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OCLARO, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) This Quarterly Report on Form 10-Q and the documents incorporated herein by reference contain forward-looking statements, within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, about our future expectations, plans or prospects and our business. You can identify these statements by the fact that they do not relate strictly to historical or current events, and contain words such as "anticipate," "estimate," "expect," "project," "intend," "will," "plan," "believe," "should," "outlook," "could," "target," "model," and other words of similar meaning in connection with discussion of future operating or financial performance. We have based our forward looking statements on our management's beliefs and assumptions based on information available to our management at the time the statements are made. There are a number of important factors that could cause our actual results or events to differ materially from those indicated by such forward-looking statements, including (i) the future performance of Oclaro and its ability to effectively integrate the operations of acquired companies following the closing of acquisitions and mergers, including its merger with Opnext, (ii) the potential inability to realize the expected and ongoing benefits and synergies of acquisitions and mergers, (iii) the impact to our operations, revenues and financial condition attributable to the flooding in Thailand, (iv) the impact of continued uncertainty in world financial markets and any resulting reduction in demand for our products, (v) our ability to meet or exceed our gross margin expectations, (vi) the effects of fluctuating product mix on our results, (vii) our ability to timely develop and commercialize new products, (viii) our ability to reduce costs and operating expenses, (ix) our ability to respond to evolving technologies and customer requirements and demands, (x) our dependence on a limited number of customers for a significant percentage of our revenues, (xi) our ability to maintain strong relationships with certain customers, (xii) our ability to effectively compete with companies that have greater name recognition, broader customer relationships and substantially greater financial, technical and marketing resources than we do, (xiii) our ability to effectively and efficiently transition to an outsourced back-end assembly and test model, (xiv) our ability to timely capitalize on any increase in market demand, (xv) increased costs related to downsizing and compliance with regulatory and legal requirements in connection with such downsizing, (xvi) competition and pricing pressure, (xvii) the potential lack of availability of credit or opportunity for equity based financing, (xviii) the risks associated with our international operations, (xix) our ability to service and repay our outstanding indebtedness pursuant to the terms of the applicable agreements, (xx) the outcome of tax audits or similar proceedings, (xxi) the outcome of pending litigation against the company, (xxii) our ability to maintain or increase our cash reserves and obtain financing on terms acceptable to us or at all, and (xxiii) other factors described in Oclaro's most recent annual report on Form 10-K, quarterly report on Form 10-Q and other documents we periodically file with the SEC. We cannot guarantee any future results, levels of activity, performance or achievements. Moreover, we assume no obligation to update forward-looking statements or update the reasons actual results could differ materially from those anticipated in forward-looking statements. Several of the important factors that may cause our actual results to differ materially from the expectations we describe in forward-looking statements are identified in the sections captioned "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Risk Factors" in this Quarterly Report on Form 10-Q and the documents incorporated herein by reference. OVERVIEW We are a tier-one provider of optical communications and laser components, modules and subsystems for a broad range of diverse markets, including telecommunications (telecom), industrial, scientific, consumer electronics and medical. In all markets, our approach is to offer a differentiated solution that is designed to make it easier for our customers to do business by combining optical technology innovation, photonic integration, and a vertically integrated approach to manufacturing and product development. Our customers include Huawei Technologies Co. Ltd (Huawei); Alcatel-Lucent; Ciena Corporation (Ciena); Fujitsu Limited (Fujitsu); Tellabs, Inc.; Infinera Corporation; Cisco Systems, Inc. (Cisco); Nokia Siemens Networks; ADVA Optical Networking; Laserline Inc.; and Ericsson. 31-------------------------------------------------------------------------------- Table of Contents RECENT EVENTS Oclaro, Inc., (the "Parent"), is a party to the Second Amended and Restated Credit Agreement, dated as of November 2, 2012 (as amended, the "Credit Agreement"), among the Parent, Oclaro Technology Limited, (the "Borrower"), each lender party thereto (the "Lenders") and Wells Fargo Capital Finance, Inc., a California corporation (the "Agent"), as administrative agent for the Lenders. On May 6, 2013, Parent, Borrower, the Lenders, the Agent and PECM Strategic Funding LP and Providence TMT Debt Opportunity Fund II LP (the "Term Lenders") entered into Amendment Number Two to the Credit Agreement and the associated guaranties and security agreements. See Note 18, Subsequent Events, to the accompanying condensed consolidated financial statements for a description of Amendment Number Two. RESULTS OF OPERATIONS The following tables set forth our condensed consolidated results of operations for the three and nine month periods indicated, along with amounts expressed as a percentage of revenues, and comparative information regarding the absolute and percentage changes in these amounts: Three Months Ended Increase March 30, 2013 December 29, 2012 Change (Decrease) (Thousands) % (Thousands) % (Thousands) % Revenues $ 141,642 100.0 $ 159,465 100.0 $ (17,823 ) (11.2 ) Cost of revenues 128,868 91.0 137,183 86.0 (8,315 ) (6.1 ) Gross profit 12,774 9.0 22,282 14.0 (9,508 ) (42.7 ) Operating expenses: Research and development 25,237 17.8 25,750 16.1 (513 ) (2.0 ) Selling, general and administrative 22,465 15.9 22,896 14.4 (431 ) (1.9 ) Amortization of intangible assets 2,400 1.7 2,402 1.5 (2 ) (0.1 ) Restructuring, acquisition and related (gains) costs, net 3,085 2.2 (23,665 ) (14.8 ) 26,750 n/m (1) Flood-related (income) expense, net (11,548 ) (8.2 ) 641 0.4 (12,189 ) n/m (1) Loss on sale of property and equipment 74 - 6 - 68 1,133.3 Total operating expenses 41,713 29.4 28,030 17.6 13,683 48.8 Operating loss (28,939 ) (20.4 ) (5,748 ) (3.6 ) (23,191 ) 403.5 Other income (expense): Interest income (expense), net (1,103 ) (0.8 ) (649 ) (0.4 ) (454 ) 70.0 Loss on foreign currency translation (7,353 ) (5.2 ) (3,423 ) (2.2 ) (3,930 ) 114.8 Other income (expense) (3,760 ) (2.6 ) - - (3,760 ) n/m (1) Total other income (expense) (12,216 ) (8.6 ) (4,072 ) (2.6 ) (8,144 ) 200.0 Loss before income taxes (41,155 ) (29.0 ) (9,820 ) (6.2 ) (31,335 ) 319.1 Income tax provision 386 0.3 1,424 0.9 (1,038 ) (72.9 ) Net loss $ (41,541 ) (29.3 ) $ (11,244 ) (7.1 ) $ (30,297 ) 269.5 32 -------------------------------------------------------------------------------- Table of Contents Three Months Ended Increase March 30, 2013 March 31, 2012 Change (Decrease) (Thousands) % (Thousands) % (Thousands) % Revenues $ 141,642 100.0 $ 88,709 100.0 $ 52,933 59.7 Cost of revenues 128,868 91.0 75,021 84.6 53,847 71.8 Gross profit 12,774 9.0 13,688 15.4 (914 ) (6.7 ) Operating expenses: Research and development 25,237 17.8 15,045 17.0 10,192 67.7 Selling, general and administrative 22,465 15.9 14,889 16.8 7,576 50.9 Amortization of intangible assets 2,400 1.7 775 0.9 1,625 209.7 Restructuring, acquisition and related (gains) costs, net 3,085 2.2 2,189 2.4 896 40.9 Flood-related income, net (11,548 ) (8.2 ) (3,267 ) (3.7 ) (8,281 ) 253.5 (Gain) loss on sale of property and equipment 74 - (13 ) - 87 n/m (1) Total operating expenses 41,713 29.4 29,618 33.4 12,095 40.8 Operating loss (28,939 ) (20.4 ) (15,930 ) (18.0 ) (13,009 ) 81.7 Other income (expense): Interest income (expense), net (1,103 ) (0.8 ) (303 ) (0.3 ) (800 ) 264.0 Loss on foreign currency translation (7,353 ) (5.2 ) (261 ) (0.3 ) (7,092 ) 2,717.2 Other income (expense) (3,760 ) (2.6 ) - - (3,760 ) n/m (1) Total other income (expense) (12,216 ) (8.6 ) (564 ) (0.6 ) (11,652 ) 2,066.0 Loss before income taxes (41,155 ) (29.0 ) (16,494 ) (18.6 ) (24,661 ) 149.5 Income tax provision 386 0.3 668 0.7 (282 ) (42.2 ) Net loss $ (41,541 ) (29.3 ) $ (17,162 ) (19.3 ) $ (24,379 ) 142.1 (1) Not meaningful. 33 -------------------------------------------------------------------------------- Table of Contents Nine Months Ended Increase March 30, 2013 March 31, 2012 Change (Decrease) (Thousands) % (Thousands) % (Thousands) % Revenues $ 449,920 100.0 $ 281,018 100.0 $ 168,902 60.1 Cost of revenues 396,425 88.1 232,422 82.7 164,003 70.6 Gross profit 53,495 11.9 48,596 17.3 4,899 10.1 Operating expenses: Research and development 76,752 17.1 49,736 17.7 27,016 54.3 Selling, general and administrative 69,778 15.5 46,848 16.7 22,930 48.9 Amortization of intangible assets 6,828 1.5 2,224 0.8 4,604 207.0 Restructuring, acquisition and related (gains) costs, net (7,944 ) (1.8 ) 3,643 1.3 (11,587 ) n/m (1) Flood-related (income) expense, net (10,643 ) (2.3 ) 5,821 2.1 (16,464 ) n/m (1) Loss on sale of property and equipment 62 - 84 - (22 ) (26.2 ) Total operating expenses 134,833 30.0 108,356 38.6 26,477 24.4 Operating loss (81,338 ) (18.1 ) (59,760 ) (21.3 ) (21,578 ) 36.1 Other income (expense): Interest income (expense), net (2,230 ) (0.5 ) (705 ) (0.3 ) (1,525 ) 216.3 Gain (loss) on foreign currency translation (10,580 ) (2.4 ) 2,429 0.9 (13,009 ) n/m (1) Other income (expense) (3,760 ) (0.8 ) 2,238 0.8 (5,998 ) n/m (1) Gain on bargain purchase 27,865 6.2 - - 27,865 n/m (1) Total other income (expense) 11,295 2.5 3,962 1.4 7,333 185.1 Loss before income taxes (70,043 ) (15.6 ) (55,798 ) (19.9 ) (14,245 ) 25.5 Income tax provision 2,993 0.6 6,774 2.4 (3,781 ) (55.8 ) Net loss $ (73,036 ) (16.2 ) $ (62,572 ) (22.3 ) $ (10,464 ) 16.7 (1) Not meaningful. Revenues Revenues for the three months ended March 30, 2013 decreased by $17.8 million, or 11 percent, compared to the three months ended December 29, 2012. The decrease in revenues was primarily due to a decline in demand for our products, largely associated with market conditions. Market demand across most of our product groups was weaker than expected during the three months ended March 30, 2013 as compared to the three months ended December 29, 2012, and reflected in particular seasonal fluctuations. We believe our revenues in the fourth quarter of fiscal year 2013 will continue to remain relatively flat as compared to the three months ended March 30, 2013, reflecting a sustained slowdown in the demand for our products, especially within the telecom market. The decrease in our revenues during the three months ended March 30, 2013 is also partially a result of our sale of the thin film filter business and interleaver product line during the second quarter of fiscal year 2013, which resulted in approximately $2.5 million in lower revenues in the third quarter of fiscal year 2013. Compared to the three months ended December 29, 2012, revenues from sales of our 40 Gb/s and 100 Gb/s transmission modules decreased by $0.5 million, or 1 percent; revenues from sales of our 10 Gb/s transmission modules decreased by $5.5 million, or 12 percent; revenues from sales of our amplification, filtering and optical switching products decreased by $10.4 million, or 33 percent; revenues from sales of our industrial and consumer products decreased by $1.5 million, or 8 percent; and revenues from sales of our transmission components remained relatively flat. 34 -------------------------------------------------------------------------------- Table of Contents Revenues for the three months ended March 30, 2013 increased by $52.9 million, or 60 percent, compared to the three months ended March 31, 2012. The increase was primarily due to the inclusion of revenues in fiscal year 2013 generated through the acquisition of Opnext on July 23, 2012. Compared to the three months ended March 31, 2012, revenues from sales of our 40 Gb/s and 100 Gb/s transmission modules increased by $18.7 million, or 98 percent; revenues from sales of our 10 Gb/s transmission modules increased by $32.9 million, or 352 percent; revenues from sales of our amplification, filtering and optical switching products decreased by $2.5 million, or 11 percent; revenues from sales of our transmission components decreased by $1.6 million, or 7 percent; and revenues from sales of our industrial and consumer products increased by $5.4 million, or 41 percent. The increase in revenue for these respective product groups was mainly attributable to our acquisition of Opnext and also our recovery from the Thai flood. The increase in revenues was also attributable to approximately $4.0 million in lower than expected revenues during the three months ended March 31, 2012, due to a short-term work stoppage in our China factory, which was subsequently resolved in the fourth quarter of fiscal year 2012. However, we believe that market demand for optical components was weaker during the three months ended March 30, 2013 than the three months ended March 31, 2012. After adjusting for the estimated impacts of the flood and work stoppage, our pro forma combined revenues including Oclaro and Opnext are lower in the current quarter than for the comparable quarter of the prior year as a result of these market conditions. For the three months ended March 30, 2013, Cisco Systems, Inc. (Cisco) accounted for $16.1 million, or 11 percent, of our revenues, and Huawei Technologies Co., Ltd. (Huawei) accounted for $15.8 million, or 11 percent, of our revenues. For the three months ended December 29, 2012, Cisco accounted for $17.9 million, or 11 percent, of our revenues, Alcatel-Lucent accounted for $16.5 million, or 10 percent, of our revenues, and Huawei accounted for $16.0 million, or 10 percent, of our revenues. For the three months ended March 31, 2012, Fujitsu Limited (Fujitsu) accounted for $14.3 million, or 16 percent, of our revenues. Revenues for the nine months ended March 30, 2013 increased by $168.9 million, or 60 percent, compared to the nine months ended March 31, 2012. The increase was primarily due to the inclusion of revenues in fiscal year 2013 generated through the acquisition of Opnext on July 23, 2012. Compared to the nine months ended March 31, 2012, revenues from sales of our 40 Gb/s and 100 Gb/s transmission modules increased by $54.2 million, or 106 percent; revenues from sales of our 10 Gb/s transmission modules increased by $96.3 million, or 295 percent; revenues from sales of our transmission components increased by $0.8 million, or 1 percent; revenues from sales of our amplification, filtering and optical switching products increased by $3.5 million, or 4 percent; and revenues from sales of our industrial and consumer products increased by $14.2 million, or 33 percent. The increase in revenue for these respective product groups was mainly attributable to our acquisition of Opnext and also our recovery from the Thai flood. The increase in revenues was also attributable to approximately $4.0 million in lower than expected revenues during the nine months ended March 31, 2012, due to a short-term work stoppage in our China factory, which was subsequently resolved in the fourth quarter of fiscal year 2012. However, we believe that market demand for optical components was weaker during the nine months ended March 30, 2013 than the nine months ended March 31, 2012. After adjusting for the estimated impacts of the flood and work stoppage, our pro forma combined revenues including Oclaro and Opnext are lower for the nine months ended March 30, 2013 than for the comparable period of the prior year as a result of these market conditions. For the nine months ended March 30, 2013, Cisco accounted for $53.5 million, or 12 percent, of our revenues, and Huawei accounted for $48.5 million, or 11 percent, of our revenues. For the nine months ended March 31, 2012, Fujitsu accounted for $38.2 million, or 14 percent, of our revenues, and Huawei accounted for $28.5 million, or 10 percent, of our revenues. Cost of Revenues Our cost of revenues consists of the costs associated with manufacturing our products, and includes the purchase of raw materials, labor costs and related overhead, including stock-based compensation charges, and the costs charged by our contract manufacturers on the products they manufacture. Charges for excess and obsolete inventory, including in regards to inventories procured by contract manufacturers on our behalf, the cost of product returns and warranty costs are also included in cost of revenues. Costs and expenses related to our manufacturing resources which are incurred in connection with the development of new products are included in research and development expense. Our cost of revenues for the three months ended March 30, 2013 decreased by $8.3 million, or 6 percent, from the three months ended December 29, 2012. The decrease was primarily related to a reduction in costs associated with lower volumes of revenue attributable to a decrease in product sales. Our cost of revenues for the three months ended March 30, 2013 increased by $53.8 million, or 72 percent, from the three months ended March 31, 2012. The increase was primarily related to higher costs associated with the inclusion of cost of revenues in fiscal year 2013 generated through the acquisition of Opnext on July 23, 2012. 35 -------------------------------------------------------------------------------- Table of Contents Our cost of revenues for the nine months ended March 30, 2013 increased by $164.0 million, or 71 percent, from the nine months ended March 31, 2012. The increase was primarily related to higher costs associated with the inclusion of cost of revenues in fiscal year 2013 generated through the acquisition of Opnext on July 23, 2012. Gross Profit Gross profit is calculated as revenues less cost of revenues. Gross margin rate is gross profit reflected as a percentage of revenues. Our gross margin rate decreased by 5 percent for the three months ended March 30, 2013, to 9 percent, compared to the three months ended December 29, 2012. The 5 percentage point decline in gross margin rate was primarily attributable to lower total revenues compared to our fixed overhead costs, as well as direct cost improvements in certain of our products not matching the level of average price erosion for those products, and due to higher excess and obsolete inventory valuation charges. Our gross margin rate decreased by 6 percent for the three months ended March 30, 2013, to 9 percent, compared to the three months ended March 31, 2012. The 6 percentage point decline in gross margin rate was primarily attributable to a lower margin over direct costs of our products, with a primary factor being the change in product mix to a higher mix of lower margin fixed wavelength 10 Gb/s transmission products, as well as direct cost improvements in certain of our products not matching the level of average price erosion for those products, and due to higher excess and obsolete inventory valuation charges. The decrease in our gross margin rate was also due to the re-assignment of certain of our manufacturing employees to efforts to restore our production capacity following the flood in Thailand, which resulted in a $1.2 million higher gross profit than would have otherwise been recorded for the three months ended March 31, 2012, as these costs were included in flood-related (income) expense during that period. Our gross margin rate decreased by 5 percent for the nine months ended March 30, 2013, to 12 percent, compared to the nine months ended March 31, 2012. The 5 percentage point decline in gross margin rate was primarily attributable to product mix with a higher mix of lower margin fixed wavelength 10 Gb/s transmission products, and due to higher excess and obsolete inventory valuation charges. The decrease in our gross margin rate was also due to the re-assignment of certain of our manufacturing employees to efforts to restore our production capacity following the flood in Thailand, which resulted in a $1.7 million higher gross profit than would have otherwise been recorded for the nine months ended March 31, 2012, as these costs were included in flood-related (income) expense during that period. The decrease in gross margin rate was partially offset by lower revenues in the second and third quarters of fiscal 2012 in relation to overhead expenses, in part caused by the flooding in Thailand and the short-term work stoppage in our China factory, resulting in a lower gross margin for that period. Research and Development Expenses Research and development expenses consist primarily of salaries and related costs of employees engaged in research and design activities, including stock-based compensation charges related to those employees, costs of design tools and computer hardware, costs related to prototyping and facilities costs for certain research and development focused sites. Research and development expenses decreased to $25.2 million for the three months ended March 30, 2013 from $25.7 million for the three months ended December 29, 2012. The decrease in research and development expenses was primarily related to a favorable impact from the Japanese yen weakening relative to the U.S. dollar. Personnel-related costs decreased to $14.6 million for the three months ended March 30, 2013, compared with $15.0 million for the three months ended December 29, 2012, and other costs, including the costs of design tools and facilities-related costs decreased to $10.6 million for the three months ended March 30, 2013, compared with $10.7 million for the three months ended December 29, 2012. Research and development expenses increased to $25.2 million for the three months ended March 30, 2013 from $15.0 million for the three months ended March 31, 2012. The increase was primarily related to the inclusion of research and development expenses in fiscal year 2013 to fund research and development associated with products acquired through the acquisition of Opnext on July 23, 2012, partially offset by other cost reduction efforts in response to softening market conditions and lower post-flood revenues. Personnel-related costs increased to $14.6 million for the three months ended March 30, 2013, compared with $10.6 million for the three months ended March 31, 2012, primarily as a result of an increase in personnel numbers following our acquisition of Opnext. In addition, in the third quarter of fiscal year 2012, as part of our Thailand flood recovery efforts, certain of our research and development employees were redirected to efforts to restore our production capacity. As a result, our research and development expenses were $0.6 million lower than they would have been otherwise, as these amounts were recorded in flood-related (income) expense, net, for the three months ended March 31, 2012. Other costs, including the costs of design tools and facilities-related costs increased to $10.6 million for the three months ended March 30, 2013, compared with $4.5 million for the three months ended March 31, 2012. 36-------------------------------------------------------------------------------- Table of Contents Research and development expenses increased to $76.8 million for the nine months ended March 30, 2013 from $49.7 million for the nine months ended March 31, 2012. The increase was primarily related to the inclusion of research and development expenses in fiscal year 2013 to fund research and development associated with products acquired through the acquisition of Opnext on July 23, 2012, partially offset by a reduction in research and development expenses related to synergies from aligning and reducing combined research and development resources of Oclaro and Opnext in association with the merger, and other cost reduction efforts in response to softening market conditions and lower post-flood revenues. Personnel-related costs increased to $44.1 million for the nine months ended March 30, 2013, compared with $30.8 million for the nine months ended March 31, 2012, primarily as a result of an increase in personnel numbers following our acquisition of Opnext. In addition, in the second and third quarters of fiscal year 2012, as part of our Thailand flood recovery efforts, certain of our research and development employees were redirected to efforts to restore our production capacity. As a result, our research and development expenses were $1.1 million lower than they would have been otherwise, as these amounts were recorded in flood-related (income) expense, net, for the nine months ended March 31, 2012. Other costs, including the costs of design tools and facilities-related costs increased to $32.7 million for the nine months ended March 30, 2013, compared with $18.9 million for the nine months ended March 31, 2012. Selling, General and Administrative Expenses Selling, general and administrative expenses consist primarily of personnel-related expenses, including stock-based compensation charges related to employees engaged in sales, general and administrative functions, legal and professional fees, facilities expenses, insurance expenses and certain information technology costs. Selling, general and administrative expenses decreased to $22.5 million for the three months ended March 30, 2013, from $22.9 million for the three months ended December 29, 2012. The decrease was primarily related to a reduction in selling, general and administrative expenses related to favorable impact from the Japanese yen weakening relative to the U.S. dollar. Personnel-related costs decreased to $12.9 million for the three months ended March 30, 2013, compared with $13.6 million for the three months ended December 29, 2012, and other costs, including legal and professional fees, facilities expenses and other miscellaneous expenses, increased to $9.5 million for the three months ended March 30, 2013, compared with $9.3 million for the three months ended March 31, 2012. Of the $9.5 million in other costs incurred in the third quarter of fiscal year 2013, $2.7 million related to audit, professional fees and insurance costs, $2.8 million related to sales and marketing costs, $1.8 million related to information technology costs, $1.6 million related to legal and executive costs, and $0.6 million related to human resources costs. Selling, general and administrative expenses increased to $22.5 million for the three months ended March 30, 2013, from $14.9 million for the three months ended March 31, 2012. The increase was primarily related to the inclusion of selling, general and administrative expenses in fiscal year 2013 attributable to the operations of Opnext, partially offset by a reduction in selling, general and administrative expenses related to synergies from aligning and reducing combined selling, general and administrative resources of Oclaro and Opnext in association with the merger, and other cost reduction efforts in response to softening market conditions and lower post-flood revenues. Personnel-related costs increased to $12.9 million for the three months ended March 30, 2013, compared with $9.1 million for the three months ended March 31, 2012, primarily as a result of an increase in personnel numbers following our acquisition of Opnext. Other costs, including legal and professional fees, facilities expenses and other miscellaneous expenses, increased to $9.5 million for the three months ended March 30, 2013, compared with $5.8 million for the three months ended March 31, 2012. Selling, general and administrative expenses increased to $69.8 million for the nine months ended March 30, 2013, from $46.8 million for the nine months ended March 31, 2012. The increase was primarily related to the inclusion of selling, general and administrative expenses in fiscal year 2013 attributable to the operations of Opnext, partially offset by a reduction in selling, general and administrative expenses related to synergies from aligning and reducing combined selling, general and administrative resources of Oclaro and Opnext in association with the merger, and other cost reduction efforts in response to softening market conditions and lower post-flood revenues. Personnel-related costs increased to $40.2 million for the nine months ended March 30, 2013, compared with $28.5 million for the nine months ended March 31, 2012, primarily as a result of an increase in personnel numbers following our acquisition of Opnext. Other costs, including legal and professional fees, facilities expenses and other miscellaneous expenses, increased to $29.6 million for the nine months ended March 30, 2013, compared with $18.4 million for the nine months ended March 31, 2012. Of the $29.6 million in other costs incurred during the nine months ended March 30, 2013, $9.8 million related to audit, professional fees and insurance costs, $8.4 million related to sales and marketing costs, $5.8 million related to information technology costs, $3.7 million related to legal and executive costs, and $1.9 million related to human resources costs. 37-------------------------------------------------------------------------------- Table of Contents Amortization of Intangible Assets Amortization of intangible assets for the three months ended March 30, 2013 remained flat as compared to the three months ended December 29, 2012. Amortization of intangible assets increased to $2.4 million and $6.8 million for the three and nine months ended March 30, 2013, respectively, from $0.8 million and $2.2 million for the three and nine months ended March 31, 2012, respectively. The increase is a result of our acquisition of Opnext, in which we recorded $28.0 million in intangible assets as our preliminary estimate of the fair value of acquired intangible assets. Restructuring, Acquisition and Related Costs In connection with the acquisition of Opnext, during the nine months ended March 30, 2013, we recorded $2.6 million in legal and professional fees, and initiated a restructuring plan to integrate the businesses. Under this restructuring plan, during the three and nine months ended March 30, 2013, we recorded $0.3 million and $8.1 million, respectively, related to workforce reductions, which are included in restructuring, acquisition and related costs in the condensed consolidated statement of operations. During the three and nine months ended March 30, 2013, we recorded $0.2 million related to lease cancellation and commitments. During the nine months ended March 30, 2013, we also recorded $0.9 million related to the impairment of certain technology that is now considered redundant following the acquisition and $0.4 million related to the write-off of net book value inventory that supported this technology during the first quarter of fiscal year 2013. During fiscal year 2012, we initiated a restructuring plan in connection with the transfer of our Shenzhen, China manufacturing operations to Venture. We expect this transition to occur in a phased and gradual transfer of products over a three year period ending in 2015 and will result in approximately $35 million in lower working capital requirements, net of related costs incurred. In connection with this transition, we recorded restructuring charges for employee separation charges of $1.1 million and $4.0 million, respectively, during the three and nine months ended March 30, 2013. During the second quarter of fiscal year 2013, we sold our thin film filter business and interleaver product line in exchange for a total purchase price of $27.0 million in cash. During the three and nine months ended March 30, 2013, we recorded an expense of $0.2 million and a gain of $25.0 million, respectively, related to this sale in the restructuring, acquisition and related costs in our condensed consolidated statement of operations. During the three months ended December 29, 2012, we recorded a gain of $25.0 million related to this sale. During the three months ended March 31, 2012, we recorded $1.2 million in employee separation costs related to previously announced restructuring plans and incurred $0.8 million in external consulting charges related to our optimization of past acquisitions. During the three months ended March 31, 2012, we also reviewed the fair value of certain remaining earnout obligations arising from the acquisition of Mintera Corporation (Mintera) and determined that the fair value of these earnouts increased by $0.7 million based on revised estimates of revenues from Mintera products. This $0.7 million increase in fair value was recorded as an increase in restructuring, acquisition and related expenses for the three months ended March 31, 2012. During the nine months ended March 31, 2012, we recorded $2.3 million in employee separation costs related to previously announced restructuring plans and incurred $3.9 million in external consulting charges related to our optimization of past acquisitions. During the nine months ended March 31, 2012, we also reviewed the fair value of certain remaining earnout obligations arising from the acquisition of Mintera and determined that the fair value of these earnouts decreased by $2.2 million based on revised estimates of revenues from Mintera products. This $2.2 million decrease in fair value was recorded as a decrease in restructuring, acquisition and related expenses for the nine months ended March 31, 2012. 38 -------------------------------------------------------------------------------- Table of Contents Flood-related (Income) Expense, Net In October 2011, certain areas in Thailand suffered major flooding as a result of monsoons. This flooding had a material and adverse impact on our business and results of operations. Our primary contract manufacturer, Fabrinet, suspended operations at two factories located in Chokchai, Thailand and Pinehurst, Thailand. The Chokchai factory suffered extensive flood damage and became inaccessible due to high water levels inside and surrounding the manufacturing facility. As a result of this flooding, we experienced a significant decline in products sales due to our inability or limited ability to manufacture certain Oclaro products and we incurred significant damage to our inventory and property and equipment located at the Chokchai facility. During the three and nine months ended March 30, 2013, we recorded flood-related benefits of $11.5 million and $10.6 million, respectively, related to advance payments from our insurers, offset in part by professional fees and related expenses incurred in connection with our recovery efforts. In March 2013, we received an $11.8 million advance payment from one of our insurers relating to losses we incurred due to the flooding in Thailand. This payment is a general advance from our insurer against all Thailand flood-related claims and was not specifically identified as reimbursement for any particular loss or claim. As there were no contingencies associated with this payment, we recorded this advance payment within flood-related (income) expense, net in our condensed consolidated statements of operations for the three and nine months ended March 30, 2013. During the three months ended December 29, 2012, we recorded flood-related charges of $0.6 million, related to professional fees and related expenses incurred in connection with our recovery efforts. During the three months ended March 31, 2012, we recorded flood-related charges of $2.5 million related to personnel costs, professional fees and related expenses incurred in connection with our recovery efforts, and $0.6 million in impairment charges related to the write-off of the net book value of property and equipment based on estimates of the damage caused by the flooding. During the nine months ended March 31, 2012, we recorded flood-related charges of $4.3 million related to personnel costs, professional fees and related expenses incurred in connection with our recovery efforts, $4.2 million in impairment charges related to the write-off of the net book value of damaged inventory and $3.7 million related to the write-off of the net book value of property and equipment based on estimates of the damage caused by the flooding. These charges are recorded within the operating expense caption flood-related (income) expense, net, in our condensed consolidated statement of operations for the three and nine months ended March 31, 2012. On February 2, 2012, we also received a $6.4 million advance payment from one of our insurers relating to losses we incurred due to the flooding in Thailand. This payment is a general advance from our insurer against all Thailand flood-related claims and was not specifically identified as reimbursement for any particular loss or claim. As there were no contingencies associated with this payment, we recorded this advance payment within flood-related (income) expense, net in our condensed consolidated statements of operations for the three and nine months ended March 31, 2012. Other Income (Expense) Other income (expense) decreased to $12.2 million in expense for the three months ended March 30, 2013 as compared to $4.1 million in expense for the three months ended December 29, 2012 and $0.6 million in expense for the three months ended March 31, 2012. This decrease was primarily due to recording a $7.4 million loss on foreign currency translation during the three months ended March 30, 2013, as compared to recording a $3.4 million loss on foreign currency translation during the three months ended December 29, 2012 and a $0.3 million loss on foreign currency translation during the three months ended March 31, 2012. The foreign currency loss in the current quarter is predominantly a result of revaluing intercompany receivables denominated in Japanese yen. The decrease was also due to recording a $1.1 million interest expense, primarily related to interest on the Convertible Notes which were issued in the second quarter of fiscal 2013 and a $3.6 million impairment charge related to the revaluation of an investment. Other income (expense) increased to $11.3 million in income for the nine months ended March 30, 2013 from $4.0 million in income for the nine months ended March 31, 2012. This increase was primarily due to recording a $27.9 million gain on bargain purchase in connection with our acquisition of Opnext in the first quarter of fiscal year 2013, partially offset by recording a $10.6 million loss on foreign currency translation during the nine months ended March 30, 2013, as compared to recording a $2.4 million gain on foreign currency translation during the nine months ended March 31, 2012. The increase was also partially offset by recording a $2.2 million interest expense, primarily related to interest on the credit facility and the Convertible Notes which were issued in the second quarter of fiscal 2013 and a $3.6 million impairment charge related to the revaluation of an investment. 39-------------------------------------------------------------------------------- Table of Contents Income Tax Provision For the three and nine months ended March 30, 2013 and for the three months ended December 29, 2012, our income tax provisions of $0.4 million, $3.0 million and $1.4 million, respectively, primarily related to our foreign operations. For the three and nine months ended March 31, 2012, our income tax provisions of $0.7 million and $6.8 million, respectively, primarily related to our foreign operations. Included in our tax provision for the nine months ended March 31, 2012, is a $4.1 million charge due to the impairment of certain net operating loss carryforwards in Switzerland. RECENT ACCOUNTING STANDARDS See Note 2, Recent Accounting Standards, to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for information regarding the effect of new accounting pronouncements on our condensed consolidated financial statements. APPLICATION OF CRITICAL ACCOUNTING POLICIES The discussion and analysis of our financial condition and results of operations is based on our condensed consolidated financial statements contained elsewhere in this Quarterly Report on Form 10-Q, which have been prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP). The preparation of our financial statements requires us to make estimates and judgments that affect our reported assets and liabilities, revenues and expenses and other financial information. Actual results may differ significantly from those based on our estimates and judgments or could be materially different if we used different assumptions, estimates or conditions. In addition, our financial condition and results of operations could vary due to a change in the application of a particular accounting policy. We identified our critical accounting policies in our Annual Report on Form 10-K for the year ended June 30, 2012 (2012 Form 10-K) related to revenue recognition and sales returns, inventory valuation, business combinations, insurance recoveries, impairment of goodwill and other intangible assets, accounting for stock-based compensation and income taxes. It is important that the discussion of our operating results be read in conjunction with the critical accounting policies discussed in our 2012 Form 10-K. LIQUIDITY AND CAPITAL RESOURCES Cash Flows from Operating Activities Net cash used by operating activities for the nine months ended March 30, 2013 was $91.7 million, primarily resulting from a net loss of $73.0 million, non-cash adjustments of $12.1 million and a $6.6 million decrease in cash due to changes in operating assets and liabilities. The $6.6 million decrease in cash due to changes in operating assets and liabilities was comprised of a $18.9 million decrease in accounts payable, a $9.9 million increase in prepaid expenses and other current assets, a $7.1 million decrease in accrued expenses and other liabilities, partially offset by a $28.2 million decrease in accounts receivable and a $1.2 million decrease in inventories. The $12.1 million decrease in cash resulting from non-cash adjustments primarily consisted of a decrease of $27.9 million for the bargain purchase gain related to the acquisition of Opnext, a decrease of $24.8 million related to the gain on the sale of the thin film filter business and interleaver product line and $1.5 million from the amortization of deferred gain from sales-leaseback transactions, partially offset by $32.1 million in depreciation and amortization, $5.4 million of expense related to stock-based compensation, $3.6 million related to an impairment charge on an investment and $0.9 million related to the impairment of certain intangibles. Net cash used by operating activities for the nine months ended March 31, 2012 was $23.9 million, primarily resulting from a net loss of $62.6 million, partially offset by $22.5 million of non-cash adjustments and a $16.2 million increase in cash due to changes in operating assets and liabilities. The $22.5 million of non-cash adjustments was primarily comprised of $16.6 million of expense related to depreciation and amortization, $7.9 million of expense related to our non-cash flood-related impairments and $4.9 million of expense related to stock-based compensation, partially offset by $2.2 million due to the revaluation of the Mintera earnout liability, $2.2 million gain on the sale of an investment, $1.9 million gain from the sale of certain assets related to a legacy product and $0.7 million from the amortization of deferred gain from a sales-leaseback transaction. The $16.2 million increase in cash due to changes in operating assets and liabilities was primarily comprised of a $21.4 million decrease in accounts receivable, a $9.7 million decrease in inventory, a $1.3 million increase in accrued expenses and other liabilities, a $0.8 million decrease in prepaid expenses and other current assets, partially offset by a $17.0 million decrease in accounts payable and a $0.1 million increase in other non-current assets. 40 -------------------------------------------------------------------------------- Table of Contents Cash Flows from Investing Activities Net cash provided by investing activities for the nine months ended March 30, 2013 was $52.6 million, primarily consisting of $36.1 million cash acquired in the acquisition of Opnext, $26.0 million in proceeds from the sale of the thin film filter business and interleaver product line, and $3.7 million reduction in restricted cash, partially offset by $13.2 million used in capital expenditures. Net cash used in investing activities for the nine months ended March 31, 2012 was $9.6 million, primarily consisting of $15.9 million used in capital expenditures, partially offset by $3.4 million in proceeds from the sale of an investment and $2.9 million in proceeds from the sale of certain assets related to a legacy product. Cash Flows from Financing Activities Net cash provided by financing activities for the nine months ended March 30, 2013 was $24.5 million, primarily consisting of $22.8 million in proceeds from the sale of convertible notes, $15.3 million in borrowings under our revolving credit facility and $1.7 million received from the issuance of common stock through stock option exercises and our employee stock purchase plan, partially offset by $8.6 million in payments in connection with the remaining earnout obligations related to our acquisition of Mintera, $5.5 million in payments on capital lease obligations and $1.1 million repayments on a note payable and revolving credit facility. Net cash provided by financing activities of $25.6 million for the nine months ended March 31, 2012 primarily consisted of $25.5 million in borrowings under our revolving credit facility and $0.1 million in proceeds from the issuance of common stock through stock option exercises. Effect of Exchange Rates on Cash and Cash Equivalents for the Nine months Ended March 30, 2013 and March 31, 2012 The effect of exchange rates on cash and cash equivalents for the nine months ended March 30, 2013 was an increase of $12.5 million, primarily consisting of $3.5 million in net gain due to the revaluation of foreign currency cash balances to the functional currency of the respective subsidiaries and from gains of approximately $4.6 million related to the revaluation of U.S. dollar denominated operating intercompany payables and receivables of our foreign subsidiaries. The effect of exchange rates on cash and cash equivalents for the nine months ended March 31, 2012 was a decrease of $4.3 million, primarily consisting of $0.6 million loss due to the revaluation of foreign currency cash balances to the functional currency of the respective subsidiaries and from a loss of approximately $3.7 million related to the revaluation of U.S. dollar denominated operating intercompany payables and receivables of our foreign subsidiaries. Credit Line and Notes As of March 30, 2013, we had an $80.0 million senior secured revolving credit facility with Wells Fargo Capital Finance, Inc. and other lenders (the Credit Agreement) with an expiration date of November 2, 2017. See Note 7, Credit Line and Notes, for additional information regarding this credit facility. As of March 30, 2013 and June 30, 2012, there was $40.0 million and $25.5 million, respectively, outstanding under the Credit Agreement and we were in compliance with all covenants. At March 30, 2013 and June 30, 2012, there were $30,000 and $0.1 million, respectively, in outstanding standby letters of credit secured under the Credit Agreement. These letters of credit expire at various intervals through June 2015. 41 -------------------------------------------------------------------------------- Table of Contents On May 6, 2013, Parent, Borrower, the Lenders, the Agent and PECM Strategic Funding LP and Providence TMT Debt Opportunity Fund II LP (the "Term Lenders") entered into Amendment Number Two to the Credit Agreement and the associated guaranties and security agreements (the "Amendment"), which amended the Credit Agreement in pertinent part by: (i) adding a $25 million term loan (the "Term Loan") to be provided by the Term Lenders; (ii) reducing the revolving credit facility from $80 million to $50 million (to be further reduced on a dollar-for-dollar basis by an amount equal to the net proceeds of certain asset sale transactions that the Parent may undertake in the future), eliminating the Borrower's option to increase the revolving credit facility to $100 million and implementing an availability block under the revolving credit facility of at least $10 million; (iii) removing the financial covenants so that Borrower is not required to maintain a minimum of $15 million of availability under the revolving credit facility or $15 million in qualified cash balances; (iv) adding an affirmative covenant that Borrower shall have consummated one or more asset sales in the very near term and with a minimum threshold of net proceeds as set forth in the Amendment, and (v) providing for payments and proceeds of asset sales to be applied to repay the credit facility and the Term Loan (with the first $20.0 million of such proceeds being applied to repay Wells Fargo Capital Finance, Inc. and Silicon Valley Bank and the next $25.0 being applied to repay Providence and the remaining proceeds being used to repay Wells Fargo Capital Finance, Inc. and Silicon Valley Bank all amounts outstanding under the credit facility), and events of default relating thereto. If any event of default were to occur, including a failure to comply with the covenant regarding asset sales described above, such an event of default would (unless waived by the Lenders) entitle the Lenders, upon notice to the Borrower and the Parent, to declare the Term Loan and all other amounts owing under the Credit Agreement, immediately due and payable. The Term Loan is payable in full on May 5, 2014. There are no amortization payments, but the Term Loan must be repaid with the proceeds of certain asset sale transactions as described above. In connection with the Amendment, and as further consideration for the Term Lenders providing the term loan, Parent issued the Term Lenders, or an affiliate thereof, warrants (the "Warrants") to purchase shares of the Parent's common stock, par value $0.01 per share (the "Common Stock"). The holders of the Warrants are entitled to exercise the Warrants for 1,836,000 shares of Common Stock at an exercise price equal to $1.50 per share (as adjusted from time to time, as provided in the Warrant Certificate representing the Warrants) for a period of one (1) year starting on the date of issuance. The Borrower paid the revolving lenders an amendment fee of $500,000 and the Term Lenders a closing fee of $2,125,000. Borrower may only prepay the principal amount of the Term Loan, in whole or in part, with the prior written consent of the Required Lenders (as defined in the Amendment). Any prepayments made on the Term Loan obligations after six months following the effective date of the term loan will be at 105% of the related obligations. Interest on the Term Loan obligations accrues at a per annum rate equal to the sum of: (A) the PIK Term Loan Interest Rate, with such accrued interest to be capitalized quarterly and added to the outstanding principal balance of the Term Loan, and (B) the Cash Term Loan Interest Rate. The PIK Term Loan Interest Rate is 2.0% beginning on the effective date of the Term Loan (the "Effective Date") up to but excluding the date six months thereafter, then it is 4.0% until the date twelve months after the Effective Date and then it is 5.0%. The Cash Term Loan Interest Rate is 7.0% beginning on the Effective Date up to but excluding the date six months thereafter, then it is 8.5% until the date twelve months after the Effective Date and then it is 10.0%. No changes were made to the interest rates or commitment fees payable under the revolving credit facility. The obligations of the Borrower under the Credit Agreement are guaranteed by the Parent and all significant subsidiaries of the Parent and the Borrower (collectively, the "Guarantors"), and are secured, pursuant to two security agreements by substantially all of the assets of the Borrower and the Guarantors, including a pledge of the capital stock holdings of the Borrower and certain Guarantors in their direct subsidiaries. Borrowings made under the Credit Agreement are subject to the terms and conditions of the Credit Agreement, as described in the Current Reports on Form 8-K filed by Parent with the Securities and Exchange Commission on November 5, 2012 and January 29, 2013, as such terms and conditions have been amended by the Amendment. In connection with the acquisition of Opnext, we assumed a 1.5 billion Japanese yen note payable to The Sumitomo Trust Bank (Sumitomo). The note is due monthly unless renewed by Sumitomo. As of March 30, 2013, the outstanding loan balance was $15.6 million, based on the exchange rate on March 30, 2013. Interest is paid monthly at the Tokyo Interbank Offered Rate plus a premium, which for our nine months ended March 30, 2013, was 1.7 percent per annum. As of March 30, 2013, we have $15.6 million in restricted cash in our condensed consolidated balance sheet related to our note payable to Sumitomo. 42-------------------------------------------------------------------------------- Table of Contents On December 14, 2012, we closed a private placement of $25.0 million aggregate principal amount 7.50% Exchangeable Senior Secured Second Lien Notes due 2018 (Convertible Notes). The sale of the Convertible Notes resulted in net proceeds of approximately $22.8 million. As of March 30, 2013, the net carrying value of the liability component was $23.7 million, the unamortized value of the debt discount was $1.2 million and the estimated fair value of the contingent obligation for the make-whole premium was valued at $0.1 million. Interest on the Convertible Notes is payable semi-annually in arrears on June 15 and December 15 of each year, beginning on June 15, 2013. During the three and nine months ended March 30, 2013, we recorded $0.5 million and $0.6 million, respectively, in interest expense related to these Convertible Notes. See Note 7, Credit Line and Notes, for additional information regarding the Convertible Notes. Future Cash Requirements We have experienced lower than expected year-to-date sales volume and our near-term liquidity has been negatively impacted, which will require us to secure additional sources of cash in order to continue to operate our business effectively. We have incurred operating losses and generated negative cash flows for the fiscal year. As of March 30, 2013, we held $80.5 million in cash and short-term investments, comprised of $59.6 million in cash and cash equivalents, $16.9 million in restricted cash and $4.0 million of short-term investments; and we had working capital of $124.4 million. Given the reduction in sales, delays in production of new programs, the continuing costs of our previously announced restructuring activities and a soft macroeconomic commercial situation, we anticipate that our net loss for the fourth quarter will be equal to, or possibly greater than, our net loss for the third quarter, further reducing the amount of cash available to us to fund our continued operations. As a result, we will be required to secure additional sources of cash sooner than we had previously expected (and likely by the end of the first quarter of fiscal 2014) in order to fund our continued operations. On May 7, 2013 we secured one such additional source of cash, a short term bridge loan from Providence Equity of $25 million (with net proceeds to us of $20.5 million after discounts and expenses). In order to obtain this loan, we amended our Credit Agreement to add Providence as a term lender under that agreement. In connection with this amendment, we agreed to complete certain asset sales and use the proceeds to repay amounts we have borrowed under the Credit Agreement in the very near term. We are actively pursuing potential asset sales with multiple potential parties, but we can make no assurances that we will be successful concluding the assets sales we have agreed to complete, that we will be able to repay the amounts we have borrowed under the Credit Agreement as required and that we will be able to obtain sufficient additional cash to operate our business over the next twelve months. If we fail to raise the additional cash required, through asset sales or from other sources, we may not be able to continue as a going concern. For additional information on the risks we face related to future cash requirements, see Item 1A. Risk Factors under "- Risks Related to Our Business - We have a history of large operating losses and we may not be able to achieve profitability in the future and maintain sufficient levels of liquidity." In addition to our current cash balances, net proceeds of $20.5 million received from Providence Equity on May 7, 2013 under our Credit Agreement (as amended and restated on May 6, 2013), other amounts expected to be available under our Credit Agreement, which are based on a percentage of eligible accounts receivable (as defined in the Credit Agreement), and amounts anticipated to be received pursuant to our Equipment and Inventory Purchase Agreement with Venture Corporation Ltd, we also expect to receive additional payments for flood-related claims, although the parties have not yet agreed to pay these claims and we are unable to predict the amount that we may ultimately receive for these claims or when or if we will receive any such payments. We are also developing plans to restructure our operations to a lower operating income break-even level. 43-------------------------------------------------------------------------------- Table of Contents In the event that any of the sources of liquidity described in the preceding paragraphs are for any reason, not available in a timely manner or in the event that we need additional liquidity beyond our current expectations, such as to fund future growth or strengthen our balance sheet or to fund the cost of restructuring activities we may find necessary to lower our operating income break-even level, we will continue to explore other sources of additional liquidity. These additional sources of liquidity could include one, or a combination, of the following: (i) issuing equity securities, (ii) incurring indebtedness secured by our assets, (iii) issuing debt and/or convertible debt securities, or (iv) selling product lines, other assets and/or portions of our business. There can be no guarantee that we will be able to raise additional funds on terms acceptable to us, or at all. Off-Balance Sheet Arrangements We indemnify our directors and certain employees as permitted by law, and have entered into indemnification agreements with our directors and executive officers. We have not recorded a liability associated with these indemnification arrangements, as we historically have not incurred any material costs associated with such indemnification obligations. Costs associated with such indemnification obligations may be mitigated by insurance coverage that we maintain, however, such insurance may not cover any, or may cover only a portion of, the amounts we may be required to pay. In addition, we may not be able to maintain such insurance coverage in the future. We also have indemnification clauses in various contracts that we enter into in the normal course of business, such as indemnification in favor of customers in respect of liabilities they may incur as a result of purchasing our products should such products infringe the intellectual property rights of a third party. We have not historically paid out any material amounts related to these indemnifications; therefore, no accrual has been made for these indemnifications. Other than as set forth above, we are not currently party to any material off-balance sheet arrangements. |