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CEVA INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion together with the consolidated financial statements and related notes appearing elsewhere in this annual report. This discussion contains forward-looking statements that involve risks and uncertainties. Actual results may differ materially from those included in such forward-looking statements. Factors that could cause actual results to differ materially include those set forth under "Risk Factors," as well as those otherwise discussed in this section and elsewhere in this annual report. See "Forward-Looking Statements and Industry Data." BUSINESS OVERVIEW The following discussion and analysis is intended to provide an investor with a narrative of our financial results and an evaluation of our financial condition and results of operations. The discussion should be read in conjunction with our consolidated financial statements and notes thereto for the year ended December 31, 2013, both appearing elsewhere in this annual report. CEVA is the world's leading licensor of DSP cores and platform solutions. Our technologies are widely licensed and power many of the world's leading semiconductor and original equipment manufacturer (OEM) companies. In 2013, our licensees shipped more than one billion CEVA-powered chipsets targeted for a wide range of diverse end markets. To date, more than 5 billion CEVA-powered devices have shipped, illustrating the strong market deployment of our technology. Our DSPs power nearly every leading handset OEM in the world today, including HTC, Huawei, Lenovo, LG Electronics, Motorola, Nokia, Samsung, Sony and ZTE, as well as hundreds of local handset manufacturers in China and India. Based on internal data and Strategy Analytics' provisional worldwide shipment data, CEVA's worldwide market share of cellular baseband chips that incorporate our technologies was approximately 40% of the worldwide shipment volume in 2013. Royalty revenues derived from the handset and mobile broadband markets accounted for approximately 84% of our total royalty revenues in 2013. We believe the adoption of our DSP cores and technologies in the handset, mobile broadband and base station markets continues to progress. Specifically, we believe the emergence of low cost smartphone platforms integrating 3G and EDGE cellular connectivity from companies such as Broadcom, Intel and Spreadtrum, all of whom are our customers, is a strong positive driver for our market share expansion. We believe that the majority of this growth will come from the increased adoption of low cost smartphones in developing countries, especially China, the broader adoption of 4G LTE-based advanced smartphones further down the road, as well as the introduction of feature set enhancements in audio, computational photography and embedded vision in smart devices. In addition, we are well positioned to capitalize on our success in handsets to expand into heterogeneous cellular base station networks composed of small cells and macrocells. Beyond products enabled by our technologies for cellular baseband, we continue to strategically target growth in non-baseband applications, such as broadband communications, audio, voice, computational photography, embedded vision and connectivity. As a testament to this, during the fourth quarter, we signed 11 new license agreements, the highest number of deals signed in a single quarter in the last seven years. Three of the agreements were in baseband, three in imaging, two in audio, two in connectivity and one foundry customer. We believe the following key elements represent significant growth drivers for the company: • CEVA is firmly established in the largest space in the semiconductor industry-baseband for mobile handset-as well as the other evolving cellular markets, such as mobile computing and machine to machine. Our competitive edge in software-defined radio technology for the next generations of LTE and Wi-Fi in base stations and broadband satellite communications, and the inherent low cost and power performance balance of our technologies, puts us in a strong position to simultaneously capitalize on mass market adoption and address all of the growth sectors of the space. 28 -------------------------------------------------------------------------------- Table of Contents • Our proven track record in baseband technologies, in particular our pioneering position in software-defined radio, allows us to expand into the base station market, both in small cells and macrocells. • The market potential for advanced audio and voice processing across mobile, automotive and consumer devices offers a new growth segment for the company. Our CEVA-TeakLite-4 DSP was specifically designed to address the increasingly complex processing and stringent low-power requirements of advanced voice pre-processing and audio post-processing algorithms, including always-on voice activation, voice trigger, noise elimination and audio rendering. Many companies are looking to replace their older in-house DSPs due to the power and performance requirements outlined above. Furthermore, the programmable nature of our audio/voice DSP combined with a large ecosystem of audio partners developing software enable our customers to significantly differentiate their products and feature sets. Our proven track record in audio/voice, with more than 3 billion audio chips shipped to date, puts us in a strong position to power audio roadmaps across this new range of addressable end markets. • The market potential for computational photography and vision analytics in cameras offers a new growth segment for the company. Our CEVA-MM3101 platform is the only one in the industry today that offers a unified computational photography and vision platform that can support these future developments. As a testament to this, we have eight customers to date addressing this new growth segment with our CEVA-MM3101 platform, including three mobile OEMs. Per ABI Research, one billion cameras were shipped in 2012, and this number is predicted to grow to 2.7 billion in 2017. 80% of this volume is attributable to smartphones, where we already have a strong foothold through our other technologies. Mobile OEMs are looking for new DSLR features such as smarter autofocus, best picture using super resolution algorithms, and better image capture in low-light environments. Furthermore, with the addition of video analytics support, cameras will enable new services like augmented reality, gesture recognition and advanced safety capabilities in cars. We see this new revolution as an opportunity for us to significantly expand our footprint in smartphones and further into tablets, PCs and automotive applications. Notwithstanding the various growth opportunities we have outlined above, our business operates in a highly competitive environment. The maintenance of our competitive position and our future growth are dependent on our ability to adapt to ever-changing technologies, short product life cycles, evolving industry standards, changing customer needs and the trend towards cellular connectivity, and voice, audio and video convergence in the markets that we operate. Competition has historically increased pricing pressures for our products and decreased our average selling prices. Royalty payments under our existing license agreements also could be lower than currently anticipated for a variety of reasons, including decreased royalty rates triggered by larger volume shipments, lower royalty rates negotiated with customers due to competitive pressure or consolidation among our customers. Moreover, some of our competitors have reduced their licensing and royalty fees to attract customers and expand their market share. In order to penetrate new markets and maintain our market share with our existing products, we may need to offer our products in the future at lower prices which may result in lower profits. In addition, our future growth is dependent not only on the continued success of our existing products but also the successful introduction of new products, which requires the dedication of resources into research and development which in turn may increase our operating expenses. Furthermore, since our products are incorporated into end products of our OEM and semiconductor customers, our business is very dependent on their ability to achieve market acceptance of their end products in the handset and consumer electronic markets, which are similarly very competitive. In addition, macroeconomic trends may significantly affect our operating results. For example, consolidation among our customers may negatively affect our revenue source, increase our existing customers' negotiation leverage and make us more dependent on a limited number of customers. Also, since we derive a significant portion of our revenues from the handset market, any negative trends in that market would adversely affect our financial results. Moreover, the semiconductor and consumer electronics industries remain volatile, which makes it extremely difficult for our customers and us to accurately forecast financial results and plan for future business activities. 29-------------------------------------------------------------------------------- Table of Contents Our license arrangements have not historically provided for substantial ongoing license payments so revenue recognized from licensing arrangements vary significantly from period to period, depending on the number and size of deals closed during a quarter, and is difficult to predict. Moreover, our royalty revenues are based on the sales of products incorporating the semiconductors or other products of our customers, and as a result we do not have direct access to information that will help us anticipate the timing and amount of future royalties. We have very little visibility into the timetable of product shipments incorporating our technology by our customers. As a result, our past operating results should not be relied upon as an indication of future results. CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (U.S. GAAP). These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The significant accounting policies that we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following: • revenue recognition; • income taxes; • equity-based compensation; and • impairment of marketable securities. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP and does not require management's judgment in its application. There are also areas in which management's judgment in selecting among available alternatives would not produce a materially different result. Revenue Recognition Significant management judgments and estimates must be made and used in connection with the recognition of revenue in any accounting period. Material differences in the amount of revenue in any given period may result if these judgments or estimates prove to be incorrect or if management's estimates change on the basis of development of business or market conditions. Management's judgments and estimates have been applied consistently and have been reliable historically. We generate our revenues from (1) licensing intellectual property, which in certain circumstances is modified for customer-specific requirements, (2) royalty revenues and (3) other revenues, which include revenues from support, training and sale of development systems. We license our IP to semiconductor companies throughout the world. These semiconductor companies then manufacture, market and sell custom-designed chipsets to OEMs of a variety of consumer electronics products. We also license our technology directly to OEMs, which are considered end users. We account for our IP license revenues and related services in accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") No. 985-605, "Software Revenue Recognition." Revenues are recognized when persuasive evidence of an arrangement exists and no further obligation exists, delivery has occurred, the license fee is fixed or determinable, and collection is reasonably assured. A license may be perpetual or time limited in its application. Revenue earned on licensing arrangements involving multiple elements are allocated to each element based on the "residual method" when vendor specific 30 -------------------------------------------------------------------------------- Table of Contents objective evidence ("VSOE") of fair value exists for all undelivered elements and VSOE does not exist for one of the delivered elements. VSOE of fair value of the undelivered elements is determined based on the substantive renewal rate as stated in the agreement. Extended payment terms in a licensing arrangement may indicate that the license fees are not deemed to be fixed or determinable. If the fee is not fixed or determinable, revenue is recognized as payments become due from the customer unless collection is not considered reasonably assured, then revenue is recognized as payments are collected from the customer, provided all other revenue recognition criteria have been met. Revenues from license fees that involve significant customization of our IP to customer-specific specifications are recognized in accordance with the principles set out in FASB ASC No. 605-35-25, "Construction-Type and Production-Type Contracts Recognition," using contract accounting on a percentage of completion method. The amount of revenue recognized is based on the total license fees under the agreement and the percentage of completion achieved. The percentage of completion is measured by the actual time incurred to date on the project compared to the total estimated project requirements, which correspond to the costs related to earned revenues. Provisions for estimated losses on uncompleted contracts are made during the period in which such losses are first determined, in the amount of the estimated loss on the entire contract. Revenues that are derived from the sale of a licensee's products that incorporate our IP are classified as royalty revenues. Royalty revenues are recognized during the quarter in which we receive a report from the licensee detailing the shipment of products that incorporate our IP, which receipt is in the quarter following the licensee's sale of such products to its customers. Royalties are calculated either as a percentage of the revenues received by our licensees on sales of products incorporating our IP or on a per unit basis, as specified in the agreements with the licensees. Non-refundable payments on account of future royalties (prepaid royalties) are included within our licensing and related revenue line on the consolidated statements of income. We may engage a third party to perform royalty audits of our licensees, and if these audits indicate any over- or under-reported royalties, we account for the results when the audits are resolved. In addition to license fees, contracts with customers generally contain an agreement to provide for post contract support and training, which consists of telephone or e-mail support, correction of errors (bug fixing) and unspecified updates and upgrades. Fees for post contract support, which takes place after delivery to the customer, are specified in the contract and are generally mandatory for the first year. After the mandatory period, the customer may extend the support agreement on similar terms on an annual basis. We recognize revenue for post contract support on a straight-line basis over the period for which technical support is contractually agreed to be provided to the licensee, typically 12 months. Revenues from training are recognized as the training is performed. Revenues from the sale of development systems are recognized when title to the product passes to the customer and all other revenue recognition criteria have been met. We usually do not provide rights of return. When rights of return are included in the license agreements, revenue is deferred until rights of return expire. Income Taxes We are subject to income taxes mainly in Israel, the U.S. and Ireland. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. We recognize income taxes under the liability method. Tax benefits are recognized from uncertain tax positions only if we believe that it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves when facts and circumstances change, such as the closing of a tax audit, the refinement of an 31 -------------------------------------------------------------------------------- Table of Contents estimate or changes in tax laws. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the effects of any reserves that are considered appropriate, as well as the related net interest and penalties. We recognize deferred tax assets and liabilities for future tax consequences arising from differences between the carrying amounts of existing assets and liabilities under GAAP and their respective tax bases, and for net operating loss carryforwards and tax credit carryforwards. We regularly review our deferred tax assets for recoverability and establish a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. To make this judgment, we must make predictions of the amount and category of taxable income from various sources and weigh all available positive and negative evidence about these possible sources of taxable income. Accounting for tax positions requires judgments, including estimating reserves for potential uncertainties. We also assess our ability to utilize tax attributes, including those in the form of carry forwards for which the benefits have already been reflected in the financial statements. While we believe the resulting tax balances as of December 31, 2012 and 2013 are appropriately accounted for, the ultimate outcome of such matters could result in favorable or unfavorable adjustments to our consolidated financial statements and such adjustments could be material. See Note 12 to our Consolidated Financial Statements for the year ended December 31, 2013 for further information regarding income taxes. We have filed or are in the process of filing local and foreign tax returns that are subject to audit by the respective tax authorities. The amount of income tax we pay is subject to ongoing audits by the tax authorities, which often result in proposed assessments. We believe that we adequately provided for any reasonably foreseeable outcomes related to tax audits and settlement. However, our future results may include favorable or unfavorable adjustments to our estimated tax liabilities in the period the assessments are made or resolved, audits are closed or when statute of limitations on potential assessments expire. Equity-Based Compensation We account for equity-based compensation in accordance with FASB ASC No. 718, "Stock Compensation" which requires the recognition of compensation expenses based on estimated fair values for all equity-based awards made to employees and non-employee directors. We estimate the fair value of equity-based awards on the date of grant using an option-pricing model. The value of the portion of an award that is ultimately expected to vest is recognized as an expense over the requisite service period in our consolidated statement of income. We recognize compensation expenses for the value of our awards, which have graded vesting based on the accelerated attribution method over the requisite service period of each of the awards, net of estimated forfeitures. Estimated forfeitures are based on actual historical pre-vesting forfeitures and the rate is adjusted to reflect changes in facts and circumstances, if any. Estimated forfeiture rate will be revised if actual forfeitures differ from the initial estimates. We use the Monte-Carlo simulation model for options and stock appreciation rights ("SARs") granted. Expected volatility was calculated based upon actual historical stock price movements over the most recent periods ending on the grant date, equal to the expected option and SAR term. We have historically not paid dividends and have no foreseeable plans to pay dividends. The risk-free interest rate is based on the yield from U.S. Treasury zero-coupon bonds with an equivalent term. The Monte-Carlo model also considers the suboptimal exercise multiple which is based on the average exercise behavior of our employees over the past years, the contractual term of the options and SARs, and the probability of termination or retirement of the holder of the options and SARs in computing the value of the options and SARs. Although our management believes that their estimates and judgments about equity-based compensation expense are reasonable, actual results and future changes in estimates may differ substantially from our current estimates. 32-------------------------------------------------------------------------------- Table of Contents Impairment of Marketable Securities Marketable securities consist of certificates of deposits, corporate bonds and government securities. We determine the appropriate classification of marketable securities at the time of purchase and re-evaluate such designation at each balance sheet date. In accordance with FASB ASC No. 320, "Investment Debt and Equity Securities," we classify marketable securities as available-for-sale. Available-for-sale securities are stated at fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), a separate component of stockholders' equity, net of taxes. Realized gains and losses on sales of marketable securities, as determined on a specific identification basis, are included in financial income, net. The amortized cost of marketable securities is adjusted for amortization of premium and accretion of discount to maturity, both of which, together with interest, are included in financial income, net. We have classified all marketable securities as short-term, even though the stated maturity date may be one year or more beyond the current balance sheet date, because we may sell these securities prior to maturity to meet liquidity needs or as part of risk versus reward objectives. We recognize an impairment charge when a decline in the fair value of our investments in debt securities below the cost basis of such securities is judged to be other-than-temporary. The determination of credit losses requires significant judgment and actual results may be materially different from our estimates. Factors considered in making such a determination include the duration and severity of the impairment, the reason for the decline in value, the ability of the issuer to meet payment obligations, the potential recovery period and our intent to sell, including whether it is more likely than not that we will be required to sell the investment before recovery of cost basis. For securities that are deemed other-than-temporarily impaired, the amount of impairment is recognized in the statement of income and is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income. During the years ended December 31, 2011, 2012 and 2013, no other-than temporary impairment were recorded related to our marketable securities. RESULTS OF OPERATIONS The following table presents line items from our consolidated statements of income as percentages of our total revenues for the periods indicated: 2011 2012 2013 Consolidated Statements of Income Data: Revenues: Licensing and related revenue 39.6 % 40.5 % 45.8 % Royalties 60.4 % 59.5 % 54.2 % Total revenues 100.0 % 100.0 % 100.0 % Cost of revenues 5.9 % 7.4 % 10.6 % Gross profit 94.1 % 92.6 % 89.4 % Operating expenses: Research and development, net 35.8 % 37.7 % 43.4 % Sales and marketing 14.8 % 17.2 % 20.6 % General and administrative 12.7 % 14.7 % 15.7 % Total operating expenses 63.3 % 69.6 % 79.7 % Operating income 30.8 % 23.0 % 9.7 % Financial income, net 4.8 % 6.3 % 5.6 % Income before taxes on income 35.6 % 29.3 % 15.3 % Income taxes 4.8 % 3.8 % 1.6 % Net income 30.8 % 25.5 % 13.7 % 33 -------------------------------------------------------------------------------- Table of Contents Discussion and Analysis Below we provide information on the significant line items in our consolidated statements of income for each of the past three fiscal years, including the percentage changes year-on-year, as well as an analysis of the principal drivers of change in these line items from year-to-year. Revenues Total Revenues 2011 2012 2013 Total revenues (in millions) $ 60.2 $ 53.7 $ 48.9 Change year-on-year - (10.9 )% (8.9 )% The decrease in total revenues from 2012 to 2013 reflected principally lower royalty revenues, offset by slightly higher licensing and related revenue. The decrease in total revenues from 2011 to 2012 reflected lower royalty revenues and lower licensing and related revenue. We generate royalty revenues mainly from our customers which ship units of chipsets incorporating our technologies. The royalties are invoiced and recognized on a quarterly basis in arrears as we receive quarterly shipment reports from our licensees. The royalty rate is based either on a certain percent of the chipset price or a fixed amount per chipset based on volume discounts. We derive a significant amount of revenues from a limited number of customers. Two customers separately accounted for 28% and 11% of our total revenues for 2013. One customer accounted for 28%, 24% and 17% of our total revenues for 2013, 2012 and 2011, respectively, and the other customer accounted for 11%, 13% and 16% of our total revenues for 2013, 2012 and 2011, respectively. With respect to our royalty revenues, four royalty paying customers each represented 10% or more of our total royalty revenues for 2013, 2012 and 2011, and collectively represented 81%, 74% and 66% of our total royalty revenues for 2013, 2012 and 2011, respectively. We expect that a significant portion of our future revenues will continue to be generated by a limited number of customers. The concentration of our customers is explainable in part by consolidation in the semiconductor industry. The loss of any significant customer could adversely affect our near-term future operating results. The following table sets forth the products and services that represented 10% or more of our total revenues in each of the periods set forth below: Year ended December 31, 2011 2012 2013 CEVA-X family 26 % 21 % 39 % CEVA TeakLite family 49 % 54 % 38 % CEVA Teak family 17 % 14 % *) *) Less than 10% We expect these products will continue to generate a significant portion of our revenues for 2014. The remaining amount consists of other families of products and services, some of which are relatively new like the MM3K product line for new non-baseband markets that each currently represented less than 10% of our total revenues. Our total revenues derived from the handsets and mobile broadband markets represented 77% of our total revenues for 2013, 2012 and 2011. 34-------------------------------------------------------------------------------- Table of Contents Licensing and related revenue 2011 2012 2013 Licensing and related revenue (in millions) $ 23.8 $ 21.7 $ 22.4 Change year-on-year - (8.8 )% 3.0 % The increase in licensing and related revenue from 2012 to 2013 principally reflected higher revenues from new market segments and related technologies, especially in the multimedia space. We signed 30 license agreements in 2013, of which 17 were with new first time CEVA customers. This trend is indicative of our strategy to expand our business reach beyond cellular baseband markets. We posted higher revenues from our CEVA-X DSP core family of products and our multimedia core family of products, which was partially offset by lower revenues from our CEVA-TeakLite DSP core family of products. The decrease in licensing and related revenue from 2011 to 2012 principally reflected lower revenues from our CEVA-X DSP core family of products and CEVA-Teak DSP core family of products, partially offset by higher revenues from our CEVA-TeakLite DSP core family of products. Our technologies are now designed in by leading semiconductor companies and OEMs in their base stations, smartphone application processors, imaging chips, audio chips, as well as automotive, smart grid, Wi-Fi, satellite communication, connectivity and GPS devices. Licensing and related revenue accounted for 45.8% of our total revenues for 2013, compared with 40.5% and 39.6% of our total revenues for 2012 and 2011, respectively. The percentage increase in licensing and related revenue principally reflect lower royalty revenues. In 2013, we signed 30 new license agreements, compared to 31 and 30 in 2012 and 2011, respectively. Starting on January 1, 2013, we consolidated other revenues within licensing revenues since the other revenues component is directly associated with licensing revenues and none of the components that comprise other revenues (support, training and development systems) is significant compared to our total revenues. Prior period numbers were conformed to our current period presentation of one revenue line titled "licensing and related revenue." Royalty Revenues 2011 2012 2013 Royalty revenues (in millions) $ 36.4 $ 32.0 $ 26.5 Change year-on-year - (12.2 )% (17.0 )% Based on Strategic Analytics and internal data, CEVA's worldwide market share of baseband chips that incorporate our technologies represented approximately 40%, 44% and 42% of the worldwide baseband volume based on third quarter shipments in 2013, 2012 and 2011, respectively, and accounted for approximately 84%, 79% and 78% of our total royalty revenues for 2013, 2012 and 2011, respectively. The decrease in royalty revenues from 2012 to 2013 reflected consumer electronic business contraction due to stagnant sales for end of life legacy products, ASP erosion in the 2G feature phone space and the overall market decrease in feature phones. The decrease in royalty revenues from 2011 to 2012 was due to (i) Intel's design loss of the iPhone baseband socket which shipped in large volumes in 2011 in comparison to 2012 and this baseband socket from Intel incorporated CEVA's technology and bore higher royalty average selling prices than other 2G phones that incorporated CEVA's technology, and (ii) a significant 2G baseband chip price erosion in 2012 which had a direct negative effect on our royalty revenues as most of our royalty arrangements for the 2G segment is based on a percent of chip sales prices. These negative trends were partially offset by higher quantities of smartphones (excluding the iPhone shipments), which bore higher royalty average selling prices. The five largest royalty-paying customers accounted for 87.3% of our total royalty revenues in 2013, compared to 81.6% and 74.0% in 2012 and 2011, respectively. 35-------------------------------------------------------------------------------- Table of Contents Our customers reported sales of 1,010 million chipsets incorporating our technologies in 2013, compared to 1,082 million in 2012 and 1,027 million in 2011. The decrease in units shipped in 2013 as compared to 2012 primarily resulted from lower feature phone shipments by major OEMs like Nokia, partially offset by increased unit shipments in smartphones in emerging economies. The increase in units shipped in 2012 as compared to 2011 primarily resulted from the strong momentum in shipments of cellular processors enabled by our DSPs that are now widely deployed across all market segments. Geographic Revenue Analysis 2011 2012 2013 (in millions, except percentages) United States $14.3 23.8% $11.4 21.2% $6.1 12.4% Europe, Middle East (EME) (1) (2) $19.9 33.0% $13.7 25.5% $13.4 27.4% Asia Pacific (APAC) (3) (4) $26.0 43.2% $28.6 53.3% $29.4 60.2% (1) Germany $12.3 20.4% $6.8 12.7% $5.5 11.3% (2) Switzerland $6.2 10.2% *) *) *) *) (3) China $13.8 22.9% $15.9 29.7% $20.5 41.9% (4) Japan *) *) $7.7 14.4% *) *) *) Less than 10% Due to the nature of our license agreements and the associated potential large individual contract amounts, the geographic spilt of revenues both in absolute dollars and percentage terms generally varies from period to period. The decrease in revenues in absolute dollars and percentage terms in the United States from 2012 to 2013 and from 2011 to 2012 reflects lower licensing activities due to less new design activities by chip vendors and OEMs, and from prolonged decision-making process for new and advanced designs and technologies. The decrease from 2011 to 2012 is also due to general economic uncertainty and was partially offset by a large key customer that increased its 3G baseband shipments, which increased our royalty revenues derived from the United States. This trend did not take place in 2013 due to slower product ramp up by a few of our U.S. customers. The slight decrease in revenues in absolute dollars and percentage in the EME region from 2012 to 2013 primarily reflected lower royalty revenues mainly due to lower shipments of feature phone based baseband chips and the breakup of one of our customers-the STE joint venture-and the resulting market share loss. The decrease in royalty revenues was partially offset by new strategic licensing revenue from a key new customer. The decrease in revenues in absolute dollars and percentage in the EME region from 2011 to 2012 primarily reflected lower royalty revenues mainly due to the 2G baseband price erosion and Intel's loss of the iPhone baseband socket. In addition, licensing activity in the EME region was minimal due to the then on-going European Union economic difficulties. The slight increase in revenues in absolute dollars and percentage terms in the APAC region from 2012 to 2013 primarily reflected higher licensing revenues in baseband and new non-baseband markets for our multimedia and audio technologies, as well as higher royalties in the low cost smartphone markets of China and other emerging economies, partially offset by lower royalties from end of life of legacy consumer electronics products. The increase in revenues in absolute dollars and percentage terms in the APAC region from 2011 to 2012 primarily reflected higher licensing revenues, mainly due to strong licensing activities in Japan, offset by overall lower royalty revenues resulting from the price erosion of 2G baseband average selling prices in the local Chinese market. 36-------------------------------------------------------------------------------- Table of Contents Cost of Revenues 2011 2012 2013 Cost of revenues (in millions) $ 3.6 $ 4.0 $ 5.2 Change year-on-year - 11.0 % 30.6 % Cost of revenues accounted for 10.6% of our total revenues for 2013, compared with 7.4% of our total revenues for 2012 and 5.9% of our total revenues for 2011. The absolute dollar and percentage increase in cost of revenues for 2013 as compared to 2012 principally reflected higher customization work for our licensees (which are allocated from the research and development expense line), higher payments to the Office of the Chief Scientist of Israel and higher sub-contractor costs, partially offset by lower salary and related costs. The absolute dollar and percentage increase in cost of revenues for 2012 as compared to 2011 principally reflected higher salary and related costs, mainly due to higher headcount and higher travel expenses. Cost of revenues includes labor-related costs and, where applicable, costs related to overhead, subcontractors, materials, travel, royalty expenses payments to the Office of the Chief Scientist of Israel and non-cash equity-based compensation expenses. Non-cash equity-based compensation expenses included in cost of revenues for the years 2013, 2012, and 2011 were $312,000, $241,000 and $239,000, respectively. Royalty expenses relate to royalties payable to the Office of the Chief Scientist of Israel that amount to 3%-3.5% of the actual sales of certain of our products, the development of which previously included grants from the Office of the Chief Scientist of Israel. The obligation to pay these royalties is contingent on actual sales of these products. Operating Expenses 2011 2012 2013 (in millions) Research and development, net $ 21.5 $ 20.2 $ 21.2 Sales and marketing $ 8.9 $ 9.2 $ 10.1 General and administration $ 7.7 $ 7.9 $ 7.7 Total operating expenses $ 38.1 $ 37.3 $ 39.0 Change year-on-year - (2.0 )% 4.3 % The increase in total operating expenses for 2013 as compared to 2012 principally reflected higher salary and related costs, higher project-related expenses and higher non-cash equity-based compensation expenses, partially offset by higher research grants received from the Office of Chief Scientist of Israel, higher cost allocation to cost of revenues for customization work for our licensees and lower professional services cost. The decrease in total operating expenses for 2012 as compared to 2011 principally reflected (i) lower salary and related costs, mainly due to lower currency exchange expenses as a result of the revaluation of the U.S. dollar against the Israeli NIS, (ii) higher research grants received from the Office of Chief Scientist of Israel, and (iii) lower commission expenses, partially offset by higher professional services cost, mainly associated with the MIPS transaction, and higher travel expenses. Research and Development Expenses, Net 2011 2012 2013 Research and development expenses, net (in millions) $ 21.5 $ 20.2 $ 21.2 Change year-on-year - (6.0 )% 4.8 % The net increase in research and development expenses for 2013 as compared to 2012 principally reflected higher project-related expenses, higher non-cash equity-based compensation expenses and higher salary and 37-------------------------------------------------------------------------------- Table of Contents related costs, partially offset by higher research grants received from the Office of Chief Scientist of Israel and higher cost allocation to cost of revenues for customization work for our licensees. The net decrease in research and development expenses for 2012 as compared to 2011 principally reflected (i) lower salary and related costs, mainly due to lower currency exchange expenses as a result of the revaluation of the U.S. dollar against the Israeli NIS, (ii) higher research grants received from the Office of Chief Scientist of Israel, and (iii) lower non-cash equity-based compensation expenses. The average number of research and development personnel in 2013 was 129, compared to 128 in 2012 and 130 in 2011. The number of research and development personnel was 140 at December 31, 2013 as compared with 125 at year-end 2012 and 134 at year-end 2011. Research and development expenses, net of related government grants, were 43.4% of our total revenues for 2013, as compared with 37.7% for 2012 and 35.8% for 2011. We recorded research grants under funding programs of the Office of the Chief Scientist of Israel of $3,213,000 in 2013, compared with $2,849,000 in 2012 and $2,518,000 in 2011. Grants received from the Office of the Chief Scientist of Israel may become repayable if certain criteria under the grants are not met. Research and development expenses consist primarily of salaries and associated costs and project-related expenses connected with the development of our intellectual property which are expensed as incurred, and non-cashequity-based compensation expenses. Non-cash equity-based compensation expenses included in research and development expenses, net for the years 2013, 2012 and 2011 were $2,014,000, $1,810,000 and $1,934,000, respectively. Research and development expenses are net of related government research grants. We view research and development as a principal strategic investment and have continued our commitment to invest heavily in this area, which represents the largest of our ongoing operating expenses. We will need to continue to invest in research and development and such expenses may increase in the future to keep pace with new trends in our industry. We anticipate higher annual operational expenses in 2014 due to higher research and developments costs, mainly related to higher headcount and related expenses. Sales and Marketing Expenses 2011 2012 2013 Sales and marketing expenses (in millions) $ 8.9 $ 9.2 $ 10.1 Change year-on-year - 3.3 % 9.3 % The increase in sales and marketing expenses for 2013 as compared to 2012 principally reflected higher salary and related expenses, higher commission and higher non-cash equity-based compensation expenses. The increase in sales and marketing expenses for 2012 as compared to 2011 principally reflected higher salary and related expenses, mainly due to higher headcount, travel expenses and marketing and trade show activities, partially offset by lower commission expenses. Sales and marketing expenses as a percentage of our total revenues were 20.6% for 2013, as compared with 17.2% for 2012 and 14.8% for 2011. The total number of sales and marketing personnel was 29 at year-end 2013, as compared with 29 at year-end 2012 and 24 at year-end 2011. Sales and marketing expenses consist primarily of salaries, commissions, travel and other costs associated with sales and marketing activities, as well as advertising, trade show participation, public relations and other marketing costs and non-cash equity-based compensation expenses. Non-cash equity-based compensation expenses included in sales and marketing expenses for the years 2013, 2012 and 2011 were $1,311,000, $1,036,000 and $1,094,000, respectively. General and Administrative Expenses 2011 2012 2013 General and administrative expenses (in millions) $ 7.6 $ 7.9 $ 7.7 Change year-on-year - 3.2 % (2.7 )% 38 -------------------------------------------------------------------------------- Table of Contents The decrease in general and administrative expenses for 2013 as compared to 2012 principally reflected lower professional services cost, partially offset by higher non-cash equity-based compensation expenses. The increase in general and administrative expenses for 2012 as compared to 2011 principally reflected higher professional services cost associated with the MIPS transaction, partially offset by lower salary and related expenses, mainly due to lower bonus provisions. General and administrative expenses as a percentage of our total revenues were 15.7% for 2013, as compared with 14.7% for 2012 and 12.7% for 2011. The total number of general and administrative personnel was 21 at year-end 2013, as compared with 22 at year-end 2012 and 21 at year-end 2011. General and administrative expenses consist primarily of fees for directors, salaries for management and administrative employees, accounting and legal fees, expenses related to investor relations and facilities expenses associated with general and administrative activities and non-cash equity-based compensation expenses. Non-cash equity-based compensation expenses included in general and administrative expenses for the years 2013, 2012 and 2011 were $2,283,000, $1,996,000 and $1,891,000, respectively. Financial Income, net 2011 2012 2013 (in millions) Financial income, net $ 2.91 $ 3.38 $ 2.71 of which: Interest income and gains and losses from marketable securities, net $ 2.92 $ 3.42 $ 2.76 Foreign exchange loss $ (0.01 ) $ (0.04 ) $ (0.05 ) Financial income, net, consists of interest earned on investments, gains and losses from sale of marketable securities, accretion (amortization) of discount (premium) on marketable securities and foreign exchange movements. The decrease in interest income, and gains and losses from marketable securities, net, for 2013 as compared to 2012 reflected lower combined cash, bank deposits and marketable securities balances held and lower yields, offset by higher gains on sale of marketable securities. The increase in interest income, and gains and losses from marketable securities, net, for 2012 as compared to 2011 reflected higher combined cash, bank deposits and marketable securities balances held and higher yields. We review our monthly expected major non-U.S. dollar denominated expenditures and look to hold equivalent non-U.S. dollar cash balances to mitigate currency fluctuations. This has resulted in a foreign exchange loss of $0.05 million, $0.04 million and $0.01 million in 2013, 2012 and 2011, respectively. Provision for Income Taxes During the years 2013, 2012 and 2011, we recorded tax expenses of $0.8 million, $2.1 million and $2.9 million, respectively. The decrease in provision for income taxes in 2013 as compared to 2012 principally reflected lower income before taxes on income. The decrease in provision for income taxes in 2012 as compared to 2011 principally reflected (i) lower income before taxes on income, (ii) lower withholding tax expenses which we were unable to obtain a refund from certain foreign tax authorities, and (iii) the utilization of losses carried forward in a certain tax jurisdiction, partially offset by a higher tax rate for our Israeli subsidiary as a result of an increase in the tax rate of one of its investment programs from a tax exempt status in 2011 to a tax rate of 10% for this investment program in 2012. We have significant operations in Israel and operations in the Republic of Ireland, and a substantial portion of our taxable income is generated there. Currently, our Israeli and Irish subsidiaries are taxed at rates substantially lower than U.S. tax rates. 39-------------------------------------------------------------------------------- Table of Contents Our Irish subsidiary qualified for a 12.5% tax rate on its trade. Interest income generated by our Irish subsidiary is taxed at a rate of 25%. Our Israeli subsidiary is entitled to various tax benefits by virtue of the "Approved Enterprise" and/or "Benefited Enterprise" status granted to its eight investment programs, as defined by the Israeli Investment Law. In accordance with the Investment Law, our Israeli subsidiary's first five investment programs were subject to corporate tax rate of 25% in 2013, and our Israeli subsidiary's sixth, seventh and eighth investment programs were subject to corporate tax rate of 10% in 2013. However, our Israeli subsidiary received an approval for the erosion of tax basis with respect to its second, third, fourth and fifth investment programs, and this resulted in an increase in the taxable income attributable to the sixth, seventh and eighth investment programs, which were subject to a reduced tax rate of 10% in 2013. The tax benefits under our Israeli subsidiary's active investment programs are scheduled to gradually expire starting in 2014. To maintain our Israeli subsidiary's eligibility for the above tax benefits, it must continue to meet certain conditions under the Investment Law. Should our Israeli subsidiary fail to meet such conditions in the future, these benefits would be cancelled and it would be subject to corporate tax in Israel at the standard corporate rate and could be required to refund tax benefits already received, with interest and adjustments for inflation based on the Israeli consumer price index. For more information about our provision for income taxes, see Note 12 to the attached Notes to Consolidated Financial Statement for the year ended December 31, 2013. LIQUIDITY AND CAPITAL RESOURCES As of December 31, 2013, we had approximately $24.1 million in cash and cash equivalents, $41.9 million in short term bank deposits, $68.5 million in marketable securities, and $17.1 million in long term bank deposits, totaling $151.6 million, as compared to $158.0 million at December 31, 2012. The decrease in 2013 as compared to 2012 principally reflected a repurchase of 1,257,004 shares of common stock for an aggregate purchase price of approximately $20 million, partially offset by net cash provided by operating activities of approximately $13 million. During 2013, we invested $105.0 million of cash in bank deposits and marketable securities. The actual maturity of bank deposits and marketable securities as of December 31, 2013, is up to 34 months from the balance sheet date. In addition, during the same period, bank deposits and marketable securities were sold or redeemed for cash amounting to $116.1 million. During 2012, we invested $125.6 million of cash in bank deposits and marketable securities with maturities up to 36 months. In addition, during the same period, bank deposits and marketable securities were sold or redeemed for cash amounting to $137.6 million. During 2011, we invested $107.0 million of cash in bank deposits and marketable securities with maturities up to 36 months. In addition, during the same period, bank deposits and marketable securities were sold or redeemed for cash amounting to $69.0 million. All of our marketable securities are classified as available-for-sale. The purchase and sale or redemption of available-for-sale marketable securities are considered part of investing cash flow. Available-for-sale marketable securities are stated at fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), a separate component of stockholders' equity, net of taxes. Realized gains and losses on sales of investments, as determined on a specific identification basis, are included in the consolidated statements of income. We did not recognize any other-than-temporarily-impaired charges on marketable securities in 2013, 2012 and 2011. For more information about our marketable securities, see Notes 1 and 2 to the attached Notes to Consolidated Financial Statement for the year ended December 31, 2013. Bank deposits are classified as short-term bank deposits and long-term bank deposits. Short-term bank deposits are deposits with maturities of more than three months but no longer than one year from the balance sheet date, whereas long-term bank deposits are deposits with maturities of more than one year as of the balance sheet date. Bank deposits are presented at their cost, including accrued interest, and purchases and sales are considered part of cash flows from investing activities. 40 -------------------------------------------------------------------------------- Table of Contents Operating Activities Cash provided by operating activities in 2013 was $13.7 million and consisted of net income of $6.7 million, adjustments for non-cash items of $7.4 million, and changes in operating assets and liabilities of $0.4 million. Adjustments for non-cash items primarily consisted of $6.6 million of depreciation and equity-based compensation expenses and $1.5 million of amortization of premiums on available-for-sale marketable securities. The slight decrease in cash from changes in operating assets and liabilities primarily consisted of an increase in deferred tax assets, net, of $1.2 million and a decrease in accrued expenses and other payables of $0.4 million, partially offset by a decrease in trade receivables of $0.6 million and an increase of accrued payroll and related benefits of $0.6 million. Cash provided by operating activities in 2012 was $18.6 million and consisted of net income of $13.7 million, adjustments for non-cash items of $4.8 million, and changes in operating assets and liabilities of $0.1 million. Adjustments for non-cash items primarily consisted of $5.6 million of depreciation and equity-based compensation expenses, $1.3 million of amortization of premiums on available-for-sale marketable securities, and $1.8 million of accrued interest on bank deposits. The slight increase in cash from changes in operating assets and liabilities primarily consisted of a decrease in prepaid expenses and other current assets of $0.9 million, an increase in trade payables of $0.6 million, an increase of accrued expenses and other payables of $0.3 million and an increase in income taxes payable of $1.1 million, partially offset by an increase in trade receivables of $1.1 million, an increase in deferred tax assets, net, of $0.7 million, a decrease in deferred revenues of $0.2 million, and a classification of excess tax benefit from equity-based compensation expenses of $0.7 million as financing cash flows. Cash provided by operating activities in 2011 was $27.1 million and consisted of net income of $18.6 million, adjustments for non-cash items of $6.5 million, and changes in operating assets and liabilities of $2.0 million. Adjustments for non-cash items primarily consisted of $5.7 million of depreciation and equity-based compensation expenses, $2.1 million of amortization of premiums on available-for-sale marketable securities, and $1.1 million of accrued interest on bank deposits. The increase in cash from changes in operating assets and liabilities primarily consisted of a decrease in prepaid expenses and other current assets of $3.3 million, mainly reflecting a tax refund, a decrease in trade receivable of $0.8 million, an increase of income tax payable of $0.5 million, and an increase in deferred revenues of $0.5 million, partially offset by an increase in deferred tax assets, net, of $1.4 million, a decrease in accrued expenses and other payables of $0.6 million and a classification of excess tax benefit from equity-based compensation expenses of $1.3 million as financing cash flows. Cash flows from operating activities may vary significantly from quarter to quarter depending on the timing of our receipts and payments. Our ongoing cash outflows from operating activities principally relate to payroll-related costs and obligations under our property leases and design tool licenses. Our primary sources of cash inflows are receipts from our accounts receivable, to some extent funding from the Office of Chief Scientist of Israel and interest earned from our cash, deposits and marketable securities. The timing of receipts of accounts receivable from customers is based upon the completion of agreed milestones or agreed dates as set out in the contracts. Investing Activities Net cash provided by investing activities in 2013 was $9.3 million, as compared with net cash provided by investing activities of $9.8 million in 2012, and net cash used in investing activities of $39.3 million in 2011. We had a cash outflow of $64.8 million and a cash inflow of $64.2 million in respect of investments in marketable securities during 2013. Included in the cash inflow during 2013 was net proceeds of $11.7 million from bank deposits. We had a cash outflow of $60.9 million and a cash inflow of $60.7 million in respect of investments in marketable securities during 2012. Included in the cash inflow during 2012 was net proceeds of $12.2 million from bank deposits. We had a cash outflow of $42.3 million and a cash inflow of $44.0 million in respect of investments in marketable securities during 2011. Included in the cash outflow during 2011 was a net investment of $39.7 million in bank deposits. Capital equipment purchases of computer hardware and software used in 41-------------------------------------------------------------------------------- Table of Contents engineering development, furniture and fixtures amounted to approximately $0.9 million in 2013, $0.7 million in 2012 and $0.4 million in 2011. We had a cash outflow of $0.9 million, $1.5 million and $0.9 million in 2013, 2012 and 2011, respectively, from a minority investment in two private companies. Financing Activities Net cash used in financing activities in 2013 was $17.3 million, as compared to net cash used in financing activities of $24.9 million in 2012 and net cash provided by financing activities of $10.0 million in 2011. In August 2008, we announced that our board of directors approved a share repurchase program for up to one million shares of common stock. In May 2010, we announced that our board of directors approved the expansion of our share repurchase program by another two million shares of common stock, with one million shares available for repurchase in accordance with Rule 10b5-1 of the Securities Exchange Act, which plan terminated by its terms in November 2011 and one million shares available for repurchase in accordance with Rule 10b-18 of the Securities Exchange Act. In January 2012, our board of directors reaffirmed its authorization for our repurchase of the remaining 1,966,700 shares of common stock available for repurchase pursuant to Rule 10b-18 of the Securities Exchange Act. In July 2013, our Company's Board of Directors authorized the repurchase of an additional two million shares of common stock pursuant to Rule 10b-18 of the Exchange Act. In 2013, we repurchased 1,257,004 shares of common stock at an average purchase price of $15.76 per share for an aggregate purchase price of $19.8 million. In 2012, we repurchased 1,482,548 shares of common stock at an average purchase price of $18.33 per share for an aggregate purchase price of $27.2 million. We did not repurchase any shares of common stock in 2011. As of December 31, 2013, 1,227,148 shares of common stock remained authorized for repurchase pursuant to our share repurchase program. In 2013, 2012 and 2011, we received $2.5 million, $1.6 million and $8.7 million, respectively, from the exercise of stock-based awards. In 2012 and 2011, we classified $0.7 million and $1.3 million, respectively, of excess tax benefit from equity-based compensation expenses as financing cash flows. We believe that our cash and cash equivalent , short-term bank deposits and marketable securities, along with cash from operations, will provide sufficient capital to fund our operations for at least the next 12 months. We cannot provide assurance, however, that the underlying assumed levels of revenues and expenses will prove to be accurate. In addition, as part of our business strategy, we occasionally evaluate potential acquisitions of businesses, products and technologies and minority equity investments. Accordingly, a portion of our available cash may be used at any time for the acquisition of complementary products or businesses or minority equity investments. Such potential transactions may require substantial capital resources, which may require us to seek additional debt or equity financing. We cannot assure you that we will be able to successfully identify suitable acquisition or investment candidates, complete acquisitions or investments, integrate acquired businesses into our current operations, or expand into new markets. Furthermore, we cannot provide assurance that additional financing will be available to us in any required time frame and on commercially reasonable terms, if at all. See "Risk Factors-We may seek to expand our business in ways that could result in diversion of resources and extra expenses." for more detailed information. 42 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations The table below presents the principal categories of our contractual obligations as of December 31, 2013: Payments Due by Period ($ in thousands) Less than More than Total 1 year 1-3 years 3-5 years 5 years Operating Lease Obligations-Leasehold properties 914 728 186 - - Purchase Obligations-design tools 2,960 1,681 1,279 - - Other purchase Obligations 220 220 - - - Total 4,094 2,629 1,465 - - Operating leasehold obligations principally relate to our offices in Ireland, Israel and the United States. Purchase obligations relate to license agreements entered into for maintenance of design tools. Other purchase obligations consist of capital and operating purchase order commitments. Other than set forth in the table above, we have no long-term debt or capital lease obligations. At December 31, 2013, our income tax payable, net of withholding tax credits, included $3,563,000 related to uncertain tax positions. Due to uncertainties in the timing of the completion of tax audits, the timing of the resolution of these positions is uncertain and we are unable to make a reasonably reliable estimate of the timing of payments. As a result, this amount is not included in the above table. In addition, at December 31, 2013, the amount of accrued severance pay was $7,255,000. Severance pay relates to accrued severance obligations to our Israeli employees as required under Israeli labor laws. These obligations are payable only upon termination, retirement or death of the respective employee. Of this amount, only $40,000 is unfunded. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements, as such term is defined in recently enacted rules by the Securities and Exchange Commission, that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. |