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STEC, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement Certain statements in this Quarterly Report on Form 10-Q are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. These forward-looking statements often can be, but are not always, identified by the use of words such as "anticipate," "assume," "believe," "continue," "could," "estimate," "expect," "goal," "intend," "may," "might," "ongoing," "plan," "potential," "predict," "project," "seeks," "should," "will," "would," and similar expressions, variations or the negative of such expressions. They include, but are not limited to: statements regarding the proposed merger with Western Digital Corporation ("WDC"), our revenue growth initiatives; growing acceptance, adoption and qualification of solid-state drives ("SSDs") within the enterprise-storage and enterprise-server markets; the evolving storage industry; changes in the average selling prices of our products; the impact of a loss of, or reduction in sales to, any of our key customers; sales to a limited number of customers continue to account for a majority of our revenues for the foreseeable future; our ability to deliver new and enhanced products on a timely basis; our ability to enter into new markets; statements concerning customer adoption and utilization of our technologies and solutions; the benefits, capabilities, performance, cost-savings and energy efficiencies of our products, solutions and other developing technologies; the adoption of our products into new applications and markets; our sales, operating results and anticipated cash flows; our ability to forecast customer demand; the seasonality of our business; the availability of certain components in our products that we obtain from a limited number of suppliers; competition from other companies in our industry; the impact of ongoing litigation against us or our directors and executive officers; our ability to attract and retain key employees; changes in political and economic conditions and local regulations, particularly outside of the United States; our ability to protect our intellectual property rights; and fluctuations in foreign currency exchange rates. We base these forward-looking statements on our current expectations and projections about future events, our assumptions regarding these events and our knowledge of facts at the time the statements are made. These forward-looking statements are subject to various risks and uncertainties, including those described in this Quarterly Report on Form 10-Q under the heading "Risk Factors" and in other filings we make from time to time with the U.S. Securities and Exchange Commission ("SEC"). Some of these risks and uncertainties may be outside our control and our actual results could differ materially from our projected results. Please see our most recent Annual Report on Form 10-K and the information contained in our subsequent SEC filings for a further discussion of these and other risks and uncertainties applicable to our business. We are not able to predict all of the factors that may affect future results. Forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q. Except as required by applicable laws or regulations, we do not undertake any obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q. Overview sTec, Inc. (collectively with our subsidiaries, is referred to in this Quarterly Report on Form 10-Q as "sTec", "we", "our" and "us") is a leading global provider of enterprise-class SSDs that are designed specifically for systems and applications that require high input and output ("IO") capabilities with low latencies for fast access to critical user data. We design and develop SSD solutions for our customers in a full range of industries and applications. We also design and develop SSD controllers, enhance them with proprietary firmware and integrate them with NAND flash media to manufacture high-performance SSDs, which provide a level of IO performance not currently possible with traditional hard disk drives ("HDDs"). We market our products to original equipment manufacturers ("OEMs"), OEM distributors, value added resellers, enterprises, and end user customers, leveraging our custom design capabilities to offer storage and server solutions to address their specific needs. Our SSDs are incorporated into products used in a variety of industries including cloud computing, defense, e-commerce, financial services, government, health care, transportation, virtualization and Web 2.0. We also manufacture small form factor Flash-based SSDs, cards and modules, as well as custom high-density dynamic random access memory ("DRAM") modules for networking, communications and embedded industrial applications. In addition, we are continuing to invest in research and development and complementary new technologies that will help us solve our customers' most complex storage and server issues. This means that we are working to develop solutions that will ultimately help our customers to accelerate applications, retrieve data faster and run more efficiently. We are headquartered in Santa Ana, California and have operations in Penang, Malaysia. We also have sales and engineering offices located in the U.S., Europe and Asia, and a research design center in Pune, India. 16 -------------------------------------------------------------------------------- Our business plan focuses on certain revenue growth initiatives, including: • Continuing to develop and qualify customized high-performance, high-endurance SSDs, including our ZeusIOPS® product; • Expanding our product portfolio to include software offerings that strategically utilize our solid-state storage technology; • Adding Peripheral Component Interconnect Express ("PCIe") based SSD products to our portfolio that reside inside the server to enable the use of Flash storage closer to the system CPU and memory; and • Expanding new market opportunities that leverage our core SSD expertise by investing in our sales and marketing infrastructure to increase our channel presence and sales to enterprise and end user customers. Over the past several years, we have expanded our custom design capabilities of Flash-based products for OEM applications. We have invested significantly in the design and development of customized SSD controllers, firmware and hardware. Also, as recently announced, the Company has targeted new market segments through its new direct sales and global channel programs, in which it added channel partners and expanded the technical and market expertise of its direct sales force to extend its reach in the enterprise and key vertical markets. Strategic acquisitions have also enabled us to improve our SSD controller design capabilities, expand our product offerings, add intellectual property to our technology portfolio and enhance our capabilities to use third-party controllers. Recent Developments-Proposed Merger with Western Digital Corporation On June 23, 2013, we entered into an Agreement and Plan of Merger with Western Digital Corporation, a Delaware corporation ("WDC"), and Lodi Ventures, Inc., a California corporation and wholly-owned subsidiary. For further information see Note 2-"Merger Agreement with Western Digital Corporation" to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. The Merger Agreement provides that, upon the terms and subject to the conditions set forth in the Merger Agreement, Merger Sub will merge with and into the Company (the "Merger"), with the Company surviving the Merger as a wholly-owned subsidiary of WDC. At the effective time of the Merger (the "Effective Time"), each outstanding share of the Company's common stock, par value $0.001 per share ("Common Stock"), (other than shares (i) owned, directly or indirectly, by WDC or Merger Sub, (ii) held in the treasury of the Company, or (iii) held by any holder who has not voted in favor of the Merger and who has properly demanded that the Company purchase such shares in accordance with Chapter 13 of the California General Corporation Law) will convert into the right to receive $6.85 in cash, without interest. All vested and unvested Company stock options (other than unvested sTec stock options that have strike prices greater than $6.85 per share) will be assumed by WDC and converted into stock options to purchase WDC common stock. All unvested sTec stock options that have strike prices greater than $6.85 per share will not be assumed and will be cancelled. All Company restricted stock units will be assumed by WDC and converted into and become rights with respect to WDC common stock. Consummation of the Merger is subject to customary conditions, including approval of the Merger Agreement and the Merger by the our shareholders, the absence of any material adverse effect on our business, financial condition or results of operations and other customary closing conditions. Moreover, each party's obligation to consummate the Merger is subject to certain other conditions, including the accuracy of the other party's representations and warranties and compliance with its covenants and agreements contained in the Merger Agreement (in each case, subject to customary materiality qualifiers). Recent Litigation Developments Please see Part II, Item 1, "Legal Proceedings," and Note 8-"Commitments and Contingencies" to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q for a discussion about: • sTec's Stipulation and Agreement of Settlement (the "Settlement Agreement") to settle and resolve all the pending claims in the federal class action litigation, without any admission or concession of wrongdoing by sTec or the other defendants. • The SEC's Complaint filed against sTec's Founder on July 29, 2012. The legal costs of this litigation are indemnified by sTec and are expected to increase in the two quarters leading up to trial, which is currently expected to take place in November 2013. Under certain limited circumstances, Manouch Moshayedi may also be entitled to be indemnified pursuant to his indemnification agreement with the Company for a portion of any or all of the civil monetary penalties, disgorgement or other payments he may be obligated to pay in connection with such litigation. 17 -------------------------------------------------------------------------------- Operating Results Volatility We have experienced volatility in our quarterly operating results and we expect this trend to continue for several reasons, including the following: • The majority of our sales are currently being generated from one product line (ZeusIOPS®) and a significant amount of our revenues is concentrated within a small number of customers. A loss or reduction of sales to any one of our major customers or a decrease in demand for our ZeusIOPS® products could materially affect our business, financial condition, results of operations and cash flows. • The introduction of new and enhanced versions of our products may shorten the life cycle of our existing products, or replace sales of some of our current products, thereby offsetting the benefit of a successful product introduction, and may cause customers to defer purchasing our existing products in anticipation of the new and enhanced versions. Conversely, customers may accelerate purchases of existing products and defer purchases of new life cycle products due to the cost and lead times involved in the qualification of new products. For example, we believe that the primary reason for the decline in our sales in the second quarter of 2013 compared to the second quarter of 2012 has been our transition to the next-generation of our ZeusIOPS® and MACH16™ SSDs and gradual customer adoption of those products, in addition to increased competition, which has decreased our market share with certain customers. • Some customers may have the ability to change, cancel or delay orders with limited or no penalties. In the absence of a non-cancellable customer supply agreement, our ability to predict future sales is limited because a majority of our quarterly product revenues comes from orders that are received just prior to or within the same quarter. • Substantially all of our sales are transacted through individual customer purchase orders as opposed to long-term contractual commitments. Each customer purchase order is unique and stands on its own and there is no assurance that we will be able to obtain additional purchase orders under the same terms and dollar commitment levels with these customers in future quarters. As a result, it is difficult to forecast our customers' demand as purchases in one period may not be indicative of purchases in future periods. • The enterprise SSD market is still in its early stages, rapidly evolving and becoming increasingly competitive. Many of these competitors are large, conglomerate businesses with considerable resources. We are facing competition from SSD suppliers with lower-cost drives. These lower cost alternatives have been gaining traction, which has resulted in a decrease in our market share with certain customers. Furthermore, competitive Serial Attached Small Computer Interface System ("SAS") and/or Fibre Channel ("FC") based SSDs have been qualified at certain of our customers, which has led to a reduction in orders of our ZeusIOPS® SSDs. A significant reduction in our market share as a result of SSD competition could materially affect our business and result of operations. In order to differentiate ourselves and our products in the market, we have continued to invest in personnel and complementary new technologies that will help us solve our customers' most complex storage and server issues. Until we further diversify our customer base and product offerings, we believe that these factors as discussed above will continue to impact quarterly operating results volatility and our business for the foreseeable future. Flash-based Products and Technologies Flash-based product revenues were $21.4 million and $39.7 million in the second quarter of 2013 and 2012, respectively. The decrease in Flash-based product revenues in the second quarter of 2013 compared to the same period in 2012 was due primarily to a $17.0 million decrease in Flash-based product sales to two customers. Sales of Flash-based products represented 91% and 97% of our total revenues in the second quarter of 2013 and 2012, respectively. A significant development in enterprise SSDs is the use of Multi Level Cell ("MLC") Flash, which is more cost-effective than Single Level Cell ("SLC") Flash. Incorporating MLC Flash into SSDs is increasingly important within the enterprise market given the growing need for cost-effective, high-performance enterprise solutions. Our MLC-based SSDs are enhanced by our proprietary technologies, including our CellCare™ technology, which increases endurance of MLC Flash to meet enterprise life requirement levels and our Secure Array of Flash Elements™ (S.A.F.E.) technology, which provides added data reliability. Our MLC-based SSDs also use our proprietary SSD ASIC controller technology to achieve fast write speeds and improved performance over the entire life of the drive. A major area of our overall research and development investment has been applied to developing and advancing our SSD technologies. We believe the advantages of SSDs are currently being defined in several distinct markets including: a) enterprise-storage applications, b) enterprise-server applications, c) data center and cloud computing environments, and d) government and defense applications. We see opportunities to leverage our SSD expertise across each of these markets where we believe our technology can outperform existing HDD solutions. 18 -------------------------------------------------------------------------------- From time to time, we may make strategic investments in order to promote our business and strategic objectives. In December 2012, we acquired a minority ownership interest in a privately held company specializing in software designed storage for approximately $5.0 million. We believe this investment will further our efforts to gain access to additional customers and leverage the benefits of our respective technologies to solve customer needs. Although the enterprise Flash-based SSD market is still in its early stages, evolving and difficult to predict, we are encouraged by the variety of applications that our SSDs are able to support. The use of data-tiering software by storage OEMs is also helping to increase the use of SSDs by enhancing the overall performance level of enterprise-storage systems. In addition, the introduction of all flash arrays by both leading and emerging storage OEMs is increasing the use of flash in the enterprise. At the same time, the availability of caching software, when coupled with SSDs, is beginning to drive greater adoption in the server space. Also, we employ certain marketing programs and sales initiatives on a selective basis with our customers in an effort to advance our SSD products. As more customers and end-users experience the benefits of SSD technology, we believe the marketplace will continue to expand. Customers Historically, a limited number of customers has accounted for a significant percentage of our revenues. Our ten largest customers accounted for an aggregate of 78% of our revenues during the second quarter of 2013, compared to 85% of our revenues during the second quarter of 2012. See Note 3, Sales Concentration, to our unaudited condensed consolidated financial statements for a breakdown of customers accounting for more than 10% of our total revenues during the three and six months ended June 30, 2013 and 2012, respectively. With certain exceptions, sales of our products are generally made through individual purchase orders and, in certain cases, under master agreements governing the terms and conditions of the customer relationships. We expect that sales of our products to a limited number of customers will continue to account for a majority of our revenues in the foreseeable future and believe that our financial results will depend in part upon the success of our customers. The composition of our major customer base changes from quarter to quarter as the market demand for our products changes and we expect this variability will continue in the future. The loss of, or a significant reduction in purchases by, any of our major customers would harm our business, financial condition and results of operations. See Part II, Item 1A, "Risk Factors- Historically, sales to a limited number of customers have comprised a significant portion of our revenues and the loss of, or significant reduction in purchases by, any key customer would harm our financial results." Revenues by Geographic Region Sales, which are derived from billings to customers, by geographic region are presented as a percentage of total revenues as follows: Three Months Ended June 30, Six Months Ended June 30, 2013 2012 2013 2012 United States 64 % 51 % 62 % 44 % Singapore * 22 % * 32 % Czech Republic * 11 % * * Other* 36 % 16 % 38 % 24 % Total 100 % 100 % 100 % 100 % * Less than 10% by geographic region Sales billed to customers in the United States as a percentage of total sales increased in the second quarter of 2013 compared to the second quarter of 2012 and in the first six months of 2013 compared to the first six months of 2012 due primarily to a decrease in product sales made to international customers, partially offset by a decrease in product sales to a single customer in the United States. Sales billed to customers in Singapore as a percentage of total sales decreased in the second quarter of 2013 compared to the second quarter of 2012 and in the first six months of 2013 compared to the first six months of 2012 due primarily to a decrease in product sales to two customers. Sales billed to customers in the Czech Republic as a percentage of total sales decreased in the second quarter of 2013 compared to the second quarter of 2012 due primarily to a decrease in product sales to a single customer. Increased competition in the market and a delay in introducing our next-generation of products have decreased our market share with certain international customers. Substantially all of our foreign sales are shipped internationally through our facility in Malaysia. For additional information regarding our international sales, see Part II, Item 1A, "Risk Factors-We face risks associated with doing business in foreign countries, including foreign currency fluctuations and trade barriers, that could lead to a decrease in demand for our products or an increase in the cost of the components used in our products." 19-------------------------------------------------------------------------------- Malaysia Income Tax Holiday As an incentive to establish operations in Malaysia, the Malaysian government provided us with a tax holiday and certain grants that are subject to meeting certain conditions and is effective through September 29, 2027. The impact of the Malaysia income tax holiday on our provision for income taxes and earnings per share is as follows (in thousands, except per share amounts): For the Three Months Ended June 30, For the Six Months Ended June 30, 2013 2012 2013 2012 Decrease in provision for income taxes $ 618 $ 1,140 $ 1,170 $ 2,100 Benefit of income tax holiday on earnings per share $ 0.01 $ 0.03 $ 0.02 $ 0.05 Seasonality We generally expect to experience some seasonality in our business resulting in lower sales in the first quarter and higher sales in the fourth quarter of each year due to corporate customers seeking to spend their full capital budgets before the end of each year. Due to the volatility of our business and concentration of our customers, seasonality may not always be a determining factor for our results of operations. For example, during the fourth quarter of 2012, we did not experience a seasonal increase in sales. We believe the decline in sales in the fourth quarter of 2012 was due primarily to increased competition and a delay in introducing our next-generation of products to market, rather than seasonality. Results of Operations The following table sets forth, for the periods indicated, certain consolidated statement of operations data reflected as a percentage of revenues. Three Months Ended June 30, Six Months Ended June 30, 2013 2012 2013 2012 Net revenues 100.0 % 100.0 % 100.0 % 100.0 % Cost of revenues 72.0 63.4 72.6 63.8 Gross profit 28.0 36.6 27.4 36.2 Operating expenses: Sales and marketing 31.6 16.9 30.7 14.9 General and administrative 68.6 32.7 62.0 24.7 Research and development 57.8 42.9 57.6 36.8 Total operating expenses 158.0 92.5 150.3 76.4 Operating loss (130.0 ) (55.9 ) (122.9 ) (40.2 ) Other (loss) income, net (0.1 ) (35.3 ) 0.0 (15.5 ) Loss from operations before income taxes (130.1 ) (91.2 ) (122.9 ) (55.7 ) Comparison of Three Months Ended June 30, 2013 to Three Months Ended June 30, 2012 Net Revenues. Our revenues decreased 42% from $40.7 million in the second quarter of 2012 to $23.5 million in the second quarter of 2013 due primarily to an $18.3 million, or 46%, decrease in Flash-based product sales, which primarily is a result of a decrease in sales to two customers and a delay in the introduction of our next-generation products and increased competition. Within Flash-based product sales, shipments of our ZeusIOPS® SSDs into the enterprise market decreased 56% from $32.2 million in the second quarter of 2012 to $14.2 million in the second quarter of 2013. Our reported revenues are net of allowances for price protection, sales returns and sales and marketing incentives. With certain exceptions, sales of our products are generally made through individual purchase orders and, in certain cases, are made under master agreements governing the terms and conditions of the customer relationships. Some customers may have the ability to change, cancel or delay orders with limited or no penalties. In the absence of a non-cancellable customer supply agreement, our ability to predict future sales is limited because a majority of our quarterly product revenues comes from orders that are received just prior to or within the same quarter. Gross Profit. Our gross profit was $6.6 million in the second quarter of 2013, compared to $14.9 million in the same period in 2012. Gross profit as a percentage of revenues was 28.0% in the second quarter of 2013, compared to 36.6% in the second quarter of 2012. The decrease in gross profit in absolute dollars was due primarily to a decrease in sales of Flash-based 20 -------------------------------------------------------------------------------- products. The decrease in gross profit as a percentage of revenue was due primarily to the decrease in revenues as discussed above, an increase in fixed production overhead and labor costs as a percentage of total revenues, and a decrease in the average selling price of certain SSD products, partially offset by a decrease in Flash component costs. Sales and Marketing. Sales and marketing expenses are comprised primarily of payroll and payroll-related expenses for our domestic and international sales and marketing employees, marketing and advertising related expenses, and expenses for trade shows. Sales and marketing expenses increased 7% from $6.9 million in the second quarter of 2012 to $7.4 million in the second quarter of 2013. Sales and marketing expenses as a percentage of revenues increased from 16.9% in the second quarter of 2012 to 31.6% in the second quarter of 2013. The increase in sales and marketing expenses in absolute dollars was due primarily to a $955,000 increase in payroll and payroll-related costs due to an increase in marketing employee headcount from 26 as of June 30, 2012 to 45 as of June 30, 2013, partially offset by a $440,000 decrease in sales commissions due to lower revenue. The increase in sales and marketing expenses as a percentage of revenues was due primarily to the fixed nature of sales and marketing costs such as certain payroll and payroll-related expenses, excluding sales commissions, and the decrease in revenues. General and Administrative. General and administrative expenses are comprised primarily of payroll and payroll-related expenses for our executive and administrative employees, professional fees and facilities overhead. General and administrative expenses increased 21% from $13.3 million in the second quarter of 2012 to $16.1 million in the second quarter of 2013. General and administrative expenses as a percentage of revenues increased from 32.7% in the second quarter of 2012 to 68.6% in the second quarter of 2013. The increase in general and administrative expenses in absolute dollars and as a percentage of revenues was primarily due to a $1.3 million increase in litigation costs related primarily to SEC litigation matters and $1.2 million of costs related to the proposed merger with WDC. The increase in general and administrative expenses as a percentage of revenues was also due to the fixed nature of certain general and administrative costs and the decrease in revenues. Research and Development. Research and development expenses are comprised primarily of payroll and payroll-related expenses for our engineering staff, product design costs, consulting fees and material costs related to new product development. Research and development expenses decreased 23% from $17.5 million in the second quarter of 2012 to $13.5 million in the second quarter of 2013. Research and development expenses as a percentage of revenues increased from 42.9% in the second quarter of 2012 to 57.8% in the second quarter of 2013. The decrease in research and development expenses in absolute dollars was due primarily to a $2.1 million decrease in payroll and payroll-related costs primarily due to a decrease in research and development employee headcount from 396 as of June 30, 2012 to 332 as of June 30, 2013, and a $1.9 million decrease in new product development expenses. The increase in research and development expenses as a percentage of revenues was due primarily to the fixed nature of certain research and development costs such as payroll and payroll-related expenses and the decrease in revenues. Other expense, net.Other expense, net was $26,000 in the second quarter of 2013 and was mainly comprised of losses on foreign currency remeasurements, partially offset by interest income and Malaysian government grant income. Other expense, net was $14.3 million in the second quarter of 2012, and was mainly comprised of $15.0 million of expenses to settle our class action litigation, partially offset by $785,000 of government grant income received from the Malaysian government authority for qualified expenses. (Benefit)provision for Income Taxes. We recorded a benefit for income taxes of $121,000 in the second quarter of 2013 and provision for income taxes of $12.5 million in the second quarter of 2012, respectively. Our effective tax rate was a 0.4% benefit in the second quarter of 2013 and a 33.6% provision in the second quarter of 2012. Our effective tax rate each quarter will differ from that of previous quarters due to various factors, such as tax legislation, the results of tax audits, the effectiveness of our tax-planning strategies, discrete items, the effect from changes to the valuation allowance and the mix of domestic and foreign earnings. The change in our effective tax rate for the second quarter of 2013 from the same period in 2012 was due primarily to the establishment of full non-cash valuation allowance against all of our net U.S. deferred tax assets during the second quarter of 2012. We operate under an income tax holiday in Malaysia, which is effective through September 29, 2027 subject to meeting certain conditions. The impact of the Malaysia income tax holiday decreased our provision for income taxes by $618,000 and $1.1 million in the second quarter of 2013 and 2012, respectively. The benefit of the income tax holiday on earnings per share was $0.01 and $0.03 in the second quarter of 2013 and 2012, respectively. We have not provided for U.S. taxes or foreign withholding taxes on approximately $66.6 million of undistributed earnings from our foreign subsidiaries because such earnings are expected to be reinvested for the foreseeable outside of the U.S. Determination of the amount of unrecognized deferred tax liability for temporary differences related to these undistributed earnings is not practicable; however, if a majority of these earnings were distributed, we have sufficient U.S. net operating loss carryforwards, tax credit carryforwards, and additional tax deductions to offset the amount of resulting taxable income such that we would not be subject to recording significant incremental income tax expense. 21 -------------------------------------------------------------------------------- Each quarter, we exercise significant judgment when assessing our deferred tax asset to determine whether all or any portion of the asset is more likely than not unrealizable under ASC 740. We are required to establish or maintain a valuation allowance against any portion of the asset we conclude is more likely than not to be unrealizable. In assessing whether a valuation allowance is required or whether an existing valuation allowance should be maintained or reversed, significant weight is given to evidence that can be objectively verified. In accordance with ASC 740, we considered key positive and negative evidence using a "more likely than not" realization standard in making the determination of whether a valuation allowance is required or whether an existing valuation allowance should be maintained or reversed. The evidence we considered includes the nature, frequency and severity of current or projected three-year historical cumulative losses, forecasts of our future taxable income, the duration of statutory carryforward periods, our utilization experience with operating losses, tax credit carryforwards and tax planning alternatives. As a result of our analysis and based on the criteria outlined in ASC 740, we continue to believe that a full non-cash valuation allowance is appropriate as of June 30, 2013 on our net U.S. deferred tax assets. The full valuation allowance on our U.S. deferred tax assets does not have any impact on our cash, nor does such an allowance preclude us from using our tax losses, tax credits or other deferred tax assets in future periods. To the extent that we are able to generate taxable income in the future to utilize our deferred tax assets, we will be able to reduce our effective tax rate by reducing all or a portion of the full non-cash valuation allowance. Net Loss. Net loss was $30.4 million and $49.6 million in the second quarter of 2013 and 2012, respectively. The decrease in net loss was due primarily to a $14.3 million decrease in other expense, net, and a $12.6 million decrease in income tax expense, partially offset by an $8.3 million decrease in gross profit during the second quarter of 2013. Comparison of Six Months Ended June 30, 2013 to Six Months Ended June 30, 2012 Net Revenues. Our revenues decreased 50% from $91.1 million in the first six months of 2012 to $45.5 million in the first six months of 2013 due primarily to a $46.2 million, or 52%, decrease in Flash-based product sales, which primarily is a result of a delay in the introduction of our next-generation products and increased competition. Within Flash-based product sales, shipments of our ZeusIOPS® SSDs into the enterprise market decreased 61% from $72.5 million in the first six months of 2012 to $28.0 million in the first six months of 2013. Gross Profit. Our gross profit was $12.5 million in the first six months of 2013, compared to $33.0 million in the same period in 2012. Gross profit as a percentage of revenues was 27.4% in the first six months of 2013, compared to 36.2% in the first six months of 2012. The decrease in gross profit in absolute dollars was due primarily to a decrease in sales of Flash-based products. The decrease in gross profit as a percentage of revenue was due primarily to the decrease in revenues as discussed above, an increase in fixed production overhead and labor costs as a percentage of total revenues, and a decrease in the average selling price of certain SSD products, partially offset by a decrease in Flash component costs. Sales and Marketing. Sales and marketing expenses are comprised primarily of payroll and payroll-related expenses for our domestic and international sales and marketing employees, marketing and advertising related expenses, and expenses for trade shows. Sales and marketing expenses increased 4% from $13.5 million in the first six months of 2012 to $14.0 million in the first six months of 2013. Sales and marketing expenses as a percentage of revenues increased from 14.9% in the first six months of 2012 to 30.7% in the first six months of 2013. The increase in sales and marketing expenses in absolute dollars was due primarily to a $1.8 million increase in payroll and payroll-related costs due to an increase in marketing employee headcount from 26 as of June 30, 2012 to 45 as of June 30, 2013, partially offset by a $1.1 million decrease in sales commissions due to lower revenue. The increase in sales and marketing expenses as a percentage of revenues was due primarily to the fixed nature of sales and marketing costs such as certain payroll and payroll-related expenses, excluding sales commissions, and the decrease in revenues. General and Administrative. General and administrative expenses are comprised primarily of payroll and payroll-related expenses for our executive and administrative employees, professional fees and facilities overhead. General and administrative expenses increased 25% from $22.5 million in the first six months of 2012 to $28.2 million in the first six months of 2013. General and administrative expenses as a percentage of revenues increased from 24.7% in the first six months of 2012 to 62.0% in the first six months of 2013. The increase in general and administrative expenses in absolute dollars and as a percentage of revenues was primarily due to a $4.1 million increase in litigation costs related primarily to SEC litigation matters and $1.2 million of costs related to the proposed merger with WDC. The increase in general and administrative expenses as a percentage of revenues was also due to the fixed nature of certain general and administrative costs and the decrease in revenues. 22 -------------------------------------------------------------------------------- Research and Development. Research and development expenses are comprised primarily of payroll and payroll-related expenses for our engineering staff, product design costs, consulting fees and material costs related to new product development. Research and development expenses decreased 22% from $33.6 million in the first six months of 2012 to $26.2 million in the first six months of 2013. Research and development expenses as a percentage of revenues increased from 36.8% in the first six months of 2012 to 57.6% in the first six months of 2013. The decrease in research and development expenses in absolute dollars was due primarily to a $4.2 million decrease in payroll and payroll-related costs primarily due to a decrease in research and development employee headcount from 396 as of June 30, 2012 to 332 as of June 30, 2013, and a $3.3 million decrease in new product development expenses. The increase in research and development expenses as a percentage of revenues was due primarily to the fixed nature of certain research and development costs such as payroll and payroll-related expenses and the decrease in revenues. Other Income (expense), net. Other income, net was $15,000 in the first six months of 2013, and was comprised of interest income and Malaysian government grant income, partially offset by losses on foreign currency remeasurements. Other expense, net was $14.1 million in the first six months of 2012 and was mainly comprised of $15.0 million of expenses to settle our class action litigation, partially offset by $942,000 of government grant income received from the Malaysian government authority for qualified expenses. (Benefit)provision for Income Taxes. We recorded a benefit for income taxes of $29,000 in the first six months of 2013 and provision for income taxes of $9.5 million in the first six months of 2012. Our effective tax rate was a 0.1% benefit in the first six months of 2013 and a 18.7% provision in the first six months of 2012. Our effective tax rate each quarter will differ from that of previous quarters due to various factors, such as tax legislation, the results of tax audits, the effectiveness of our tax-planning strategies, discrete items, the effect from changes to the valuation allowance and the mix of domestic and foreign earnings. The change in our effective tax rate for the six months ended June 30, 2013 from the same period in 2012 was due primarily to the establishment of a full non-cash valuation allowance against all our net U.S. deferred tax assets during the second quarter of 2012. We operate under an income tax holiday in Malaysia, which is effective through September 29, 2027 subject to meeting certain conditions. The impact of the Malaysia income tax holiday decreased our provision for income taxes by $1.2 million and $2.1 million in the first six months of 2013 and 2012, respectively. The benefit of the income tax holiday on earnings per share was $0.02 and $0.05 in the first six months of 2013 and 2012, respectively. We have not provided for U.S. taxes or foreign withholding taxes on approximately $66.6 million of undistributed earnings from our foreign subsidiaries because such earnings are expected to be reinvested for the foreseeable outside of the U.S. Determination of the amount of unrecognized deferred tax liability for temporary differences related to these undistributed earnings is not practicable; however, if a majority of these earnings were distributed, we have sufficient U.S. net operating loss carryforwards, tax credit carryforwards, and additional tax deductions to offset the amount of resulting taxable income such that we would not be subject to recording significant incremental income tax expense. Each quarter, we exercise significant judgment when assessing our deferred tax asset to determine whether all or any portion of the asset is more likely than not unrealizable under ASC 740. We are required to establish or maintain a valuation allowance against any portion of the asset we conclude is more likely than not to be unrealizable. In assessing whether a valuation allowance is required or whether an existing valuation allowance should be maintained or reversed, significant weight is given to evidence that can be objectively verified. In accordance with ASC 740, we considered key positive and negative evidence using a "more likely than not" realization standard in making the determination of whether a valuation allowance is required or whether an existing valuation allowance should be maintained or reversed. The evidence we considered includes the nature, frequency and severity of current or projected three-year historical cumulative losses, forecasts of our future taxable income, the duration of statutory carryforward periods, our utilization experience with operating losses, tax credit carryforwards and tax planning alternatives. As a result of our analysis and based on the criteria outlined in ASC 740, we continue to believe that a full non-cash valuation allowance is appropriate as of June 30, 2013 on our net U.S. deferred tax assets. The full valuation allowance on our U.S. deferred tax assets does not have any impact on our cash, nor does such an allowance preclude us from using our tax losses, tax credits or other deferred tax assets in future periods. To the extent that we are able to generate taxable income in the future to utilize our deferred tax assets, we will be able to reduce our effective tax rate by reducing all or a portion of the full non-cash valuation allowance. Net Loss. Net loss was $55.9 million and $60.3 million in the first six months of 2013 and 2012, respectively. The decrease in net loss was due primarily to a $14.1 million decrease in other expense, net, a $9.5 million decrease in income tax expense, and a $1.3 million decrease in operating expenses, partially offset by a $20.5 million decrease in gross profit. 23-------------------------------------------------------------------------------- Comparison of Three Months Ended June 30, 2013 to Three Months Ended March 31, 2013 Net Revenues. Our revenues increased 7% from $22.0 million in the first quarter of 2013 to $23.5 million in the second quarter of 2013 due primarily to $550,000 of non-recurring engineering services, a $490,000 increase in Flash-based product sales and a $455,000 increase in other revenues related to the sale of raw materials. Within Flash-based product sales, shipments of our ZeusIOPS® SSDs into the enterprise market increased 2% from $13.9 million in the first quarter of 2013 to $14.2 million in the second quarter of 2013. Gross Profit. Our gross profit was $6.6 million in the second quarter of 2013, compared to $5.9 million in the first quarter of 2013. Gross profit as a percentage of revenues was 28.0% in the second quarter of 2013, compared to 26.8% in the first quarter of 2013. The increase in gross profit in absolute dollars and as a percentage of revenue was due primarily to profit on non-recurring engineering services recognized in the second quarter of 2013. Sales and Marketing. Sales and marketing expenses are comprised primarily of payroll and payroll-related expenses for our domestic and international sales and marketing employees, marketing and advertising related expenses, and expenses for trade shows. Sales and marketing expenses increased 12% from $6.6 million in the first quarter of 2013 to $7.4 million in the second quarter of 2013. Sales and marketing expenses as a percentage of revenues increased from 29.8% in the first quarter of 2013 to 31.6% in the second quarter of 2013. The increase in sales and marketing expenses in absolute dollars and as a percentage of revenues was due primarily to a $265,000 increase in payroll and payroll-related costs due to an increase in marketing employee headcount and a $285,000 increase in tradeshow and travel expenses. General and Administrative. General and administrative expenses are comprised primarily of payroll and payroll-related expenses for our executive and administrative employees, professional fees and facilities overhead. General and administrative expenses increased 33% from $12.1 million in the first quarter of 2013 to $16.1 million in the second quarter of 2013. General and administrative expenses as a percentage of revenues increased from 54.9% in the first quarter of 2013 to 68.6% in the second quarter of 2013. The increase in general and administrative expenses in absolute dollars and as a percentage of revenues was primarily due to a $2.8 million increase in litigation costs related primarily to SEC litigation matters and $1.2 million of costs related to the proposed merger with WDC. Research and Development. Research and development expenses are comprised primarily of payroll and payroll-related expenses for our engineering staff, product design costs, consulting fees and material costs related to new product development. Research and development expenses increased 6% from $12.7 million in the first quarter of 2013 to $13.5 million in the second quarter of 2013. Research and development expenses as a percentage of revenues increased from 57.5% in the first quarter of 2013 to 57.8% in the second quarter of 2013. The increase in research and development expenses in absolute dollars and as a percentage of revenues was due primarily to a $651,000 increase in new product development expenses. Other Income (expense), net. Other expense, net was $26,000 in the second quarter of 2013 and was comprised of losses on foreign currency remeasurements, partially offset by interest income and Malaysian government grant income. Other income, net was $41,000 in the first quarter of 2013 and was comprised of by interest income and Malaysian government grant income, partially offset by losses on foreign currency remeasurements. (Benefit)provision for Income Taxes. We recorded a benefit for income taxes of $121,000 in the second quarter of 2013 and a provision for income taxes of $92,000 for the first quarter of 2013. Our effective tax rate was 0.4% benefit for the second quarter of 2013 and a 0.4% provision for the first quarter of 2013. Our effective tax rate each quarter will differ from previous quarters due to various factors, such as tax legislation, the results of tax audits, the effectiveness of our tax-planning strategies, discrete items, the effect of changes to the valuation allowance, and the mix of domestic and foreign earnings. The change from a provision for income taxes in the first quarter of 2013 to a benefit for income taxes in the second quarter of 2013 was due to the recognition of previously unrecognized tax benefits from the expiration of the statute of limitations during the second quarter of 2013. We operate under an income tax holiday in Malaysia, which is effective through September 29, 2027 subject to meeting certain conditions. The impact of the Malaysia income tax holiday decreased our provision for income taxes by $618,000 and $552,000 for the second quarter of 2013 and first quarter of 2013, respectively. The benefit of the income tax holiday on earnings per share was $0.01 in the second quarter of 2013 and first quarter of 2013. Net Loss. Net loss was $30.4 million and $25.5 million in the second quarter of 2013 and first quarter of 2013, respectively. The quarterly increase in net loss was due primarily to a $5.7 million increase in operating expenses, partially offset by a $670,000 increase in gross profit. 24-------------------------------------------------------------------------------- Liquidity and Capital Resources Working Capital, Cash and Cash Equivalents As of June 30, 2013, we had working capital of $139.7 million, including $116.3 million of cash and cash equivalents, compared to working capital of $185.9 million, including $158.2 million of cash and cash equivalents as of December 31, 2012, and working capital of $221.2 million, including $207.2 million of cash and cash equivalents as of June 30, 2012. Current assets were 5.2 times current liabilities as of June 30, 2013, compared to 4.2 times current liabilities as of December 31, 2012 and 4.3 times current liabilities as of June 30, 2012. As of June 30, 2013, of the $116.3 million of aggregate cash and cash equivalents held by us, the amount of cash and cash equivalents held by our foreign subsidiaries was $61.4 million. If these funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds. However, our intent is to reinvest these funds for the foreseeable future outside of the U.S. Further, our current liquidity position and business plan do not demonstrate a need to repatriate the foreign-held funds for our U.S. operations. If we are not able to achieve the planned improvements in the financial performance of our U.S. operations we may need to re-assess our conclusion that these foreign funds will not need to be remitted to the U.S. in the foreseeable future. However, if a majority of these earnings were distributed, we have sufficient U.S. net operating loss carryforwards, tax credit carryforwards, and additional tax deductions to offset the amount of resulting taxable income such that we would not be subject to recording significant incremental income tax expense. Operating Activities Net cash used in operating activities was $24.0 million in the first six months of 2013 and resulted primarily from a net loss of $55.9 million, partially offset by a $7.1 million increase in accounts payable, a $5.3 million decrease in accounts receivable, net of allowances, a $4.0 million increase in accrued and other liabilities, $6.9 million of non-cash stock-based compensation expense, and $6.4 million of non-cash depreciation and amortization. Accounts receivable decreased due primarily to a decrease in revenues in the second quarter of 2013, compared to the fourth quarter of 2012. Investing Activities Net cash used in investing activities was $2.6 million in the first six months of 2013 resulting from purchases of property, plant and equipment related primarily to tenant improvements, computer equipment, and engineering equipment at our Malaysia and U.S. facilities. As of June 30, 2013, we have made capital expenditures of approximately $47 million in connection with our Malaysia facility primarily related to building construction costs, acquisition of land and purchases of production equipment. We estimate that total additional investments in property, plant and equipment will be approximately $38 million over the next five years ending June 30, 2018. We expect that the substantial majority of these estimated investments will relate to our Malaysia operations. Financing Activities Net cash used in financing activities was $15.3 million in the first six months of 2013 and resulted primarily from the transfer of $15.2 million into an escrow account in the custody of the United States District Court for the Central District of California in accordance with the terms of the Settlement Agreement as described in Note 8- "Commitments and Contingencies" to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q. From time to time, our board of directors has authorized various programs to repurchase shares of our common stock depending on market conditions and other factors. Currently we do not have any repurchase programs in effect and did not have such programs in effect in the first six months of 2013. On March 28, 2013, the Company's subsidiary, sTec Technology Sdn. Bhd. ("sTec Malaysia"), terminated its $1.0 million aggregate principal short-term credit facility (the "Short-term Facility") with Deutsche Bank (Malaysia) Berhad. The purpose of the Short-term Facility was to facilitate general business transactions and fund working capital requirements for sTec Malaysia, on an as-needed basis. We believe that our existing assets, cash and cash equivalents on hand will be sufficient to meet our capital needs for at least the next twelve months. However, it is possible that we may need or elect to raise additional cash to fund our activities beyond the next twelve months, to expand our operations, or to consummate acquisitions of other businesses, products or technologies. We could consider raising such funds by accessing the capital or credit markets to issue equity or debt securities, or by borrowing money. In addition, even though we may not need additional funds, we may still elect to sell additional equity securities or obtain additional credit facilities for other reasons. There can be no assurance that we will be 25 -------------------------------------------------------------------------------- able to obtain additional funds on commercially favorable terms, or at all. If we raise additional funds by issuing more equity or new convertible debt securities, the ownership percentages of existing shareholders would be reduced. In addition, the equity or debt securities that we issue may have rights, preferences or privileges senior to those of the holders of our common stock. Moreover, while the Merger Agreement is in effect, subject to certain exceptions, we and our subsidiaries are also restricted in the ability to issue equity interests, incur indebtedness above certain levels and engage in other specified activities. We determine our future capital and operating requirements and liquidity based, in large part, upon our projected financial performance, and we regularly review and update these projections due to changes in general economic conditions, our current and projected operating and financial results, the competitive landscape and other factors. Although we believe we have sufficient capital to fund our activities for at least the next twelve months, our future capital requirements may vary materially from those now planned. The amount of capital that we will need in the future will depend on many factors, including: • General economic and political conditions and specific conditions in the markets we address, including the continuing volatility in the technology sector and semiconductor industry and fluctuation in the global economy; • 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, which may lead them to reduce their level of purchases or to seek credit or other accommodations from us; • Whether our revenues increase or decrease substantially; • Our relationships with suppliers and customers; • The market acceptance of our products; • Expansion of our international business, including the opening of offices and facilities in foreign countries; • Price discounts on our products to our customers; • Our pursuit of strategic transactions, including acquisitions, joint ventures and capital investments; • Our business, product, capital expenditure and research and development plans and product and technology roadmaps; • The levels of inventory and accounts receivable that we maintain; • Our entrance into new markets; • Capital improvements to new and existing facilities; • Technological advances; and • Our responses to competitive products. Contractual Obligations and Off-Balance Sheet Arrangements Other than lease commitments incurred in the normal course of business (see Contractual Obligation table below), we do not have any material off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interest in transferred assets, or any obligations arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in the consolidated financial statements. Additionally, we do not have any interest in, or relationship with, any special purpose entities. In the ordinary course of business, we may provide indemnities of varying scope and terms to customers, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of our breach of such commercial agreements, services to be provided by us, or from intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and certain of our officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. We maintain director and officer insurance, which may cover certain liabilities arising from our obligation to indemnify our directors and officers in certain circumstances. It is not possible to determine the maximum potential amount under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Such indemnification agreements may not be subject to maximum loss clauses. 26-------------------------------------------------------------------------------- Set forth in the table below is our estimate of our significant contractual obligations as of June 30, 2013 (in thousands): Less than More than Total 1 year 1-3 years 3-5 years 5 years Contractual Obligation Non-cancelable inventory purchase commitments $ 34,855 $ 34,855 $ - $ - $ - Operating lease obligations 4,686 1,339 2,513 834 - Non-cancelable capital equipment purchase commitments 281 281 - - - Other non-cancelable purchase commitments 1,083 1,083 - - - Total $ 40,905 $ 37,558 $ 2,513 $ 834 $ - New Accounting Pronouncements We have implemented all new accounting pronouncements that are in effect and that may impact our consolidated financial statements, and we do not believe that there are any other new accounting pronouncements that have been issued that might have a material impact on our consolidated financial statements. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles and include the accounts of sTec, Inc. and each of its subsidiaries. All accounts and transactions among sTec and its subsidiaries have been eliminated in consolidation. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses for each period. Information with respect to our critical accounting policies which we believe could have the most significant effect on our reported results and require subjective or complex judgments is contained in the notes to the consolidated financial statements in the Annual Report on Form 10-K for the fiscal year ended December 31, 2012. There have been no significant changes in our critical accounting policies and estimates during the six months ended June 30, 2013 as compared to that which was previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012. |