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DOT HILL SYSTEMS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement for Forward-Looking Information Certain statements contained in this quarterly report on Form 10-Q, including, statements regarding the development, growth and expansion of our business, our intent, belief or current expectations, primarily with respect to our future operating performance and the products we expect to offer, and other statements regarding matters that are not historical facts, are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and are subject to the "safe harbor" created by these sections. Because such forward-looking statements are subject to risks and uncertainties, many of which are beyond our control, actual results may differ materially from those expressed or implied by such forward-looking statements. Some of the factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements can be found in Part II, Item 1A, "Risk Factors" and in our reports filed with the Securities and Exchange Commission, or SEC, including our Annual Report on Form 10-K for the year ended December 31, 2012. Readers are cautioned not to place undue reliance on forward-looking statements. The forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update such statements to reflect events that occur or circumstances that exist after the date on which they are made. The following discussion of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included in the preceding pages in this quarterly report on Form 10-Q and our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2012. Overview We design, manufacture and market a range of software and hardware storage systems for the entry and midrange storage markets. We focus on selling through server-based original equipment manufacturers (OEMs), such as Hewlett-Packard, or HP, Dell Inc. or Dell, Lenovo Group Limited, or Lenovo, Advanced Micro Devices, Inc., or AMD, Stratus Technologies, or Stratus, and Wipro Limited; as well as into vertical markets, which primarily include media and entertainment, telecommunications, 13-------------------------------------------------------------------------------- Table of Contents HPC Digital Image Archive, Big Data and oil and gas. Our vertical market customers are OEMs, who embed our products into their solutions, as well as resellers. Typical customers for our storage systems products, which include our AssuredSANTM line of storage array products, include organizations requiring high reliability, high performance networked or direct attached storage and data management solutions in an open systems architecture. Our storage solutions consist of integrated hardware, firmware and software products employing a modular system that allows end-users to add various protocol, performance, capacity or data protection schemes as needed. Our broad range of products, from small capacity direct attached to complete multi-hundred terabyte, or TB, storage area networks, or SANs, provide end-users with a cost-effective means of addressing increasing storage demands at compelling price-performance points. Our current product family based on our AssuredSANTM architecture provides high performance and large disk array capacities for a broad variety of environments, employing Fibre Channel, Internet Small Computer Systems Interface, or iSCSI or Serial Attached SCSI, or SAS, interconnects to switches and/or hosts. In addition, our Assured family of data protection software products provides additional layers of data protection options to complement our line of storage disk arrays. Our current mainstream AssuredSANTM 2000 and 3000 series of entry-level storage products and Just a Bunch of Disks, or JBOD, arrays are targeted primarily at mainstream enterprise and small-to-medium business, or SMB, applications. Some of our AssuredSANTM products have been distinguished by certification as Network Equipment Building System, or NEBS, Level 3 (a telecommunications standard for equipment used in central offices) and are MIL-STD-810F (a military standard created by the U.S. government) compliant based on their ruggedness and reliability. In February 2010, we launched the latest AssuredSANTM 3000 series of storage arrays that provide high speed interface options including 8 gigabyte, or GB, Fibre Channel, 1GB and 10GB iSCSI over Ethernet and 6GB SAS connectivity. On August 22, 2012, we introduced AssuredSANTM Pro 5000 Series with RealStorTM software that incorporates autonomic real-time data tiering via a virtualized back-end. With RealStorTM, businesses gain the advantage of very high performance SSDs, using them to their maximum benefit, while storing less frequently accessed data on slower, but much less expensive hard disk drives. On the same day, we also introduced our AssuredSANTM 4000 Series next-generation, high performance storage solution designed to deliver best-in-class price performance, 99.999 percent availability, and exceptional streaming throughput. The Series 4000 shares the same architecture as the Pro 5000 Series. Our Series 2000 and 3000 products are characterized by International Data Corporation (IDC) as Band 2 and Band 3 products. With the announcement of our Series 4000 and 5000 products, we now have products characterized within IDC Price Bands 4 and 5 products, which increases our total available market, as measured by end-user sales price, from $4.0 billion to $10.6 billion. Our agreements with our customers do not contain any minimum purchase commitments and may be terminated at any time upon notice from the applicable customer. Our ability to achieve and maintain profitability will depend on, among other things, the level and mix of orders we receive from such customers, the amounts we spend on marketing support, the amounts we spend for inventory support and incremental internal investment, our ability to reduce product cost, our product lead time, our ability to meet delivery schedules required by our customers and the economic environment. Our products and services are sold worldwide to facilitate server and SAN storage implementations, primarily through server-based OEMs, vertical markets partners that include embedded OEMs that integrate our products into their solutions, and VARs. Our storage system products' server-based OEM partners currently include, among others, HP, Lenovo and Stratus, who purchase our AssuredSANTM products, and Dell and AMD, who purchase our AssuredVRA products. Our vertical markets partners include Motorola, Inc., Tektronix, Samsung Electronics, Concurrent Computer Corporation, Autodesk Inc., Harris Broadcast Communications and Nokia Siemens Network. Although our products and services are sold worldwide, the majority of our net revenue is derived from our U.S. operations. We began shipping products to HP in the fourth quarter of 2007. In January 2008, we amended our agreement with HP to allow for sales of additional products to additional divisions within HP. Our products are primarily sold as HP's MSA 2000/P2000 product family. Sales to HP increased significantly during 2008 and increased again in 2009 primarily as a result of the successful launch and market acceptance of the HP MSA 2000 products. HP launched its third generation product line, now called the P2000 product line, in February 2010. Sales to HP increased again in 2010 as we began selling our next generation host interfaces across the HP P2000 product line. In October 2011, we extended our supply agreement with HP by five years to expire in October 2016 and also extended the expiration of 1.6 million warrants granted to HP in March 2008 to expire concurrently with the supply agreement in October 2016. Net revenue from HP approximated 63% of our total net revenue for the three months ended March 31, 2013. The agreement with HP does not contain any minimum purchase commitments, however, we expect sales to HP to continue to represent a substantial percentage of our total net revenue in 2013. We expect to generate additional revenue from our indirect channel as well as new and potential new OEM customers. In addition, the demand for our products has been affected in the past, and may continue to be affected in the future, by various factors, including, but not limited to, the following: 14-------------------------------------------------------------------------------- Table of Contents • our ability to maintain and enhance relationships with our customers, in particular our OEM customers, as well as our ability to win new business; • our ability to source critical components such as integrated circuits, hard disk drives, memory and other components on a timely basis; • the amount of field failures resulting in product replacements or recalls; • our ability to launch new products in accordance with OEM specifications, schedules and milestones; • our ability to sell Dot Hill branded products through resellers; • our ability to win new server-based OEM customers and OEMs who embed our products into their solutions; • general economic and political conditions and specific conditions in the markets we address, including the continuing volatility in the technology sector, current general economic volatility and trends in the data storage markets in various geographic regions; • the timing, rescheduling or cancellation of significant customer orders and our ability, as well as the ability of our customers, to manage inventory; and • the inability of certain of our customers who depend on credit to have access to their traditional sources of credit to finance the purchase of products from us, particularly in the current global economic environment, which may lead them to reduce their level of purchases or to seek credit or other accommodations from us. For these and other reasons, our net revenue and results of operations for the three months ended March 31, 2013 and prior periods may not necessarily be indicative of future net revenue and results of operations. Our manufacturing strategy includes outsourcing substantially all of our manufacturing to third-party manufacturers in order to reduce sales cycle times and manufacturing infrastructure, enhance working capital and improve margins by taking advantage of the third parties' manufacturing and procurement economies of scale. In September 2008, we entered into a manufacturing agreement with Foxconn Technology Group, or Foxconn. Under the terms of the agreement, Foxconn supplies us with manufacturing, assembly and test services from its facilities in China and final integration services including final assembly, testing and configure-to-order services through its worldwide facilities. In November 2011, we amended our agreement with Foxconn to extend the manufacturing agreement for a period of three years. In addition, Foxconn agreed to waive the requirement for a letter of credit and improved our payment terms. The majority of our products sold in 2012 and to date in 2013 were manufactured by Foxconn. We expect Foxconn to manufacture substantially all of our products in 2013. We derive the majority of our net revenue from sales of our Series 2000 and 3000 family of products, which are included in our AssuredSANTM product line. Cost of goods sold includes costs of materials, subcontractor costs, salary and related benefits for the production and service departments, depreciation and amortization of equipment and intangible assets used in the production and service departments, production facility rent and allocation of overhead as well as manufacturing variances and freight. Research and development expenses consist primarily of project-related expenses, consulting charges and salaries for employees directly engaged in research and development. Sales and marketing expenses consist primarily of salaries and commissions, marketing related costs, advertising, customer-related evaluation unit expenses, promotional costs and travel expenses. General and administrative expenses consist primarily of compensation to officers and employees performing administrative functions, as well as expenditures for legal, accounting and other administrative services and fluctuations in currency valuations. Other income (expense), net is comprised primarily of interest income earned on our cash and cash equivalents and other miscellaneous income and expense items. In the first quarter of 2012, our management approved, committed to, and initiated a restructuring and cost reduction plan, or the 2012 Plan, that is associated with the closure of our Israel Technology Development Center. The 2012 Plan is designed to re-align our software investments to focus on accelerating the development of embedded software features, in order to launch a competitive set of mid-range storage array products in 2012, and to provide more differentiated entry-level products for both OEM and channel customers. Substantially all of our 2012 Plan workforce reductions were completed by July 31, 2012. The closure of our Israel Technology Development Center is now recorded in discontinued operations, since we have ceased all ongoing operational activities by the end of 2012. Critical Accounting Policies and Estimates An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if 15-------------------------------------------------------------------------------- Table of Contents changes in the estimate that are reasonably likely to occur could materially impact the unaudited condensed consolidated financial statements. Except as noted below, management believes that there have been no significant changes during the three months ended March 31, 2013, to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012. Revenue Recognition We derive our revenue from sales of our hardware products, software and services. Hardware Hardware product revenue consists of revenue from sales of our AssuredSAN storage systems that is integrated with industry standard hardware which is essential to the functionality of the integrated system product. We recognize hardware product revenue when the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred; (iii) the price is fixed or determinable; and (iv) collectability is reasonably assured. Revenue is recognized for hardware product sales upon transfer of title and risk of loss to the customer and in addition, upon installation for certain of our AssuredUVS appliance products. We record reductions to revenue for estimated product returns and pricing adjustments in the same period that the related revenue is recorded. These estimates are based on historical sales returns, analysis of credit memo data and other factors known at the time. If actual future returns and pricing adjustments differ from past experience and our estimates, additional revenue reserves may be required. Software In accordance with the specific guidance for recognizing software revenue, where applicable, we recognize revenue from perpetual software licenses at the inception of the license term assuming all revenue recognition criteria have been met. We use the relative method to allocate revenue to software licenses at the inception of the license term when vendor-specific objective evidence, or VSOE, of fair value for all unspecified software updates and enhancements related to our products through service contracts is available. We have established VSOE for the fair value of our support services as measured by the stated renewal prices paid by our customers when the services are sold separately on a standalone basis. Specific long-term software contracts may contain multiple deliverables including software licenses, services, training and post-contract support for which we have not established VSOE for the fair value of any of the elements. Under specific guidance for recognizing software revenue, we begin recognizing revenue upon the delivery of all the elements except post-contract support (PCS). We defer all the direct and incremental costs related to the deliverables in these contracts until delivery of all the elements except PCS. The deferred revenue and costs are amortized over the contractual PCS support periods. During the preparation of the Company's consolidated financial statements for the year ended December 31, 2012 and the accounting analysis for the renewal of a long-term software contract, the Company determined that it had applied an inappropriate revenue recognition methodology to one of its long-term software contracts in 2010, 2011 and during the first three quarters of 2012. The Company recorded revenue as royalty payments were received on this contract and should have deferred all the revenue and direct and incremental costs until all the deliverables, except PCS, were delivered in 2012. This resulted in an overstatement of $0.6 million of revenue and $0.4 million of costs for the three months ended March 31, 2012, which was corrected in the fourth quarter of 2012. Service Our service revenue primarily includes out-of-warranty repairs and product maintenance contracts. Out-of warranty repairs primarily consist of product repair services performed by our contract manufacturers for those customers that allowed their original product warranty to expire without purchasing one of our higher level support service plans. Revenue from these out-of-warranty repairs, and the associated cost of sales, is recognized in the period these services are provided. Service revenue also consists of product maintenance contracts purchased by our customers as an extension of our standard warranty. Revenue from our product maintenance contracts is deferred and recognized ratably over the contract term, generally 12 to 36 months. Net revenue derived from services was less than 10% of total revenue for all periods presented. Revenue Recognition for Arrangements with Multiple Deliverables For multi-element arrangements that include hardware products containing software essential to the hardware product's functionality, undelivered software elements that relate to the hardware product's essential software, and undelivered non-software services, we allocate revenue to all deliverables based on their relative selling prices. In such circumstances, we use a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) VSOE of fair value, (ii) third-party evidence of selling price, or TPE, and (iii) best estimate of the selling price, or ESP. VSOE generally exists only when we sell 16-------------------------------------------------------------------------------- Table of Contents the deliverable separately and represents the actual price charged by us for that deliverable. ESPs reflect our best estimates of what the selling prices of elements would be if they were sold regularly on a standalone basis. From time to time, we enter into arrangements with customers that include acceptance criteria. In such instances, we defer all revenue on the arrangement until customer acceptance is obtained or the acceptance clause lapses. Revenue Recognition for Sales to Channel Partners On sales to channel partners, we evaluate whether fees are considered fixed or determinable by considering a number of factors, including our ability to estimate returns, payment terms and our relationship and past history with the particular channel partner. If fees are not considered fixed or determinable at the time of sale to a channel partner, revenue recognition is deferred until there is persuasive evidence indicating the product has sold through to an end-user. Persuasive evidence of sell-through may include reports from channel partners documenting sell-through activity or data indicating an order has shipped to an end-user. Deferred Revenue We defer revenue on upfront nonrefundable payments from our customers and recognize it ratably over the term of the agreement, unless the payment is in exchange for products delivered that represent the culmination of a separate earnings process. When we provide consideration to a customer, we recognize the value of that consideration as a reduction in net revenue. We may be required to maintain inventory with certain of our largest OEM customers, which we refer to as hubbing arrangements. Pursuant to these arrangements we deliver products to a customer or a designated third-party warehouse based upon the customer's projected needs, but do not recognize product revenue unless and until the customer has removed our product from the warehouse to incorporate into its end products. Results of Operations The following table sets forth certain items from our statements of operations as a percentage of net revenue for the periods indicated (percentages may not aggregate due to rounding): Three Months Ended March 31, 2012 2013 NET REVENUE 100.0 % 100.0 % COST OF GOODS SOLD 71.5 67.5 GROSS PROFIT 28.5 32.5 OPERATING EXPENSES: Research and development 16.8 19.6 Sales and marketing 6.4 7.0 General and administrative 5.2 7.1 Total operating expenses 28.4 33.7 OPERATING INCOME (LOSS) 0.1 (1.2 ) Other income (expense), net - -INCOME (LOSS) BEFORE INCOME TAXES AND DISCONTINUED OPERATIONS 0.1 (1.2 ) INCOME TAX EXPENSE (BENEFIT) (0.2 ) 0.1 INCOME (LOSS) FROM CONTINUING OPERATIONS 0.3 (1.3 ) LOSS FROM DISCONTINUED OPERATIONS (3.7 ) (0.9 ) NET LOSS (3.4 )% (2.2 )% Three Months Ended March 31, 2012 Compared to the Three Months Ended March 31, 2013 Net Revenue Three Months Ended March 31, Decrease % Change 2012 2013 (in thousands, except percentages) Net Revenue $ 54,598 $ 44,480 $ (10,118 ) (18.5 )% 17-------------------------------------------------------------------------------- Table of Contents Net revenue decreased approximately $10.1 million from $54.6 million for the three months ended March 31, 2012 to $44.5 million for the three months ended March 31, 2013. The decrease in net revenue was primarily due to a $5.3 million decrease in revenue from HP from $33.2 million for the three months ended March 31, 2012 to $27.9 million for the three months ended March 31, 2013. Additionally, sales to Tektronix decreased $5.2 million, from $10.4 million for the three months ended March 31, 2012 to $5.2 million for the three months ended March 31, 2013. Sales to Tektronix during the first quarter of 2012 resulted from an increase in demand combined with fulfilling orders that were on backlog from the prior year. However, we expect sales to HP and Tektronix to continue to represent a substantial portion of our net revenue during 2013. Sales to HP approximated 61% of our net revenue for the three months ended March 31, 2012 compared to 63% of our net revenue for the three months ended March 31, 2013. Sales to Tektronix approximated 19% of our net revenue for the three months ended March 31, 2012 compared to 12% of our net revenue for the three months ended March 31, 2013. These decreases were partially offset by an increase of $0.4 million in sales to various other OEM customers. Cost of Goods Sold and Gross Profit Three Months Ended March Three Months Ended March % 31, 2012 31, 2013 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Cost of Goods Sold $ 39,033 71.5 % $ 30,040 67.5 % $ (8,993 ) (23.0 )% Gross Profit $ 15,565 28.5 % $ 14,440 32.5 % $ (1,125 ) (7.2 )% Cost of goods sold decreased for the three months ended March 31, 2013 compared to the three months ended March 31, 2012 primarily as a result of the decrease in sales revenue. Gross profit margin increased from 28.5% for the three months ended March 31, 2012 to 32.5% for the three months ended March 31, 2013. Gross profit margin benefited from manufacturing cost reductions, component cost reductions, a more favorable product and customer mix and decreased warranty related costs. During the first quarter of 2013, we were able to negotiate more favorable rates with a third-party service provider. Accordingly, we adjusted our warranty accrual by $0.8 million to reflect this change. Research and Development Expenses Three Months Ended March Three Months Ended March % 31, 2012 31, 2013 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Research and Development Expenses $ 9,197 16.8 % $ 8,713 19.6 % $ (484 ) (5.3 )% Research and development expenses decreased $0.5 million to $8.7 million for the three months ended March 31, 2013 compared to $9.2 million for the three months ended March 31, 2012. The decrease was primarily due to the deferral of research and development costs under a software contract of $0.4 million, a $0.2 million decrease in stock compensation expense and a $0.1 million decrease in travel expenses. These decreases were partially offset by a $0.2 million increase in depreciation expense. The decrease in stock compensation expense is due to an overall decline in value of the unvested options and awards pool, driven by lower share price on grant date and increased use of options versus unvested stock awards. The increase in depreciation expense resulted from the acquisition of materials to support strategic development projects. We expect that the timing of our engineering material purchases and additional headcount requirements to support new product releases will affect the amount of research and development expenses in future periods. Sales and Marketing Expenses Three Months Ended March Three Months Ended March % 31, 2012 31, 2013 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Sales and Marketing Expenses $ 3,477 6.4 % $ 3,108 7.0 % $ (369 ) (10.6 )% 18-------------------------------------------------------------------------------- Table of Contents Sales and marketing expense decreased approximately $0.4 million to $3.1 million for the three months ended March 31, 2013 compared to $3.5 million for the three months ended March 31, 2012. This decrease was primarily due to a decrease in bank credit card charges of $0.2 million, associated with sales to a customer, and a decrease in salaries and payroll related expenses of $0.1 million. The decrease in salaries and payroll related expenses is due to a decrease in sales commissions from lower sales levels during the quarter. General and Administrative Expenses Three Months Ended March Three Months Ended March % 31, 2012 31, 2013 Increase Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) General and Administrative Expenses $ 2,834 5.2 % $ 3,137 7.1 % $ 303 10.7 % General and administrative expenses increased approximately $0.3 million to $3.1 million for the three months ended March 31, 2013 compared to $2.8 million for the three months ended March 31, 2012. The increase was primarily due to a $0.3 million increase in salaries and payroll related expenses, caused by an increase in bonus expense as compared to the first quarter of 2012, as well as the hiring of key administrative personnel. Other Income (Expense), net % Three Months Ended March 31, 2012 Three Months Ended March 31, 2013 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Other Income (Expense), net $ 12 - % $ (8 ) - % $ 20 (166.7 )% Other income (expense), net consists of interest income on our cash and cash equivalents, interest expense related to our note payable and other miscellaneous items. Income Taxes We recorded an income tax benefit of $0.1 million for the three months ended March 31, 2012, as compared to minimal expense for the three months ended March 31, 2013. Our provision primarily includes estimated liabilities relating to tax expense in certain states in which we operate, offset partially by the statute of limitations expiring on certain tax positions involving our foreign subsidiaries. The increase from prior year is due to an increase in sales within a certain state, which assesses tax at a gross margin level. Loss From Discontinued Operations Three Months Ended March 31, % 2012 Three Months Ended March 31, 2013 Decrease Change % of Net % of Net Amount Revenue Amount Revenue (in thousands, except percentages) Loss From Discontinued Operations $ (2,028 ) (3.7 )% $ (421 ) (0.9 )% $ (1,607 ) (79.2 )% Loss from discontinued operations decreased $1.6 million to $0.4 million for the three months ended March 31, 2013 compared to $2.0 million for the three months ended March 31, 2012. The decline in losses was primarily driven by the Company's decision in the first quarter of 2012 to close down our Israel Technology Center and exit out of our AssuredUVS business. See Note 3 of Notes to Unaudited Condensed Consolidated Financial Statements for more details regarding our discontinued operations. Liquidity and Capital Resources The primary drivers affecting cash and liquidity are net losses, working capital requirements and capital expenditures. Historically, the payment terms we have had to offer our customers have been relatively similar to the terms received from our creditors and suppliers. We typically bill customers on an open account basis subject to our standard credit quality and payment terms ranging between net 30 and net 45 days. If our net revenue increases, it is likely that our accounts receivable balance will also increase. Conversely, if our net revenue decreases, it is likely that our accounts receivable will also decrease. Our accounts receivable could increase if customers, such as large OEM customers, delay their payments or if we grant them extended 19-------------------------------------------------------------------------------- Table of Contents payment terms. Our accounts payable also increase or decrease in connection with changes in volumes as well as our cash conservation strategies. As of March 31, 2013, we had $40.3 million of cash and cash equivalents and $33.9 million of working capital compared to $40.3 million of cash and cash equivalents and $34.3 million of working capital as of December 31, 2012. The changes in cash and cash equivalents are further described below. Cash equivalents include highly liquid investments purchased with original maturities of 90 days or less and consist principally of money market funds. As of March 31, 2013, $2.7 million of the $40.3 million of cash, cash equivalents, and marketable securities was held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., we could be required to accrue and pay taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. Operating Activities Net cash provided by operating activities for the three months ended March 31, 2013 was $0.9 million compared to net cash used in operating activities of $4.3 million for the three months ended March 31, 2012. The operating activities that affected cash consisted primarily of a net loss, which totaled $1.0 million for the three months ended March 31, 2013 compared to a net loss of $1.9 million for the three months ended March 31, 2012. The decrease in our net loss for the three months ended March 31, 2013 was primarily attributable to our exit from our AssuredUVS business, including the closing of our Israel Technology Center, combined with improved margins due to changes in product mix. The adjustments to reconcile net loss to net cash used in operating activities for the three months ended March 31, 2013 for items that did not affect cash consisted of depreciation and amortization of $0.7 million and stock-based compensation expense of $0.7 million. Cash flows from operations reflects the positive impact of $2.5 million related to a decrease in accounts receivable, which was primarily due to a decrease in the number of days sales outstanding, which decreased from 50 days at the end of the fourth quarter of 2012 to 45 days at the end of the first quarter of 2013. Additionally, the balance in accounts receivable at December 31, 2012 was larger due to seasonal year-end demand. Cash flows from operations also reflects a positive impact of $0.5 million related to an increase in accounts payable at March 31, 2013, which is also reflected in our days payable outstanding which increased from 62 days at the end of the fourth quarter of 2012 to 69 days at the end of the first quarter of 2013. Deferred revenue had a $0.7 million positive impact to cash from operations due to an increase in prepaid maintenance agreements sold through our Channel partners. Cash flows from operations also reflect the impact of $0.1 million related to an overall increase in other long-term liabilities, primarily due to increased deferred rents on our facility leases in Longmont, CO. Cash flows from operations reflect a negative impact of $0.3 million due to an increase in prepaid expenses and other assets. Prepaid expenses increased due to the renewal of several prepaid maintenance agreements during the first quarter of 2013. Accrued compensation and other expenses negatively impacted the cash from operations by $3.1 million due to payments on a settlement with a material customer related to failed power supply units, and a decrease in payments related to shutting down the Israel Technology Development Center. Investing Activities Cash used in investing activities for the three months ended March 31, 2013 was approximately $1.2 million compared to $0.3 million for the three months ended March 31, 2012. Cash used in investing activities for the three months ended March 31, 2013 was due to purchases of property and equipment primarily associated with test and other equipment used by our contract manufacturing partners in the production of our products and for equipment used in our Longmont, Colorado engineering laboratories. Financing Activities Cash provided by financing activities for the three months ended March 31, 2013 was approximately $0.3 million compared to an insignificant amount of cash used in financing activities for the three months ended March 31, 2012. Cash provided by financing activities for the three months ended March 31, 2013 was primarily due to the sale of stock to employees under our employee stock plans of approximately $0.4 million, partially offset by tax liability payments of $0.1 million made by Dot Hill associated with employee equity awards. Based on current macro-economic conditions and conditions in the state of the data storage systems markets, our own organizational structure and our current outlook, we presently expect our cash and cash equivalents will be sufficient to fund our operations, working capital and capital requirements for at least the next 12 months. However, our capital resources could be negatively impacted by unforeseen future events. 20-------------------------------------------------------------------------------- Table of Contents Our standard warranty provides that if our systems do not function to published specifications, we will repair or replace the defective component or system without charge generally for a period of approximately three years. We generally extend to our customers the warranties provided to us by our suppliers, and accordingly, the majority of our warranty obligations to customers are typically intended to be covered by corresponding supplier warranties. For warranty costs not covered by our suppliers, we provide for estimated warranty costs in the period the revenue is recognized. Estimated liabilities for product warranties are included in accrued expenses. During 2009, we discovered a quality issue associated with certain power supply devices provided by a long-term component supplier, which resulted in a higher than expected level of power supply failures to us and our customers. A significant customer of ours was impacted by this issue, and provided us with an estimation of the additional costs it would incur related to the customer's internal overhead costs, in addition to third-party direct costs. A final settlement with this material customer was reached during the second quarter of 2012. The estimated remaining liability is approximately $0.2 million as of March 31, 2013, which relates to costs for extension of warranty coverage on these units. While our estimated liability relating to failed power supply units is subject to some uncertainty until final settlement, based on our current expectation of sales volumes with this material customer, we do not believe the incurrence of an additional loss is either probable or reasonably possible at this time. Our component supplier continued to re-work and distribute to our customer the affected population of power supplies at no cost to us. During 2011, as the claims from our customer became clearer, we commenced negotiations with our component supplier for fair and reasonable costs that we have and are likely to incur through the warranty period associated with this component failure. Pursuant to the final settlement agreement, the supplier agreed to cash consideration of $1.2 million, of which we received $1.1 million subsequent to the signing of the settlement agreement, with the remaining $0.1 million to be received in one remaining installment during 2013. Additionally, our supplier committed to product rebates and/or price concessions on product orders for a period of 39 months from the execution of the settlement agreement, in return for our agreement to release our supplier from all obligations relating to the power supply failures known by us to date. This agreement is not subject to any required future purchases. In addition, we have commenced discussions with our General Liability and Errors and Omissions Insurance and underwriters and will continue to pursue our rights to cover any damages we incur and that are not reimbursed by our supplier. The insurance company has issued a reservation of rights letter to us and at this time, it is not possible to estimate to what extent the residual amounts, if any, we will be covered by our carrier. As of March 31, 2013 we have not assumed or recorded any insurance reimbursement. To the extent our settlement agreements with our customer and our component supplier are not on mutually beneficial terms, or our component supplier does not continue to reimburse us for the expenses incurred by us or our customers, and we are unsuccessful in recovering such expenses from our insurance provider, we could incur additional expenses which could potentially have a material effect on our financial statements and liquidity. In January 2012, Dot Hill filed an arbitration claim against a customer for unpaid money owed to Dot Hill under the OEM and License Agreement entered into by the parties in July 2010 (the "Agreement"). Pursuant to the Agreement, the customer licensed portions of our UVS software and bundled it with its hardware and software. Our customer was required to pay licensing and support fees under the Agreement. However, during the second calendar quarter of 2011, the customer stopped making payments. Our customer filed a counter claim for $0.6 million, primarily for damages and reimbursement of specific amounts paid under the Agreement. The case was heard at arbitration, which was completed in March 2013, and a judgment was issued in April 2013. We have recorded a liability in the amount of the settlement as of March 31, 2013 totaling $0.1 million, included in accrued expenses in the accompanying unaudited condensed consolidated balance sheet. The actual amount and timing of working capital and capital expenditures that we may incur in future periods may vary significantly and will depend upon numerous factors, including the timing and extent of net revenue and expenditures from our core business and strategic investments, the overall level of net profits or losses, our ability to manage our relationships with our contract manufacturers, the potential growth or decline in inventory to support our customers, costs associated with product quality issues and the recovery, if any, of such costs from a supplier, the status of our relationships with key customers, partners and suppliers, the timing and extent of the introduction of new products and services, growth in operations and the economic environment. In addition, the actual amount and timing of working capital will depend on our ability to maintain payment terms with our suppliers consistent with the credit terms of our customers. For example, if Foxconn, our major contract manufacturing partner, were to shorten our payment terms with them, or if HP were to lengthen their payment terms with us, our financial condition could be harmed. We maintain a credit facility with Silicon Valley Bank for cash advances of up to an aggregate of $30 million based upon an advance rate dependent on certain concentration limits within eligible accounts receivable. These limitations exclude certain eligible customer receivables if an individual customer account balance exceeds 25, 50 or 70 percentof the total eligible 21-------------------------------------------------------------------------------- Table of Contents accounts receivable, depending on the customer, as defined by our Loan and Security Agreement with Silicon Valley Bank. Borrowings under the credit facility bear interest at the prime rate and are secured by substantially all of our accounts receivable, deposit and securities accounts. The agreement provides for a negative pledge on our inventory and intellectual property, subject to certain exceptions, and contains usual and customary covenants for an arrangement of its type, including an obligation that we maintain at all times a net worth, as defined in the agreement, of $50 million(subject to certain increases). The agreement also includes provisions to increase the financing facility by $20 million subject to our meeting certain requirements, including $40 million in borrowing base for the immediately preceding 90 days, and Silicon Valley Bank locating a lender willing to finance the additional facility. In addition, if our cash and cash equivalents net of the total amount outstanding under the credit facility fall below $20 million (measured on a rolling three-month basis), the interest rate will increase to prime plus 1% and additional restrictions will apply. The maturity date of the credit facility is July 21, 2015. As of March 31, 2013, there was $2.8 million outstanding under the Silicon Valley Bank line of credit. There was $17.7 million available for borrowing under the agreement as of March 31, 2013. We are currently in compliance with all covenant requirements. At March 31, 2013, our long-term commitments had not materially changed from those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2012. Off-Balance Sheet Arrangements At March 31, 2013, we did not have any relationship with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance variable interest, 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. In addition, we did not engage in trading activities involving non-exchange traded contracts. As a result, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. We do not have relationships and transactions with persons and entities that derive benefits from their non-independent relationship with us or our related parties except as disclosed herein. We enter into indemnification agreements with third parties in the ordinary course of business that generally require us to reimburse losses suffered by the third party due to various events, such as lawsuits arising from patent or copyright infringement. These indemnification obligations are considered off-balance sheet arrangements under accounting guidance. It is not possible to determine the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Such indemnification agreements may not be subject to maximum loss clauses. Historically, we have not incurred material costs as a result of obligations under these agreements. Recent Accounting Pronouncements Please see Note 1 of the Notes to Unaudited Condensed Consolidated Financial Statements. Item 3. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Risk We place our cash equivalents with high-credit-quality financial institutions, investing primarily in money market accounts. We have established guidelines relative to credit ratings, diversification and maturities that seek to maintain safety and liquidity. Our investment strategy generally results in lower yields on investments but reduces the risk to principal in the short term prior to these funds being invested in our business. Our interest income is sensitive to changes in the general level of interest rates. In this regard, changes in interest rates can affect the interest earned on our cash equivalents. A 10% unfavorable change in the interest rate would not materially impact our March 31, 2013 financial statements. We have a line of credit agreement, which accrues interest on any outstanding balances at the prime rate. As of March 31, 2013, there was $2.8 million outstanding under this line. As we make borrowings under this line, we are exposed to interest rate risk on such debt. Indicated changes in interest rates are based on hypothetical movements and are not necessarily indicative of the actual results that may occur. Future earnings and losses will be affected by actual fluctuations in interest rates. Foreign Currency Exchange Rate Risk We conduct a portion of our business in currencies other than the U.S. dollar, the currency in which our unaudited condensed consolidated financial statements are reported. The most significant foreign currencies that subjected us to foreign currency exchange rate risk for the three months March 31, 2013 were the Euro, British Pound and the Japanese Yen. Correspondingly, our operating results could be adversely affected by foreign currency exchange rate volatility relative to the U.S. dollar. Although we continue to evaluate strategies to mitigate risks related to the effect of fluctuations in currency 22-------------------------------------------------------------------------------- Table of Contents exchange rates, we will likely continue to recognize gains or losses from international transactions and foreign currency changes. Although foreign currency transaction gains and losses have not historically been material, we incurred $0.3 million in foreign currency transaction losses during the three months ended March 31, 2013, primarily resulting from the re-measurement process of certain of our foreign subsidiaries that maintain their books of record in a currency other than the functional currency. Future changes in foreign currency rates could adversely impact our financial statements. A 10% unfavorable change in exchange rates would result in foreign currency losses of approximately $0.6 million. Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on management's evaluation (with the participation of our chief executive officer and chief financial officer), as of the end of the period covered by this report, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)), are effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and is accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting There were no changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the period covered by this quarterly report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. |