to $8.2 million as of January 31, 2012. The decrease in net operating liabilities was primarily due to a decrease of $3.4 million for deferred revenue and increases of $1.3 million for other assets, partially offset by a decrease of $2.6 million for deferred inventory costs and an increase of $1.4 million for accounts payable and accrued liabilities. Deferred revenue decreased during fiscal 2012 primarily due to the timing of revenue recognition, including continued amortization of pre-existing deferred revenue from prior periods, and fewer transactions subject to deferral as a result of the new revenue recognition rules adopted during fiscal 2012, while the decrease in other assets was primarily due to initial public offering related costs incurred during fiscal 2012. The increases in deferred inventory costs and accounts payable and accrued liabilities were primarily the result of an increases in sales and shipments and the related increase in unit volume to meet increased demand. Cash provided by operating activities of $3.7 million in the year ended January 31, 2011 reflected a net loss of $2.5 million, partially offset by non-cash charges of $1.0 million for depreciation and amortization and $0.8 million for stock-based compensation. Our net operating liabilities excluding cash and cash equivalents, increased from $4.9 million as of January 31, 2010 to $9.1 million as of January 31, 2011. The increase was primarily a result of increases of $5.2 million for accounts payable and accrued liabilities and $4.3 million for deferred revenue, partially offset by increases of $3.8 million in accounts receivable and $2.0 million in deferred inventory costs. The increases in accounts receivable and deferred revenue during fiscal 2011 were primarily the result of increases in sales and shipments of our IP video processing and distribution solution for multi-screen video services and our growth into the North American telecommunications and cable services markets. Similarly, the increases in accounts payable, accrued liabilities and deferred inventory costs were primarily the result of our increases in sales and shipments and the related increase in unit volume to meet the increased demand. Cash Flows from Investing Activities In the year ended January 31, 2013, our investing activities consisted of a net $3.6 million investment in corporate bonds in accordance with guidelines set forth in our investment policy and capital expenditures amounting to $4.1 million primarily for the purchase of equipment. 57-------------------------------------------------------------------------------- Table of Contents Our investing activities consisted solely of capital expenditures and amounted to $1.3 million and $2.8 million in the year ended January 31, 2011 and 2012, respectively, for purchases of equipment. Cash Flows from Financing Activities In the year ended January 31, 2013, cash provided by financing activities was $49.0 million, primarily as a result of cash proceeds of $49.8 million from the initial public offering of common stock in April 2012, net of offering costs paid and a repayment of $1.0 million on our credit facility. In the year ended January 31, 2012, cash provided by financing activities was $18.0 million, primarily as a result of cash proceeds of $16.3 million received from the issuance of Series I redeemable convertible preferred stock and $1.0 million from our credit facility. In the year ended January 31, 2011, cash provided by financing activities was $3.5 million, primarily as a result of cash proceeds of $6.2 million received from the issuance of Series H convertible preferred stock, partially offset by cash payments of $2.7 million on our notes payable. OFF-BALANCE SHEET ARRANGEMENTS As of January 31, 2013, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. CONTRACTUAL OBLIGATIONS AND COMMITMENTS The following summarizes our contractual obligations as of January 31, 2013: Payments Due by Period Less Than 1 More Than 5 Contractual Obligations: Year 1-3 Years 3-5 Years Years Total (in thousands) Operating lease obligations $ 918 $ 1,659 $ 1,182 $ 2,117 $ 5,876 French governmental research grant repayments 396 268 - - 664 Uncertain tax positions 462 526 - - 988 Total $ 1,776 $ 2,453 $ 1,182 $ 2,117 $ 7,528 We outsource the manufacturing, assembly and testing of our encoding products to FutureQuest Incorporated ("FQ"). We generally do not use custom materials in our products and therefore, our obligation to FQ is limited to purchase orders. To the extent that we cancel a purchase order, we are only liable to the extent that FQ cannot otherwise utilize those components. To date, we have never been required to purchase any such components. Our outstanding purchase orders are not material as of January 31, 2013. 58-------------------------------------------------------------------------------- Table of Contents [ Back To TMCnet.com's Homepage ]