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IKANOS COMMUNICATIONS - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
[February 28, 2014]

IKANOS COMMUNICATIONS - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes that are included elsewhere in this Annual Report on Form 10-K.

Overview We are a leading provider of advanced semiconductor products and software for delivering high speed broadband solutions to the digital home. Our broadband multi-mode and digital subscriber line (DSL) processors and other semiconductor offerings power carrier infrastructure (referred to as Access or CO) and customer premises equipment (referred to as Gateway or CPE) for network equipment manufacturers (NEMs) supplying leading telecommunications service providers. Our products are at the core of DSL access multiplexers (DSLAMs), optical network terminals (ONTs), concentrators, modems, voice over Internet Protocol (VoIP) terminal adapters, integrated access devices (IADs), and residential gateways (RGs). Our products have been deployed by service providers globally, including in Asia, Europe, and North and South America, and are also actively being evaluated and scheduled to be evaluated by other service providers for deployment in their networks.



Our products reflect advanced designs in silicon, systems, and firmware and are programmable and highly scalable. Our expertise in the integration of digital signal processor (DSP) algorithms with advanced digital, analog, and mixed signal semiconductors enables us to offer high-performance, high-density, and low-power asymmetric DSL (ADSL) and very-high bit rate DSL (VDSL) products. We are releasing new VDSL-based solutions to the market that offer vectoring and bonding to increase speeds over existing telecom carrier copper infrastructure.

These products support high speed broadband service providers' multi-play deployment plans to the digital home while keeping their capital and operating expenditures relatively low compared to competing frameworks. Our broadband DSL products consist of high performance CO and CPE chips. We have demonstrated: (1) an aggregate downstream and upstream rate of 300 megabits per second (Mbps) over a single pair copper line at a distance of up to 200 meters, and (2) 150Mbps aggregate data rate up to a distance of 500 meters. Our DSL revenue mix over the last three years has transitioned away from ADSL in favor of VDSL, in-line with global market trends. We also offer a line of multi-mode communications processors (CPs) for RGs that support a variety of wide area network (WAN) topologies for telecom carriers, wireless carriers, and cable multiple system operators (MSOs), including Ethernet and gigabit Ethernet, passive optical network (PON), DSL, and wireless broadband. In addition to our DSL and RG processors, we recently announced inSIGHT, our new suite of CPE-based software products. inSIGHT will offer carriers the ability to remotely monitor and diagnose line impairments and noise issues to facilitate fast and cost-effective discovery and resolution of service disruptions, thereby increasing their subscriber satisfaction rate and reducing operating costs.


We outsource all of our semiconductor fabrication, assembly, and test functions, which allows us to focus on the design, development, sales, and marketing of our products and reduces the level of our capital investment. In 2012, we expanded our outsourced model by transitioning a majority of our day-to-day supply chain management, production test engineering, and production quality engineering functions (Master Services) to eSilicon Corporation (eSilicon) under a Master Services and Supply Agreement (Service Agreement). Pursuant to the Service Agreement, we place orders for our finished goods products with eSilicon, who, in turn, contracts with wafer foundries and the assembly and test subcontractors and manages these operational functions for us on a day-to-day level. During the first half of 2012, we began to transition these Master Services to eSilicon. As of the end of 2013, we have completed the transition of Master Services to eSilicon.

Our semiconductor customers consist primarily of NEMs, original design manufacturers (ODMs), contract manufacturers (CMs), and original equipment manufacturers (OEMs), and include vendors such as Sagemcom Tunisie (Sagemcom), Askey Computer Corporation (Askey), NEC Corporation (NEC) and AVM Computersysteme Vertriebs GmbH (AVM). Our products are deployed in the networks of telecom carriers such as AT&T Inc. (AT&T), Bell Canada, Orange S.A.

(formerly, France Telecom) (Orange), KDDI Corporation (KDDI), and Nippon Telegraph and Telephone Corporation (NTT).

45-------------------------------------------------------------------------------- Table of Contents We incurred a net loss of $30.4 million in 2013 and had an accumulated deficit of $326.1 million as of December 29, 2013. To achieve consistent profitability, we will need to generate and sustain higher revenue, while maintaining cost and expense levels appropriate and necessary for our business.

We filed a shelf registration statement with the Securities and Exchange Commission (SEC) on October 25, 2010 (declared effective on November 1, 2010) under which we might offer and sell up to $30.0 million of common stock and warrants. On November 11, 2010 and December 7, 2010, we sold a total of 12.8 million shares of common stock in an underwritten offering for $13.5 million. After deducting underwriting fees, legal, accounting, and other costs, we realized proceeds of $12.5 million. The shelf registration expired on November 1, 2013.

In January 2011, we entered into a Loan and Security Agreement (Loan Agreement) with Silicon Valley Bank (SVB), which provides us with a revolving line of credit of up to $15.0 million, as described below. From time-to-time during 2012 and 2013, we have drawn down on our line of credit for working capital purposes.

As of December 29, 2013, $12.0 million was outstanding under the Loan Agreement.

Interest on advances against the line is equal to 6.5% as of December 29, 2013 and is payable monthly. We may repay the advances under the Loan Agreement, in whole or in part, at any time, without premium or penalty. The Loan Agreement's original maturity date was April 14, 2013. On February 19, 2013, we amended the Loan Agreement to extend the term until April 14, 2015.

We utilize the line of credit with SVB to partially fund our operations. We were in compliance with all covenants as of December 29, 2013 and expect to be in compliance through the first quarter of 2014. However, we anticipate that we may not be in compliance with all of the covenants contained in the Loan Agreement during certain periods of 2014 and, accordingly, have begun negotiations with SVB.

We filed a Registration Statement on Form S-1 on August 23, 2013 and amended it thereafter (declared effective on November 6, 2013) under which we might offer and sell up to $35.0 million of common stock. On November 7, 2013 and November 22, 2013, we sold an aggregate of 26.4 million shares of common stock in an underwritten offering for $26.4 million. After deducting underwriting fees, legal, accounting, and other costs we realized net proceeds of $24.0 million.

We were incorporated in April 1999 and, through December 31, 2001, we were engaged principally in research and development. We began commercial shipment of our products in the fourth quarter of 2002. Our revenue was $136.6 million in 2011, $125.9 million in 2012, and $79.7 million in 2013.

Quarterly revenue fluctuations are characteristic of our industry and affect our business, especially due to the concentration of our revenue among a few customers and a limited number of products. These quarterly fluctuations can result from a variety of factors, including a mismatch of supply and demand.

Specifically, service providers purchase equipment based on planned deployment.

However, service providers may deploy equipment more slowly than initially planned, while OEMs continue for a time to manufacture equipment at rates higher than the rate at which equipment is deployed. As a result, periodically and usually without significant notice, service providers will reduce orders with OEMs for new equipment, and OEMs, in turn, will reduce orders for our products, which will adversely impact the quarterly demand for our products, even when deployment rates may be generally increasing.

Our industry is continually transitioning to new technologies and products.

Large industry transitions are unpredictable due to factors including, but not limited to, extended product trials, qualifications, and the transformation of existing platforms to new platforms. Furthermore, the environment in which we market and sell our products has become increasingly competitive and cost sensitive. Our competitors may also be able to provide higher degrees of integration due to their broader range of products.

Our future revenue growth depends on the successful qualification and adoption of our new product platforms. In addition to these qualifications, our operations may be adversely affected by our customers' 46-------------------------------------------------------------------------------- Table of Contents transition strategies from existing systems that use our product to systems that may not use our products. As is customary in our industry, we may elect to end-of-life certain products and, as a result, certain customers may enter into last time buy arrangements which could impact future revenues. Certain of our customers entered into last time buys of some products during 2011, 2012, and, to a lesser extent, during 2013. In some cases products may become mature or uncompetitive causing customers to transition to solutions from other manufacturers, in whole or in part.

It is inherently difficult to predict if and when platforms will pass qualification, when service providers will begin to deploy the equipment, and at what rate, because we do not control the qualification criteria or process, and the systems manufacturers and service providers do not always share all of the information available to them regarding qualification and deployment criteria.

Additionally, we have limited visibility into the buying patterns of our OEMs, who, in turn, are affected by changes in the buying and roll out patterns of the service provider market. To the extent that we manufacture inventory to a forecast, we may have excess inventory if the forecast differs from actual results.

We have several new products in development. We believe that our team of engineers, our current products, technology, patents, and other intellectual property will allow us to create new products that could increase our market share and enable us to implement our digital home initiatives, our next generation VDSL development, and our future G.fast products. However, many of these new products may not offset the declines in revenue on our mature products during the near term. Failure to generate revenues from these new products, or delays in the timing of the release of these products, could have a material adverse effect on our revenues, results of operations, cash flows, and financial position.

On February 28, 2013, Mr. Michael Kelly resigned from his position as Vice President of Worldwide Sales. On May 6, 2013, we appointed Mr. Stuart Krometis our Vice President of Worldwide Sales.

Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and the results of operations are based on our consolidated financial statements that have been prepared in accordance with accounting principles generally accepted in the United States (GAAP). In preparing our consolidated financial statements, we make assumptions, judgments, and estimates that can have a significant impact on amounts reported in our consolidated financial statements. We base our assumptions, judgments, and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. On a regular basis, we evaluate our assumptions, judgments, and estimates and make changes accordingly. We also discuss our critical accounting estimates with the Audit Committee of our Board of Directors. We believe that the assumptions, judgments, and estimates involved in the accounting for revenue, cost of revenue, marketable securities, accounts receivable, inventories, warranty, income taxes, impairment of goodwill and related intangibles, acquisitions, and stock-based compensation expense have the greatest potential impact on our consolidated financial statements, so we consider these to be our critical accounting policies. We discuss below the critical accounting estimates associated with these policies. Historically, our assumptions, judgments, and estimates relative to our critical accounting policies have not differed materially from actual results.

Revenue Recognition We recognize revenue when the following criteria are met: 1) persuasive evidence of an arrangement exists, 2) delivery has occurred, 3) our price to the customer is fixed or determinable, and 4) collection is reasonably assured. Since our semiconductor products are reliant upon firmware, we defer revenue recognition until the essential firmware is delivered and when legal title and risk of ownership has transferred. In addition, we record reductions to revenue for estimated product returns and pricing adjustments, such as volume purchase incentives, in the same period that the related revenue is recorded. The amount of these reductions is based on historical 47-------------------------------------------------------------------------------- Table of Contents sales returns, analysis of credit memo data, specific criteria included in volume purchase incentives agreements, and other factors known at the time.

Additional reductions to revenue would result if actual product returns exceed our estimates or if we settle any claims brought by our customers that are in excess of our standard warranty terms for cash payments. Revenue from product sales to distributors is recognized under the sell-in method when product is delivered to the distributor offset by any contractual return rights.

As noted above, in multi-element arrangements that include combination of semiconductor products with firmware that is essential to the semiconductor products' functionality, when certain firmware elements are not yet delivered, judgment is required to properly identify the accounting units of the multiple deliverable transactions and to determine the manner in which revenue should be allocated among the accounting units. We allocate the arrangement consideration based on each element's relative fair value using vendor-specific objective evidence, third-party evidence, or estimated selling prices, as the basis of fair value. The allocation of value to each element is derived based on management's best estimate of selling price when vendor-specific evidence or third-party evidence is unavailable. Revenue is recognized for the accounting units when the basic revenue recognition criteria are met.

Accounts Receivable Allowance We perform ongoing credit evaluations of our customers and adjust credit limits, as determined by our review of current credit information. We continuously monitor collections and payments from our customers and maintain an allowance for doubtful accounts based upon our historical experience, our anticipation of uncollectible accounts receivable, and any specific customer collection issues that we have identified. While our credit losses have historically been low and within our expectations, we may not continue to experience the same credit loss rates that we have in the past. Our receivables are concentrated in a relatively small number of customers. Therefore, a significant change in the liquidity, financial terms, financial position, or willingness to pay timely, or at all, of any one of our significant customers would have a significant impact on our results of operations and cash flows.

Inventory We value our inventory at the lower of cost or estimated market value. Cost is determined by the first-in, first-out method and estimated market value represents the estimated net realizable value. We estimate market value based on our current pricing, market conditions, and specific customer information. We write down inventory for estimated obsolescence of unmarketable inventory and quantities on hand in excess of estimated near-term demand and market conditions. If actual shipments are less favorable than expected, additional charges may be required. Additionally, we specifically reduce inventory to the lower of cost or market if pricing trends or forecasts indicate that the carrying value of inventory exceeds its estimated selling price. Once inventory is written down, a new accounting basis is established, and it is not written back up in future periods. However, if such inventory is subsequently sold, gross margins will be positively affected.

Warranty We provide for the estimated cost of product warranties at the time revenue is recognized based on our historical experience of similar products. While we engage in product quality programs and processes, including monitoring and evaluating the quality of our suppliers, our warranty accrual is affected by our contractual obligations, product failure rates, and the estimated and actual cost incurred by us and our customers for replacing defective parts. Costs may include replacement parts, labor to rework, and freight charges. We monitor product returns during the warranty period and maintain an accrual for the related warranty expenses. Should actual failure rates, cost of product replacement, and inbound and outbound freight costs differ from our estimates, revisions to the estimated warranty reserve would be required.

48-------------------------------------------------------------------------------- Table of Contents Acquisitions We allocate the purchase price of acquired companies to the tangible and intangible assets acquired, liabilities assumed, as well as purchased in-process research and development (IPR&D) based on the estimated fair values. We use various models to determine the fair values of the assets acquired and liabilities assumed. These models include the discounted cash flow (DCF), the royalty savings method, and the cost savings approach. The valuation requires management to make significant estimates and assumptions, especially with respect to long-lived and intangible assets.

Critical estimates in valuing certain of the intangible assets include, but are not limited to, future expected cash flows from customer contracts, customer lists, distribution agreements, and acquired developed technologies and patents; expected costs to develop the IPR&D into commercially viable products and estimated cash flows from the projects when completed; the acquired company's brand awareness and market position as well as assumptions about the period of time the brand will continue to be used in the combined company's product portfolio; and discount rates. We derive our discount rates from our internal rate of return based on our internal forecasts and we may adjust the discount rate giving consideration to specific risk factors of each asset. Management's estimates of fair value are based upon assumptions believed to be reasonable but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur.

Accounting for Income Taxes We record the estimated future tax effects of temporary differences between the tax basis of assets and liabilities and amounts reported in the balance sheets, as well as operating loss and tax credit carry-forwards. We have recorded a full valuation allowance against our deferred tax asset except for certain foreign tax jurisdictions. Based on our historical losses and other available objective evidence, we have determined it is more likely than not that the deferred tax asset will not be realized. While we have considered potential future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the full valuation allowance, in the event that we were to determine that we would be able to realize our deferred tax assets in the future, an adjustment to the deferred tax asset would increase net income in the period such determination was made. In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. Further, in accordance with authoritative guidance, we recognize liabilities for uncertain tax positions based on the two-step process prescribed within the interpretation. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement.

Prior to the fourth quarter of 2011, we did not provide for Federal income tax and withholding taxes for unremitted foreign earnings of our foreign affiliates because the unremitted earnings were deemed to be permanently reinvested.

Beginning in the fourth quarter of 2011 we began to provide for Federal income tax and foreign withholding taxes for those unremitted earnings because we determined that those funds may no longer be permanently reinvested.

Stock-Based Compensation Expense We account for share-based compensation related to share-based transactions in accordance with authoritative guidance. Under the fair value recognition provisions, share-based payment expense is estimated at the grant date based on the fair value of the award and is recognized as an expense ratably over the requisite service period of the award. Determining the appropriate fair value model and calculating the fair value of stock-based awards requires judgment, including estimating stock price volatility and expected life. We have estimated the expected volatility as an input into the Black-Scholes valuation formula when assessing the fair value of options granted. Our current estimate of volatility was based upon a blend of average historical volatilities of our 49-------------------------------------------------------------------------------- Table of Contents stock price and that of our peer group. To the extent volatility of our stock price increases in the future, our estimates of the fair value of options granted in the future could increase, thereby increasing share-based payment expense in future periods. In addition, we apply an expected forfeiture rate when amortizing share-based payment expense. Our estimate of the forfeiture rate was primarily based upon historical experience of employee turnover. To the extent that we revise this estimate in the future, our share-based payment expense could be materially affected in the quarter of revision, as well as in following quarters. Our expected term of options granted was derived from the average midpoint between vesting and the contractual term. In the future, we may change or refine our approach of deriving these input estimates as empirical evidence regarding these input estimates becomes available. These changes could impact our fair value of options granted in the future.

The above items are not a comprehensive list of all of our accounting policies.

In many cases, the accounting treatment of a particular transaction is specifically dictated by authoritative guidance with no need for our management's judgment in its application. There are also areas in which our management's judgment in selecting any available alternative would not produce a materially different result. See our consolidated financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K that contain accounting policies and other disclosures in accordance with authoritative guidance.

Results of Operations Revenue Our revenue is primarily derived from sales of our semiconductor products.

Revenue from product sales is generally recognized upon shipment, net of sales returns, rebates, and allowances and other deferrals that pertain to software delivery obligations. Revenue from product sales to distributors is generally recognized under the sell-in method when product is delivered to the distributor offset by any contractual return rights.

As is typical in our industry, the selling prices of our products generally decline over time. Therefore, our ability to increase revenue is dependent upon our ability to increase unit sales volumes of existing products and to introduce and sell new products. The continuing effects of the worldwide recession have adversely affected the businesses of service providers, causing them to re-evaluate how they employ capital. Consequently, the rate at which broadband infrastructure is upgraded may slow and new broadband programs could be delayed.

Our revenue has declined in each of the last three years as our new product revenue has not grown sufficiently to offset the decline in revenue of our legacy products. The effect of these trends resulted in lower quarterly revenue beginning in the third and fourth quarters of 2010 and continuing into 2011.

Quarterly revenue was generally flat in 2012. During 2013, revenue decreased during the first and second quarters and remained relatively flat for the remainder of the year. We expect that our first quarter 2014 revenue will be lower than our fourth quarter 2013 revenue.

Total revenue for 2013 declined by $46.2 million, or 37%, to $79.7 million from $125.9 in 2012. Our four largest customers accounted for approximately 60% of our revenue in 2013. Our five largest customers accounted for approximately 60% of our revenue in 2012. Revenue from Asia as a percent of total revenue decreased from 68% to 57%, while revenue in Europe increased from 29% to 39%.

Revenue from the Americas (including Latin America) increased from 3% to 4% of total revenue. During 2012, we began selling our next generation CPE product chipsets (Fusiv Vx185, Vx183, Vx175, and Vx173). As noted above, even with the introduction of these new products, we continued to be adversely affected by the aging of our existing products as well as changes affecting the entire broadband industry generally. Revenue in the first quarter of 2013 declined from $31.8 million in the fourth quarter of 2012 to $26.2 million in the first quarter of 2013. Revenue continued to decline by $7.0 million to $19.1 million during the second quarter and by an additional $2.2 million to $16.9 million for the third quarter. Revenue improved by $0.7 million to $17.6 million for the fourth quarter.

Two factors were primarily responsible for the decline in our 2013 revenue and this trend may continue into 2014. First, the decline we saw in our legacy products was greater than expected and outpaced the growth in 50-------------------------------------------------------------------------------- Table of Contents revenue of our new products. However, concurrent with this, we did see a continuing shift in our revenue mix in favor of our new products. Revenue from new products (Vx 183/185/180/175/173 and Velocity-1) reached approximately 58% in 2013 versus approximately 33% in 2012. Secondly, we experienced delays in the introduction of certain new products, which pushed out the ramp of these new products in some end markets. We anticipate that customer ramps of our new products will continue to gain momentum.

We generally sell our products to OEMs through a combination of our direct sales force, third-party sales representatives, and distributors. Sales are generally made under short-term, non-cancelable purchase orders. We also have volume purchase agreements with certain customers who provide us with non-binding forecasts. Although certain OEM customers may provide us with rolling forecasts, our ability to predict future sales in any given period is limited and subject to change based on demand for our OEM customers' systems and their supply chain decisions. Historically, a small number of OEM customers, the composition of which has varied over time, have accounted for a substantial portion of our revenue. We expect that significant customer concentration will continue for the foreseeable future, but it may diversify across more carrier end customers as we expect more service providers worldwide to begin deployments of our broadband solutions. Sales through distributors are made under the sell-in method under which we recognize revenue when product is delivered to the distributor offset by any contractual return right at the time of sale. Although revenue from distributor sales has been less than 5% annually, we anticipate that this will increase in 2014. The following direct customers each accounted for more than 10% of our revenue for the years indicated. Sales made to OEMs are based on information that we receive at the time of ordering.

Our Direct Customer 2013 2012 2011 Sagemcom Tunisie 24 % 19 % 20 % Askey Computer Corporation (a contract manufacturer for Sagemcom) 14 13 * AVM Computersysteme Vertriebs GmbH 11 * * Paltek Corporation 10 * 10 Flextronics Manufacturing (H.K.) Ltd. * 12 * * Less than 10% Revenue by Country as a Percentage of Total Revenue 2013 2012 2011 France 25 % 20 % 20 % Taiwan 22 18 12 Japan 18 19 21 Germany 12 6 1 China 5 12 11 Hong Kong 2 14 10 United States 3 1 2 Other 13 10 23 The table above reflects sales to our direct customers based on where they are headquartered. It does not necessarily reflect carrier deployment of our products as we do not sell directly to them. Comparing 2013 to 2012 by geography, revenue improvements as a percent of sales in France and Germany were offset by declines in revenue from China and Hong Kong. Comparing 2012 to 2011 by geography, revenue improvements in Taiwan and Hong Kong were offset by declines in revenue from Japan and the Netherlands.

Revenue by Product Family as a Percentage of Total Revenue 2013 2012 2011 Gateway 76 % 75 % 65 % Access 24 25 35 51 -------------------------------------------------------------------------------- Table of Contents We track our products within two product families: Gateway and Access. The Access product family consists of semiconductor and software products that power the carrier infrastructure, as well as any node in a hybrid-fiber-copper network where fiber is terminated and copper is used to reach the consumer premises. The Gateway product family includes a variety of processors and the associated software designed for devices deployed at the customer premises. Gateway products enable service providers to offer their subscribers a variety services, including internet access, voice, over-the-top content, and security, among others.

Cost and Operating Expenses Year over Year Change 2013 2012 2011 2013/2012 2012/2011 (In millions) (Percent) Cost of revenue $ 39.1 $ 64.8 $ 65.9 (40 )% (2 )% Research and development 51.1 57.5 55.8 (11 ) 3Sales, general and administrative 18.8 19.1 22.3 (1 ) (14 ) Restructuring charges - 1.1 (0.1 ) nm nm nm-not meaningful Operating Expenses as a Percent of Total Revenue: 2013 2012 2011 Cost of revenue 49 % 51 % 48 % Research and development 64 46 41 Sales, general and administrative 24 15 16 Cost of revenue. Our cost of revenue consists primarily of the cost of silicon wafers purchased from third-party foundries and third-party costs associated with assembling, testing, and shipping of our semiconductors. Because we do not have formal, long-term pricing agreements with our manufacturing partners, our wafer costs and services are subject to price fluctuations based on the cyclical demand for semiconductors, among other factors. In addition, after we purchase wafers from foundries, we may incur yield loss related to the manufacturing process that creates usable die from the wafers. Manufacturing yield is the percentage of acceptable product resulting from the manufacturing process determined at the time that the product is tested. If our manufacturing yield decreases, our cost per unit increases. This could have a significant adverse effect on our cost of revenue. In addition to raw material costs and usage, the cost of revenue also includes payments to eSilicon under our Services Agreement, accruals for actual and estimated warranty obligations and write-downs of excess and obsolete inventories, payroll and related personnel costs, certain variable cost components such as gold adder, licensed third-party intellectual property, depreciation of equipment, and amortization of acquisition-related intangibles.

Gross margin increased by 2% from 49% in 2012 to 51% in 2013. Gross margins improved due to lower intangible amortization costs and lower royalty costs.

Intangible amortization was $1.1 million lower in 2013 compared to 2012. In 2012, charges related to the patent license agreement in 2012 and prior years amounted to $1.5 million. Costs related to this patent license agreement were $0.5 million in 2013.

Gross margin decreased by 3% from 52% in 2011 to 49% in 2012. The reduction in margin was primarily due to sales of inventory in 2011 that had been previously written off in 2010. In 2012 we sold $0.4 million of inventory previously written off versus $4.1 million in 2011. Margins were also adversely affected by a charge of $1.5 million in 2012 related to a patent license agreement covering the current year and certain prior periods. These items were marginally offset by a $0.4 million reduction in the amortization of acquired intangible assets.

In addition, there continued to be significant pressure on margins due to our aging product lines combined with lower margins related to the ramping of our new Fusiv product chipsets discussed above.

52-------------------------------------------------------------------------------- Table of Contents Research and development expenses. All research and development (R&D) expenses are recognized as incurred and generally consist of compensation and associated expenses of employees engaged in research and development; contractors; tapeout expenses; reference board development; development testing, evaluation kits and tools; stock-based compensation; amortization of acquisition-related intangibles; and depreciation expense. Before releasing new products, we incur charges for mask sets, prototype wafers, mask set revisions, bring-up boards, and other qualification materials, which we refer to as tapeout expenses. These tapeout expenses may cause our R&D expenses to fluctuate because they are not incurred uniformly every quarter.

During 2013, R&D expenses were $51.1 million, a decrease of $6.5 million, or 11%, from $57.5 million in 2012. The decrease in R&D expenses is primarily related to lower tapeout costs, which declined from $8.7 million in 2012 to $3.0 million in 2013. Other backend and product development costs declined by $0.9 million in 2013 compared to 2012. Headcount at the end of 2013 remained flat compared to 2012. Salary and related costs increased by approximately $0.3 million. All other costs remained relatively unchanged with a net increase of $0.4 million.

During 2012, R&D expenses were $57.5 million, an increase of $1.7 million, or 3%, from $55.8 million in 2011. The increase in R&D expenses is primarily related to higher tapeout costs in 2012 of $2.9 million related to product development and other backend costs of $1.7 million related to other materials, supplies, and services. Consulting costs increased by $1.0 million in 2012 compared to 2011 as we increased our product development spending. In addition, during 2011 we received a credit of $0.9 million related to qualified R&D expenditures made by a foreign subsidiary. We did not receive a similar credit in 2012. These cost increases were offset by a reduction in personnel costs of $5.1 million, in part, the result of our February 2012 restructuring.

Our R&D personnel are located primarily in the United States and India. As of December 29, 2013, we had 202 engineers engaged in R&D of whom 67 were located in India, and 136 were located in the United States. This compares to 205 at the end of 2012 and 247 at the end of 2011.

Selling, general, and administrative expenses. Selling, general, and administrative (SG&A) expenses generally consist of compensation and related expenses for personnel; public company expenses; legal, recruiting and auditing fees; and deprecation. For 2013, SG&A expenses were $18.8 million, a decrease of $0.3 million, or 1%, from $19.1 million in 2012. The decrease in SG&A expense is attributable to lower personnel costs of $0.3 million, attributable to lower executive bonuses; lower related travel and entertainment costs; and lower building and utility costs. Partially offsetting these cost reductions were higher stock-based compensation costs of $0.3 million.

For 2012, SG&A expenses were $19.1 million, a decrease of $3.2 million, or 14%, from $22.3 million in 2011. The decrease in SG&A expense is attributable to lower personnel costs of $2.9 million, attributable to lower personnel levels following the first quarter restructuring; lower related travel and entertainment costs of $0.4 million, and lower building and utility costs.

Partially offsetting these cost reductions were higher consulting costs of $0.5 million and higher depreciation of $1.3 million due to the write off of certain software assets.

As of December 29, 2013 SG&A headcount was 61, effectively flat from the end of years 2012 and 2011.

Restructuring charges. There was no restructuring activity or charge during 2013.

In an effort to manage our operating expenses to our projected revenue forecast, on January 30, 2012 the Board of Directors approved and management initiated a corporate restructuring plan that included a reduction in force of approximately 16%. Employees were notified on February 1 and 2, 2012 of their planned termination. We incurred a total net pre-tax restructuring charge of $1.1 million in 2012. This charge included expenses related to severance for terminated employees and other exit-related costs arising from contractual and other obligations. The net restructuring charges were cash expenditures.

53-------------------------------------------------------------------------------- Table of Contents During 2011, we recognized a benefit of $0.1 million associated with our reversal of certain restructuring expense accruals (from our 2010 restructuring plan) that did not occur. As of January 1, 2012 our remaining restructuring liability consisted of $0.2 million for a software tool license. We made payments of $0.2 million under the software tool license during 2012.

Gain on Sale of Marketable Securities There was no gain or loss on the sale of marketable securities in years 2013 and 2012.

During 2010 we held auction rate securities with a purchase face value of $5.0 million. The carrying value of the securities was $2.0 million at the end of 2010 and was comprised of a cost basis of $0.7 million and $1.3 million unrealized gain. In early 2011 we sold these securities for $2.0 million and recognized the gain of $1.3 million.

Other Expense, Net Interest income and other, net consists of interest income earned on our cash, cash equivalents, and short-term investments, other non-operating expenses, and interest expense, primarily related to loans under our Loan Agreement with SVB.

It also includes other non-operating income and expense items such as gains and losses on foreign exchange and the sales of fixed assets.

Interest income and other income (expense), net was an expense of $0.6 million in 2013 compared to net expense of $0.1 million in 2012 and net expense of $0.4 million in 2011. The expense of $0.6 million in 2013 was attributable to exchange losses resulting from a decline in the Indian rupee and the euro.

Interest expense related to the Loan Agreement was $0.2 million. These expenses were partially offset by interest income related to our certificates of deposit.

The $0.1 million expense in 2012 resulted predominantly from foreign exchange losses of $0.3 million recognized on the Indian rupee and euro offset by interest income of $0.1 million on our certificates of deposit. The $0.4 million net expense in 2011 reflects $0.5 million of foreign exchange losses predominantly in India and France offset slightly by interest and other income.

Other income of $0.1 million in 2010 reflected interest and other income of $0.3 million offset by foreign exchange losses of $0.2 million.

Provision for Income Taxes Income taxes are comprised mostly of federal income tax, foreign income taxes, and state minimum taxes. The income tax provision decreased by $0.4 million to $0.6 million for 2013 compared to $1.0 million for 2012. The decrease is predominantly due to tax contingencies recorded during 2012. There was no significant tax contingency recorded during 2013. Our income tax provision primarily represents foreign taxes on certain of our international subsidiaries as well as federal taxes on unremitted earnings of foreign subsidiaries.

We are subject to taxation in the U.S., various states, and certain foreign jurisdictions. We are currently undergoing an income tax audit in India and Singapore. Otherwise, there are no ongoing examinations by income taxing authorities at this time. We do not expect any material adjustments to our reserves. Our tax years from 2005 to 2013 remain open in various tax jurisdictions.

Net Loss As a result of the above factors, we reported a net loss of $30.4 million in 2013 compared to net losses of $17.6 million in 2012 and $7.5 million in 2011.

We have incurred net losses throughout most of our history. Over the past several years, we have taken and continue to take actions to reduce our operating expense structure such as consolidating locations, reducing capital expenditures, outsourcing our back-end physical design, reducing the number of development projects, and reducing overall headcount. In addition, we are taking steps to reduce unit manufacturing costs by working to achieve better wafer pricing based on larger volume of purchases, consolidating business with vendors, and reducing other input costs. Over the long term it is our expectation that these steps will result in operating income, excluding stock-based compensation and amortization of intangibles.

54-------------------------------------------------------------------------------- Table of Contents Liquidity, Capital Resources, and Going Concern Cash, cash equivalents, and short-term investments increased by $8.3 million to $39.5 million as of December 29, 2013, compared to $31.2 million as of December 30, 2012. We have funded our operations primarily through cash from private and public offerings of our common stock, our line of credit, cash generated from the sale of our products, proceeds from the exercise of stock options, and stock purchased under our employee stock purchase plan. Our uses of cash include payroll and payroll-related expenses, manufacturing costs, purchases of equipment, tools, and software as well as operating expenses, such as tapeouts, marketing programs, travel, professional services, facilities, and other costs. We believe that there may be additional working capital requirements needed to fund and operate our business. In the near future we expect to finance our operations primarily through existing cash balances and the Loan Agreement. However, we may require additional cash resources during 2014 as a result of changes in our business conditions or other developments. If we should need additional funds, we believe that we will secure such funds either through our line of credit, the issuance of additional equity, or other similar activities.

The following table summarizes our statement of cash flows (in millions): 2013 2012 2011 Statements of Cash Flows Data: Cash and cash equivalents-beginning of year $ 28.4 $ 34.8 $ 28.9 Net cash provided by (used in) operating activities (20.0 ) (2.3 ) 6.8 Net cash used in investing activities (5.0 ) (9.7 ) (1.7 ) Net cash provided by financing activities 32.6 5.6 0.8 Cash and cash equivalents-end of year $ 36.0 $ 28.4 $ 34.8 Cash and short-term investments held by foreign subsidiaries was $6.5 million, $6.6 million, and $32.6 million as of our 2013, 2012, and 2011 year ends, respectively. When we entered into the Services Agreement with eSilicon, we changed the international structure that we had established in 2011. Effectively eSilicon replaced our operations activity handled by our subsidiary in Singapore. This change enabled us to reduce the cash held by our Singapore subsidiary and return the cash to the accounts in the name of the parent.

We filed a Registration Statement on Form S-1 on August 23, 2013 and amended it thereafter (declared effective on November 6, 2013) under which we might offer and sell up to $35.0 million of common stock. On November 7, 2013 and November 22, 2013, we sold an aggregate of 26.4 million shares of common stock in an underwritten offering for $26.4 million. After deducting underwriting fees, legal, accounting, and other costs we realized net proceeds of $24.0 million.

Our net loss was approximately $30.4 million in 2013. As of December 29, 2013, we had an accumulated deficit of approximately $326.1 million. We utilize the line of credit with SVB under the Loan Agreement to partially fund our operations, which agreement was originally entered into in January 2011. On April 12, 2012, we amended the Loan Agreement and, among other changes, extended the maturity date to April 14, 2013 and amended the financial covenants to reflect then-current business circumstances. We amended the Loan Agreement again on February 19, 2013 to update the financial covenants to coincide with our then-current operating plan. On August 8, 2013, we again amended our Loan Agreement with SVB, to change existing financial covenants to coincide with our then-current operating plan. The revised financial covenants include the following: 1) a minimum adjusted quick ratio of 1.0:1, tested on a monthly basis; 2) a minimum cash balance to be held with SVB ranging between $10.0 million and $25.0 million, tested on a monthly basis, and 3) a minimum EBITDA amount between zero and $(10.0) million, tested on a quarterly basis. Under the Loan Agreement, we may borrow up to $15.0 million limited by the borrowing base calculation. The borrowing base is calculated at 80% of eligible accounts receivable, as defined in the Loan Agreement. All cash collections will be applied to the outstanding principal balance on a daily basis, but may be borrowed immediately after pay down. Interest is fixed at SVB's prime rate plus 250 basis points, with a floor of 4.00%.

55-------------------------------------------------------------------------------- Table of Contents We expect to be in compliance with the terms of the Loan Agreement through the first quarter of 2014. However, we anticipate that we may not be in compliance with all of the covenants contained in the Loan Agreement during certain periods in 2014 and, accordingly, have begun negotiations with SVB.

We may need to take further actions to generate adequate cash flows or earnings to ensure compliance and fund our future capital requirements, including the potential need for additional financing. There can be no assurance that sufficient debt or equity financing will be available or, if available, that such financing will be on terms and conditions acceptable to us. There can be no assurance that we will be successful in revising the covenants with SVB or in raising additional debt or equity financing. If we are unsuccessful in these efforts, we will need to implement significant cost reduction strategies that could affect our long-term business plan. These efforts may include, but are not limited to: consolidating locations, reducing capital expenditures, and reducing overall headcount.

As a result of our recurring losses from operations, our accumulated deficit, and the potential need to revise our covenants with SVB which may require us to raise additional capital to remain in compliance with certain debt covenants and fund our operating and capital requirements, there is uncertainty regarding our ability to maintain liquidity sufficient to operate our business effectively, which raises substantial doubt as to our ability to continue as a going concern.

Notwithstanding our need to comply with certain covenants, to achieve consistent profitability and to fund our operations, we will need to generate and sustain higher revenue, while maintaining cost and expense levels appropriate and necessary for our business. The amount and timing of these future capital requirements will depend upon many factors including our rate of revenue growth, our ability to develop future revenue streams, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the timing of introductions of new products and enhancements to existing products, the costs to ensure access to adequate manufacturing capacity, and the continuing market acceptance of our products.

Operating Activities During 2013, we used $20.0 million in net cash from operating activities while incurring a loss of $30.4 million. Included in the net loss were non-cash charges amounting to $8.7 million that resulted from amortization of intangibles and acquired technology of $0.8 million, stock-based compensation of $3.6 million, and depreciation and amortization of $4.3 million. Favorable cash flow resulted from a decrease in inventories of $6.1 million and in prepaid expenses and other assets of $3.3 million. This improvement was offset by a decrease in accounts payable and accrued liabilities of $7.5 million and an increase in accounts receivable of $0.1 million. Prepaid expenses declined primarily due to lower prepaid wafer purchases for eSilicon. Prepayment to eSilicon was $0.8 million as of December 29, 2013 compared to $2.7 million as of December 30, 2012. Accounts receivable days sales outstanding have grown from 45 days as of December 30, 2012 to 86 days as of December 29, 2013 as sales declines and timing of shipments have changed from 2012 to 2013, with a higher percentage of shipments being later in our fiscal periods, resulting in higher receivables at our period end.

During 2012, we used $2.3 million in net cash from operating activities while incurring a loss of $17.6 million. Included in the net loss were non-cash charges amounting to $10.2 million that resulted from amortization of intangibles and acquired technology of $2.1 million, stock-based compensation of $2.9 million, depreciation and amortization of $5.2 million. Cash flow from reductions in accounts receivable of $2.6 million and inventory of $1.4 million and increases in accounts payable and accrued liabilities of $5.2 million were partially offset by an increase in prepaid expense and other assets of $4.1 million. The decrease in accounts receivable reflects lower fourth quarter sales ($31.8 million in 2012 versus $35.4 million in 2011). Collections have been strong as days sales outstanding were 45 days as of December 30, 2012 compared to days sales outstanding of 47 days as of January 1, 2012. The lower inventory balance reflects the effect of our Services Agreement with eSilicon, who is responsible for purchasing and assembling our products as discussed above.

56-------------------------------------------------------------------------------- Table of Contents Prepaid expenses increased primarily due to our arrangement with eSilicon as we have been prepaying eSilicon the cost of wafer purchases. Prepayment to eSilicon was $2.7 million as of December 30, 2012. There were no prepayments to eSilicon as of January 1, 2012.

During 2011, we generated $6.8 million in net cash from operating activities while incurring a loss of $7.5 million. Included in the net loss were non-cash charges amounting to $10.4 million that resulted from amortization of intangibles and acquired technology of $2.5 million, stock-based compensation of $3.2 million, and depreciation and amortization of $4.7 million. Cash flow from reductions in accounts receivable of $5.8 million and inventory of $7.6 million were partially offset by a reductions in accounts payable and accrued liabilities of $7.0 million and increase in prepaid expense and other assets of $1.2 million. In addition, the $1.3 million gain on the sale of our auction rate securities is a reduction to cash from operation activities, but the proceeds of $2.0 million from the sale are included in cash from investing activities. The decrease in accounts receivable reflects lower fourth quarter sales ($35.4 million in 2011 versus $37.1 million in 2010) and stronger collections resulting in days sales outstanding of 47 days as of January 1, 2012 versus 59 days as of January 2, 2011. The lower inventory balance as of the end of the fourth quarter reflected our lower sales expectations for the first quarter of 2012.

Investing Activities During 2013, cash flow used in investing activities was $5.0 million, which was comprised of the purchases of property and equipment of $4.3 million and the net purchases of certificates of deposit of $0.7 million. During 2012 cash flow used in investing activities was $9.7 million, which was comprised of the purchases of property and equipment of $6.9 million and the net purchases of certificates of deposit of $2.8 million. During 2011, cash flow used in investing activities was $1.8 million which was comprised of gross proceeds from the sale of our remaining auction rate securities of $2.0 million, offset by the purchases of property and equipment of $3.8 million.

Our short-term investments consist of certificates of deposits. Previously, when we have had investments in marketable securities, our investment portfolio has been classified as "available for sale," and our investment objectives were to preserve principal and provide liquidity, while maximizing yields without significantly increasing risk. We would sell an investment at any time if the quality rating of the investment declined, the yield on the investment was no longer attractive, or we were in need of cash. We have used cash to acquire businesses and technologies that enhance and expand our product offering and we anticipate that we will continue to do so in the future. The nature of these transactions makes it difficult to predict the amount and timing of such cash requirements. We also anticipate that we will continue to purchase necessary property and equipment in the normal course of our business. The amount and timing of these purchases and the related cash outflows in future periods depend on a number of factors, including the hiring of employees, the rate of change of computer hardware and software used in our business, and our business outlook.

Financing Activities During 2013 cash flow from financing activities provided $32.6 million. In November 2013 we sold an aggregate of 26.4 million shares of common stock in an underwritten offering for $26.4 million. After deducting underwriting fees, legal, accounting, and other costs, we realized net proceeds of $24.0 million.

Employee purchases of our common stock under our Employee Stock Purchase Plan amounted to $1.6 million. Net proceeds under our Loan Agreement were $7.0 million as we drew down $35.3 million and repaid $28.3 million.

During 2012 cash flow from financing activities provided $5.6 million. Employee purchases of our stock under the Employee Stock Purchase Plan amounted to $0.6 million. Net proceeds under our Revolving Line Loan Agreement were $5.0 million as we drew down a total of $10.0 million under the agreement during the third and fourth quarters and repaid $5.0 million in the fourth quarter.

57-------------------------------------------------------------------------------- Table of Contents During 2011 cash flow from financing activities provided $0.8 million and was comprised predominantly of purchases of our stock under our Employee Stock Purchase Plan.

Contractual Commitments and Off Balance Sheet Arrangements We do not use off balance sheet arrangements with unconsolidated entities or related parties, nor do we use other forms of off balance sheet arrangements such as special purpose entities and research and development arrangements.

Accordingly, our liquidity and capital resources are not subject to off balance sheet risks from unconsolidated entities.

We lease certain office facilities, equipment, and software under non-cancelable operating leases. The following table summarizes our contractual obligations as of December 29, 2013 and the effect those obligations are expected to have on our liquidity and cash flow in future periods (in millions): 2015 and 2017 and There- Total 2014 2016 2018 after Operating lease payments $ 8.0 $ 2.5 $ 3.7 $ 1.8 $ - CAD software tools 6.8 4.0 2.8 - - Inventory purchase obligations 5.1 5.1 - - - Non-current income tax payable 0.8 - - - 0.8 Royalties 0.8 0.4 0.4 - - $ 21.5 $ 12.0 $ 6.9 $ 1.8 $ 0.8 For the purpose of this table, purchase obligations for the purchase of goods or services are defined as agreements that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Our purchase orders are based on our current manufacturing needs and are fulfilled by our vendors within short time horizons.

In addition, we have purchase orders that represent authorizations to purchase rather than binding agreements. We do not have significant agreements for the purchase of raw materials or other goods specifying minimum quantities or set prices that exceed our expected requirements.

Non-current income tax payable represents both the tax obligation and related accrued interest. We are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to the uncertainties in the timing of tax outcomes.

In the normal course of business, we provide indemnifications of varying scope to customers against claims of intellectual property infringement made by third parties arising from the use of our products. Historically, costs related to these indemnification provisions have not been significant, and we are unable to estimate the maximum potential impact of these indemnification provisions on our future consolidated results of operations.

Recent Accounting Pronouncements In July 2013, the Financial Accounting Standards Board issued an amendment to the accounting guidance related to the financial statement presentation of an unrecognized tax benefit when a net operating loss carry-forward, a similar tax loss or a tax credit carry-forward exists. The guidance requires an unrecognized tax benefit to be presented as a decrease in a deferred tax asset where a net operating loss, a similar tax loss, or a tax credit carry-forward exists and certain criteria are met. We are reviewing the guidance and do not expect any significant effect upon our consolidated financial position, results of operations, or cash flows.

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