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GIGOPTIX, 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 and analysis in conjunction with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under "Risk Factors" in Item 1A of this Annual Report on Form 10-K and our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K,including Note 1-Organization and Basis of Presentation, to such consolidated financial statements and elsewhere as set forth in this Annual Report on Form 10-K. We assume no obligation to update the forward-looking statements or such risk factors. Please see "Special Note Regarding Forward- Looking Statements" above. Overview We are a leading fabless supplier of high speed semiconductor components that enable end-to-end information streaming over optical and wireless networks. Our products address long haul and metro telecommunications applications as well as emerging high-growth opportunities for Cloud and datacenter connectivity, interactive applications for consumer electronics, high-speed optical and wireless networks, and the industrial, defense and avionics industries. The business is made up of two product lines: our High-Speed Communications (HSC) product line and our Industrial product line. Through our HSC product line we offer a broad portfolio of high performance optical and wireless components to telecommunications (telecom) and data communications (datacom) customers, including i) mixed signal radio frequency integrated circuits (RFIC), including 10 to 400 gigabit per second (Gbps) laser and optical drivers and trans-impedance amplifiers (TIA) for telecom, datacom, and consumer electronic fiber-optic applications; ii) power amplifiers and transceivers for microwave and millimeter monolithic microwave integrated circuit (MMIC) wireless applications including 71 to 73 Ghz and 81 to 83 Ghz power amplifiers and transceiver chips; and iii) integrated systems in a package (SIP) solutions for both fiber-optic and wireless applications. The HSC product line also partners with key customers on development projects that generate engineering project revenue and helps to position us for future product revenues with these key customers. Through our Industrial product line, we offer a wide range of digital and mixed-signal application specific integrated circuit (ASIC) solutions for industrial, military, avionics, medical and communications markets. The Industrial product line partners with ASIC customers on development projects that generate engineering project revenue and which generally lead to future product revenues with these ASIC customers. We focus on the specification, design, development and sale of analog semiconductor integrated circuits (ICs), multi-chip module (MCM) solutions, and digital and mixed signal ASICs, as well as wireless communications MMICs and modules. We believe we are an industry leader in the fast growing market for electronic solutions that enable high-bandwidth optical connections found in telecom, datacom and storage systems, and, increasingly, in consumer electronics and computing systems. Since inception, we have expanded our customer base with the acquisition and integration of five businesses with complementary products and customers. In so doing, we have expanded our product line from a few leading 10Gbps ultra-long haul optical drivers at our inception in July 2007 to a line of products today that include: drivers, receivers and TIAs for 10 to 400Gbps optical applications; power amplifiers; and custom ASICs spanning 0.6um to 65nm technology nodes. Our direct sales force is based in three countries and is supported by a significant number of channel representatives and distributors that sell our products throughout North America, Europe, Japan and Asia. Historically, we have incurred net losses. For the years ended December 31, 2013 and 2012, we incurred net losses of $1.9 million and $7.0 million, respectively, and cash inflows from operations of $3.3 million and outflows from operations of $2.0 million, respectively. As of December 31, 2013 and 2012, we had an accumulated deficit of $96.4 million and $94.5 million, respectively. We expect development, sales and other operating expenses to increase in the future as we expand our business. Our fiscal year ends on December 31. The consolidated financial statements include our accounts and the accounts of our wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. 37-------------------------------------------------------------------------------- Table of Contents Our total revenues by product line are set forth in the following table (in thousands): Years ended December 31, 2013 2012 HSC $ 19,886 $ 21,307 Industrial 9,040 14,549 Government - 878 Total revenue $ 28,926 $ 36,734 We market and sell our products in Asia, North America, Europe and other locations through our direct sales force, distributors and sales representatives. The percentage of our sales shipped outside the United States was approximately 76% and 72% in fiscal 2013 and fiscal 2012, respectively. We measure sales location by the shipping destination, even if the customer is headquartered in the U.S. We anticipate that sales to international customers will continue to represent a significant percentage of our net sales. Our sales are generally made by purchase orders. Since industry practice allows customers to reschedule or cancel orders on relatively short notice, backlog may not be a good indicator of our future sales. Cancellations of customer orders or changes in product specifications could result in the loss of anticipated sales without allowing us sufficient time to reduce our inventory and operating expenses. Since a significant portion of our revenue is from the telecom and datacom markets, our business may be subject to seasonality, with increased revenues in the third and fourth calendar quarters of each year, when customers place orders to meet year-end demand. However, due to the complex nature of the markets we serve and the broad fluctuations in economic conditions in the U.S. and other countries, it is difficult for us to assess the impact of seasonal factors on our business. We are subject to the risks of conducting business internationally, including economic conditions in Asia, particularly Taiwan, Japan and China, changes in trade policy and regulatory requirements, duties, tariffs and other trade barriers and restrictions, the burdens of complying with foreign laws and, possibly, political instability. Most of our foundries and assembly and test subcontractors are located in Asia. Although our international sales are largely denominated in U.S. dollars, we have foreign operations where expenses are generally denominated in the local currency. Such transactions expose us to the risk of exchange rate fluctuations. We monitor our exposure to foreign currency fluctuations, but have not adopted any hedging strategies to date. There can be no assurance that exchange rate fluctuations will not harm our business and operating results in the future. Due to the continued uncertain economic conditions, in the markets which we serve, our current or potential customers may delay or reduce purchases of our products, which would adversely affect our revenues and harm our business and financial results. We expect our business to be adversely impacted by any future downturn in the U.S. or global economies. In the past, industry downturns have resulted in reduced demand and declining average selling prices for our products which adversely affected our business. We expect to continue to experience these adverse business conditions in the event of further downturns. Critical Accounting Policies and Estimates Management's Discussion and Analysis of Financial Condition and Results of Operations discuss our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates its estimates and judgments, including those related to product returns, bad debts, inventories, asset impairments, deferred tax assets, accrued warranty reserves, restructuring costs, contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management believes the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. We also have other key accounting policies that are less subjective, and therefore, their application would not have a material impact on our reported results of operations. The following is a discussion of our critical accounting policies, as well as the estimates and judgments involved. 38 -------------------------------------------------------------------------------- Table of Contents Revenue Recognition Revenue from sales of optical drivers and receivers, multi-chip modules (MCMs), ASICs and other products is recognized when persuasive evidence of a sales arrangement exists, transfer of title occurs, the sales price is fixed or determinable and collection of the resulting receivable is reasonably assured. Revenue for product shipments is recognized upon delivery of the product to the customer. Provisions are made for sales returns and warranties at the time revenue is recorded. Customer purchase orders are generally used to determine the existence of an arrangement. Transfer of title and risk of ownership occur based on defined terms in customer purchase orders, and generally pass to the customer upon shipment, at which point goods are delivered to a carrier. There are no formal customer acceptance terms or further obligations, outside of our standard product warranty. We assess whether the sales price is fixed or determinable based on the payment terms associated with the transaction. Collectibility is assessed based primarily on the credit worthiness of the customer as determined through ongoing credit evaluations of the customer's financial condition, as well as consideration of the customer's payment history. We record revenue from non-recurring engineering projects associated with product development that we enter into with certain customers. In general, these projects are associated with complex technology development, and as such we do not have certainty about our ability to achieve the program milestones. Achievement of the milestone is dependent on our performance and is typically accepted by the customer. The payment associated with achieving the milestone is generally commensurate with our effort or the value of the deliverable and is nonrefundable. Therefore, we record the expenses related to these projects in the periods incurred and recognize revenue only when we have earned the revenue and achieved the development milestones. Revenue from these projects is typically recorded at 100% gross margin because the costs associated with these projects are expensed as incurred and generally included in research and development expense. These efforts generally benefit our overall product development programs beyond the specific project requested by our customer. Excluding the revenue and gross profit associated with development programs and other non-product revenue, gross margin was 54% and 49% for the years ended December 31, 2013 and 2012, respectively. We sell some products to distributors at the price listed in our price book for that distributor. Certain distributor agreements provide for semi-annual stock rotation privileges of 5% to 10% of net sales for the previous six-month period. At the time of sale, we record a sales reserve for stock rotations approved by management. We offset the sales reserve against revenues, producing the net revenue amount reported in the consolidated statements of operations. Each month we adjust the sales reserve for the estimated stock rotation privilege anticipated to be utilized by the distributors. When the distributors pay our invoices, they may claim stock rotations when appropriate. Once claimed, we process the requests against the prior authorizations and reduce the reserve previously established for that customer. As of December 31, 2013 and 2012, the reserve for stock rotations was $151,000 and $65,000, respectively, and is recorded in other current liabilities on the consolidated balance sheets. We record transaction-based taxes including, but not limited to, sales, use, value added, and excise taxes, on a net basis in our consolidated statements of operations. Allowance for Doubtful Accounts We make ongoing assumptions relating to the collectibility of our accounts receivable in our calculation of the allowance for doubtful accounts. In determining the amount of the allowance, we make judgments about the creditworthiness of customers based on ongoing credit evaluations and assess current economic trends affecting our customers that might impact the level of credit losses in the future and result in different rates of bad debts than previously seen. We also consider our historical level of credit losses. As of December 31, 2013 and 2012, our allowances for doubtful accounts were $220,000 and $337,000, respectively. Inventories Inventories are stated at the lower of standard cost (which approximates actual cost on a first in, first out basis) or market (net realizable value). Cost includes labor, material and overhead costs. Determining fair market value of inventories involves numerous judgments, including projecting average selling prices and sales volumes for future periods and costs to complete products in work in process inventories. As a result of this analysis, when fair market values are below our costs, we record a charge to cost of revenue in advance of when the inventory is scrapped or sold. We evaluate our ending inventories for excess quantities and obsolescence on a quarterly basis. This evaluation includes an analysis of historical and forecasted sales quantities by product. Inventories on hand in excess of estimated future demand are written down. In addition, we write-off inventories that are considered obsolete. Obsolescence is determined from several factors, including competitiveness of product offerings, market conditions and product life cycles when determining obsolescence. Increases to the provision for excess and obsolete inventory are charged to cost of revenue. At the point of the loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. If this lower-cost inventory is subsequently sold, the related provision is matched to the movement of related product inventory, which may result in lower costs and higher gross margins for those products. 39 -------------------------------------------------------------------------------- Table of Contents Our inventories include high-technology parts that may be subject to rapid technological obsolescence and which are sold in a highly competitive industry. If actual product demand or selling prices are less favorable than we estimate, we may be required to take additional inventory write-downs. Long-Lived Assets and Intangible Assets Long-lived assets include equipment, furniture and fixtures, licenses, leasehold improvements, semiconductor masks used in production and intangible assets. When events or changes in circumstances indicate that the carrying amount of long-lived assets may not be recoverable, we test for recoverability based on an estimate of undiscounted cash flows as compared to the asset's carrying amount. If the carrying value exceeds the estimated future cash flows, the asset is considered to be impaired. The amount of impairment is measured as the difference between the carrying amount and the fair value of the impaired asset. Factors we consider important that could trigger an impairment review include continued operating losses, significant negative industry trends, significant underutilization of the assets and significant changes in the way we plan to use the assets. In addition, we must use our judgment in determining the groups of assets for which impairment tests are separately performed. The estimation of future cash flows involves numerous assumptions, which require our judgment, including, but not limited to, future use of the assets for our operations versus sale or disposal of the assets, future-selling prices for our products and future production and sales volumes. Goodwill Goodwill is recorded when the purchase price of an acquisition exceeds the fair value of the net purchased tangible and intangible assets acquired and is carried at cost. Goodwill is not amortized, but is reviewed annually for impairment. We perform our annual goodwill impairment analysis in the fourth quarter of each year or more frequently if we believe indicators of impairment exist. Factors that we consider important which could trigger an impairment review include the following: · significant underperformance relative to historical or projected future operating results; · significant adverse change in the extent or manner in which a long-lived asset is being used or in its physical condition; · significant negative industry or economic trends; and · significant decline in the Company's market capitalization. When evaluating goodwill for impairment, we may initially perform a qualitative assessment which includes a review and analysis of certain quantitative factors to estimate if a reporting units' fair value significantly exceeds its carrying value. When the estimate of a reporting unit's fair value appears more likely than not to be less than its carrying value based on this qualitative assessment, we continue to the first step of a two step impairment test. The first step requires a comparison of the fair value of the reporting unit to its net book value, including goodwill. The fair value of the reporting units is determined based on a weighting of income and market approaches. Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future cash flows. Under the market approach, we estimate the fair value based on market multiples of revenue or earnings for comparable companies. Determining the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, and future economic and market conditions and determination of appropriate market comparables. We base these fair value estimates on reasonable assumptions but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates. A potential impairment exists if the fair value of the reporting unit is lower than its net book value. The second step of the process is only performed if a potential impairment exists, and it involves determining the difference between the fair values of the reporting unit's net assets, other than goodwill, and the fair value of the reporting unit, and, if the difference is less than the net book value of goodwill, an impairment charge is recorded. In the event that we determine that the value of goodwill has become impaired, we will record a charge for the amount of impairment during the fiscal quarter in which the determination is made. We operate in one reporting unit. We conducted our 2013 annual goodwill impairment analysis in the fourth quarter of 2013 and no goodwill impairment was indicated. Income Taxes As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our current tax exposure and assessing temporary differences resulting from differing treatment of items, such as deferred revenues, for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we establish a valuation allowance or increase this allowance in a period; we will include an additional tax provision in our consolidated statement of operations. 40 -------------------------------------------------------------------------------- Table of Contents We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. 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 of being realized upon ultimate settlement. Whether the more-likely-than-not recognition threshold is met for a tax position is a matter of judgment based on the individual facts and circumstances of that position evaluated in light of all available evidence. Stock-based Compensation Stock-based compensation is measured at the date of grant, based on the fair value of the award. For options, we amortize the compensation costs on a straight-line basis over the requisite service period of the option, which is generally the option vesting term of four years. For restricted stock units (RSUs), we amortize the compensation costs on a straight-line basis over the requisite service period of the RSU grant, which is generally the vesting term of one to four years. The benefits of tax deductions in excess of recognized compensation expense must be reported as a financing cash flow, rather than as an operating cash flow. This may reduce future net cash flows from operations and increase future net financing cash flows. All of our stock compensation is accounted for as an equity instrument. We estimate the fair value of stock options granted using a Black-Scholes option-pricing model. This model requires the input of highly subjective assumptions, along with certain policy elections, including the options' expected life and the price volatility of our underlying stock. Actual volatility, expected lives, interest rates and forfeitures may be different from our assumptions, which would result in an actual value of the options being different from estimated. Expected Term-Our expected term used in the Black-Scholes option-pricing model represents the period that our stock options are expected to be outstanding and is derived from the historical expected terms of "guideline" companies selected based on similar industry and product focus. Expected Volatility-Our expected volatility used in the Black-Scholes option-pricing model is derived from a combination of historical and implied volatility of "guideline" companies selected based on similar industry and product focus. Expected Dividend-We have never paid dividends and currently do not intend to do so, and accordingly, the dividend yield percentage is zero for all periods. Risk-Free Interest Rate-We base the risk-free interest rate used in the Black-Scholes option-pricing model on the implied yield currently available on U.S. Treasury constant maturities issued with a term equivalent to the expected term of the option. We make an estimate of expected forfeitures and recognize compensation costs only for those equity awards expected to vest. When estimating forfeitures, we consider voluntary termination behavior as well as an analysis of actual option forfeitures. For RSUs, stock-based compensation is based on the fair value of our common stock at the grant date. The fair value of RSUs granted is the product of the number of shares granted and the grant date fair value of our common stock. RSUs are converted into shares of our common stock upon vesting on a one-for-one basis. Typically, vesting of RSUs is subject to the employee's continuing service. RSUs generally vest over a period of one to four years and are expensed ratably on a straight-line basis over their respective vesting period net of estimated forfeitures. Recent Accounting Pronouncements In February 2013, the Financial Accounting Standards Board ("FASB") issued an accounting standards update requiring centralized disclosure of amounts reclassified from accumulated other comprehensive income ("AOCI") to net income. The amounts and the source reclassified out of each component of AOCI and the income statement line item affected by the reclassification should be presented either parenthetically on the face of the financial statements or in the notes. The entity does not need to show the income statement line item affected for certain components that are not required to be reclassified to net income in their entirety to net income, instead it would cross-reference to the related footnote. This standard is effective for reporting periods beginning after December 15, 2012 and early adoption is permitted. We adopted this standard during 2013 and the adoption did not have a material impact on our consolidated financial statements. In February 2013, the FASB issued an accounting standards update requiring disclosure of obligations resulting from joint and several liability arrangements for which the total amount of the obligation is fixed at the reporting date. The entity has to disclose the following information about each obligation: the nature of the arrangement, the total outstanding amount under the arrangement, the carrying amount of a liability and the carrying amount of a receivable recognized, the nature of any recourse provisions, how liability was measured initially, and where the entry was recorded in the financial statements. This standard is effective for fiscal years beginning after December 15, 2013 and early adoption is permitted. We adopted this standard during 2013 and the adoption did not have a material impact on our consolidated financial statements. 41 -------------------------------------------------------------------------------- Table of Contents In March 2013, the FASB issued an accounting standards update requiring derecognition of certain subsidiaries or groups of assets within a foreign entity or of an investment in a foreign entity. For transactions occurring within a foreign entity, cumulative translation adjustment ("CTA") would be released only upon complete or substantially complete liquidation of the foreign entity. Transactions within a foreign entity involve a component of a foreign entity, such as a subsidiary, a group of assets, or an equity investment. For transactions occurring in a foreign entity, CTA will be released based on the type of transaction. Transactions in a foreign entity involve a direct ownership interest of a foreign entity. This standard is effective for fiscal years beginning after December 15, 2013 and early adoption is permitted. We adopted this standard during 2013 and the adoption did not have a material impact on our consolidated financial statements. In July 2013, the FASB issued an accounting standards update requiring disclosure of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The entity has to disclose an unrecognized tax benefit, or a portion of an unrecognized tax benefit that should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. The assessment of whether a deferred tax asset is available is based on the unrecognized tax benefit and deferred tax asset that exist at the reporting date and should be made presuming disallowance of the tax position at the reporting date. The standard is effective for fiscal years beginning after December 15, 2013. We adopted this standard during 2013 and the adoption did not have a material impact on our consolidated financial statements. Results of Operations Year Ended December 31, 2013 Compared to Year Ended December 31, 2012 The following table sets forth our consolidated results of operations for the fiscal years ended December 31, 2013 and 2012, and the year-over-year increase (decrease) in our results, expressed both in dollar amounts (thousands) and as a percentage of total revenues, except where indicated: Years Ended December 31, 2013 2012 Amount Amount Change (in thousands) % of Revenue (in thousands) % of Revenue (in thousands) % Change Revenue Product $ 24,841 86 % $ 33,308 91 % $ (8,467 ) -25 % Development fees and other 4,085 14 % 3,426 9 % 659 19 % Total revenue 28,926 100 % 36,734 100 % (7,808 ) -21 % Total cost of revenue 11,522 40 % 16,941 46 % (5,419 ) -32 % Gross profit 17,404 60 % 19,793 54 % (2,389 ) -12 % Research and development expense 13,878 48 % 13,516 37 % 362 3 % Selling, general and administrative expense 9,388 32 % 11,709 32 % (2,321 ) -20 % Restructuring expense 950 3 % 93 0 % 857 922 % Special litigation-related expense (income) (4,786 ) -17 % 1,351 4 % (6,137 ) -454 % Total operating expenses 19,430 67 % 26,669 73 % (7,239 ) -27 % Loss from operations (2,026 ) -7 % (6,876 ) -19 % 4,850 71 % Interest expense, net (127 ) 0 % (267 ) -1 % 140 52 % Other income, net 257 1 % 220 1 % 37 17 % Loss before provision for income taxes (1,896 ) -7 % (6,923 ) -19 % 5,027 73 % Provision for income taxes 50 0 % 81 0 % (31 ) -38 % Net loss $ (1,946 ) -7 % $ (7,004 ) -19 % $ 5,058 72 % 42-------------------------------------------------------------------------------- Table of Contents Revenue Years Ended December 31, 2013 2012 (in thousands) Product $ 24,841 $ 33,308 Development fees and other 4,085 3,426 Total revenue $ 28,926 $ 36,734 Decrease period over period $ (7,808 ) Percentage decrease, period over period -21 % Total revenue for the year ended December 31, 2013 was $28.9 million, a decrease of $7.8 million or 21%, compared with $36.7 million for the year ended December 31, 2012. For the year ended December 31, 2013, 86% of our revenue was contributed by product revenue and 14% of our revenue was contributed by development fees and other revenue. For the year ended December 31, 2012, 91% of our revenue was contributed by product revenue and 9% of our revenue was contributed by development fees and other revenue. Product revenue for the year ended December 31, 2013 was $24.8 million, a decrease of $8.5 million or 25%, compared with $33.3 million for the year ended December 31, 2012. The decrease in product revenue during 2013 was primarily due to the end-of-life of certain products in 2013 from our Industrial ASIC and RF product groups, obtained in the prior ChipX and Endwave acquisitions. The Industrial product line decreased $5.5 million from 2012 to 2013. The HSC product line decreased $1.4 million from 2012 to 2013. Development fees and other revenue for the year ended December 31, 2013 was $4.1 million, an increase of $659,000 or 19%, compared with $3.4 million for the year ended December 31, 2012. We experienced an increase in development fees and other revenue primarily due to an increase in the number and size of development projects in our HSC product line Gross Profit and Cost of Revenue Years Ended December 31, 2013 2012 (in thousands) Total cost of revenue $ 11,522 $ 16,941 Gross profit $ 17,404 $ 19,793 Gross margin 60 % 54 % Decrease period over period $ (2,389 ) Percentage decrease, period over period -12 % Gross profit consists of revenue less cost of revenue. Cost of revenue consists primarily of the costs to manufacture saleable chips, including outsourced wafer fabrication and testing; costs of direct materials; equipment depreciation; costs associated with procurement, production control and quality assurance; fees paid to our offshore manufacturing vendors; reserves for potential excess or obsolete material; costs related to stock-based compensation; accrued costs associated with potential warranty returns; and amortization of certain identified intangible assets. Amortization expense of identified intangible assets, namely existing technology, is presented within cost of revenue, as the intangible assets were determined to be directly attributable to revenue generating activities. Gross profit for the year ended December 31, 2013 was $17.4 million, or a gross margin of 60%, compared to a gross profit of $19.8 million, or a gross margin of 54%, for the year ended December 31, 2012. The increase in gross margin is primarily due to a change in product mix towards certain higher margin products including revenue from development projects, and away from certain low margin RF transceivers and ASIC products. We record revenue from non-recurring engineering projects associated with product development that we enter into with certain customers. In general, these projects are associated with complex technology development, and as such we do not have certainty about our ability to achieve the program milestones. Achievement of the milestone is dependent on our performance and is typically accepted by the customer. The payment associated with achieving the milestone is generally commensurate with our effort or the value of the deliverable and is nonrefundable. Therefore, we record the expenses related to these projects in the periods incurred and recognize revenue only when we have earned the revenue and achieved the development milestones. Revenue from these projects is typically recorded at 100% gross margin because the costs associated with these projects are expensed as incurred and generally included in research and development expense. These efforts generally benefit our overall product development programs beyond the specific project requested by our customer. 43 -------------------------------------------------------------------------------- Table of Contents Development project revenue and other non-product revenue for the year ended December 31, 2013 was $4.1 million compared with $3.4 million for the year ended December 31, 2012. Excluding the revenue and gross profit associated with development programs and other non-product revenue, gross margin was 54% and 49% for the years ended December 31, 2013 and 2012, respectively. Research and Development Expense Years Ended December 31, 2013 2012 (in thousands) Research and development expense $ 13,878 $ 13,516 Percentage of revenue 48 % 37 % Increase period over period $ 362 Percentage increase, period over period 3 % Research and development expenses are expensed as incurred. Research and development expense consists primarily of salaries and related expenses for research and development personnel, consulting and engineering design, non-capitalized tools and equipment, engineering related semiconductor masks, depreciation for equipment, engineering expenses paid to outside technology development suppliers, allocated facilities costs and expenses related to stock-based compensation. Research and development expense for the year ended December 31, 2013 was $13.9 million compared to $13.5 million for the year ended December 31, 2012, an increase of $362,000 or 3%. Research and development costs increased in absolute dollars compared to 2012 primarily due to a $714,000 increase in research and development wafer tape-out expenses associated with our development projects and a $174,000 increase in project materials which were partially offset by a $545,000 decrease in stock-based compensation. In 2014, we expect research and development expense to increase moderately in absolute dollars from 2013. Selling, General and Administrative Expense Years Ended December 31, 2013 2012 (in thousands) Selling, general and administrative expense $ 9,388 $ 11,709 Percentage of revenue 32 % 32 % Decrease period over period $ (2,321 ) Percentage decrease, period over period -20 % Selling, general and administrative expenses consist primarily of salaries and related expenses for executive, accounting, finance, sales, marketing and administration personnel, professional fees, allocated facilities costs, promotional activities and expenses related to stock-based compensation. Selling, general and administrative expense for the year ended December 31, 2013 was $9.4 million compared to $11.7 million for the year ended December 31, 2012, a decrease of $2.3 million or 20%. Selling, general and administrative expenses decreased in absolute dollars compared to 2012 primarily due to an $889,000 decrease in stock compensation, $543,000 decrease in professional fees, a $478,000 decrease in outside services, and a $70,000 decrease in marketing and promotional activities. In 2014, we expect selling, general and administrative expense to increase moderately in absolute dollars compared with 2013. 44 -------------------------------------------------------------------------------- Table of Contents Restructuring Expense Years Ended December 31, 2013 2012 (in thousands) Restructuring expense $ 950 $ 93 Percentage of revenue 3 % 0 % Increase period over period $ 857 Percentage increase, period over period 922 % During 2013, we recorded a restructuring expense of $950,000. The components of the restructuring charge included $662,000 of non-cash expenses associated with the acceleration of stock options and restricted stock units and $288,000 of cash expenses for severance, benefits and payroll taxes and other costs associated with employee terminations. During 2012, we recorded a restructuring expense of $93,000 that is the result of $207,000 of severance related expense including severance payments, benefits, payroll taxes, expenses associated with the acceleration of stock options, and other costs associated with the restructuring activities we undertook to reduce our expenses during the first quarter of 2012 partially offset by a $74,000 benefit from the sublet of our Palo Alto facility, as we were able to sublet the property at a higher lease rate than we originally estimated, and a $40,000 benefit due to lower than anticipated restructuring charges related to the Endwave merger during the second quarter of 2012. Special Litigation-related Expense (Income) During 2013, we incurred a special litigation-related benefit of $4.8 million, which was due to a $7.3 million one-time litigation settlement for the M/A-Com ("Optomai") case, partially offset by $2.5 million of legal fees associated with the Optomai case and $108,000 of legal fees associated with the Advantech case. See Note 13-Legal Settlement for further detail related to Optomai. During 2012, we incurred special litigation-related expenses of $1.4 million due to legal fees associated with the Optomai case. Interest Expense, Net, and Other Income (Expense), Net Years Ended December 31, 2013 2012 (in thousands) Interest expense, net $ (127 ) $ (267 ) Other income (expense), net 257 220 Total $ 130 $ (47 ) Interest expense, net and other income, net consist primarily of gains and losses related to foreign currency transactions, gains and losses related to property and equipment disposals, interest on line of credit, interest on capital leases and amortization of loan fees in connection with our Silicon Valley Bank line of credit and loan. Interest expense, net for the year ended December 31, 2013 was $127,000 compared to $267,000 for the year ended December 31, 2012. Interest expense, net decreased in absolute dollars compared to 2012 primarily due to less interest on capital leases and amortization of loan fees. Other income, net for the year ended December 31, 2013 was income of $257,000 which primarily consisted of $160,000 gain on the sale of property and equipment and $95,000 gain on sale of materials. Other income, net for the year ended December 31, 2012 was income of $220,000 which primarily consisted of $163,000 gain on the sale of property and equipment and $41,000 for foreign exchange transaction gains. 45 -------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes Years Ended December 31, 2013 2012 (in thousands) Provision for income taxes $ 50 $ 81 Decrease period over period $ (31 ) Percentage decrease, period over period -38 % Income tax expense was $50,000 and $81,000 in the years ended December 31, 2013 and 2012, respectively, and our effective tax rate was approximately 3% and 1% for those periods. The income tax provision for the years ended December 31, 2013 and 2012 were due primarily to state taxes, United States withholding taxes and foreign taxes due. We have incurred book losses in all tax jurisdictions and have a full valuation allowance against such losses. Liquidity and Capital Resources Cash and cash equivalents and cash flow data for the periods presented were as follows (in thousands): As of the years ended December 31, 2013 2012 Cash and cash equivalents $ 20,377 $ 10,147 Years ended December 31, 2013 2012Net cash provided by (used in) operating activities $ 3,321 $ (1,976 ) Net cash used in investing activities $ (1,376 ) $ (1,496 ) Net cash provided by (used in) financing activities $ 8,113 $ (2,097 ) Public Offering On December 19, 2013, we entered into an underwriting agreement (the "Underwriting Agreement") with Roth Capital Partners, LLC as representative of several underwriters to the Underwriting Agreement relating to a public offering of an aggregate of 8,325,000 shares (the "Shares") of our common stock, par value $0.001 per share at a public offering price of $1.42 per share. The Shares are accompanied by the associated rights to purchase shares of Series A Junior Preferred Stock, par value $0.001 per share, created by the Rights Agreement, dated December 16, 2011, between us and the American Stock Transfer & Trust Company, LLC, as Rights Agent (the "Rights Agreement"). Under the terms of the Underwriting Agreement, we granted the underwriters a 30 day option to purchase up to an additional 1,248,750 shares of common stock to cover over-allotments. On December 24, 2013, we completed our public offering of 9,573,750 newly issued shares of common stock at a price to the public of $1.42 per share. The number of shares sold in the offering included the underwriter's full exercise on December 24, 2013 of their over-allotment option of 1,248,750 shares of common stock. The net proceeds from the offering was approximately $12.3 million which consisted of $12.5 million after underwriting discounts, commissions and expenses less an additional $250,000 for legal, accounting, registration and other transaction costs related to the public offering. Operating Activities During 2013, operating activities provided $3.3 million of cash. Our net loss from continuing operations, adjusted for depreciation, stock-based compensation and other non-cash items, was an income of $6.0 million. The remaining use of $2.7 million of cash in 2013 was primarily due to a decrease in accounts payable of $1.5 million, an increase in prepaid and other current assets of $797,000, an increase in inventories of $506,000, a decrease in other current and long-term liabilities of $203,000 and a decrease in accrued restructuring of $140,000 which were partially offset by an increase in accrued compensation of $324,000. In addition, we incurred a special litigation-related benefit of $4.8 million, which was due to a $7.3 million one-time litigation settlement for the Optomai case, partially offset by $2.5 million of legal fees associated with the Optomai case. Operating activities used cash of $2.0 million in the year ended December 31, 2012. This resulted from a net loss of $7.0 million and we experienced cash usage for working capital for a decrease in other current liabilities of $2.5 million, an increase in inventories of $1.6 million and an increase in prepaid and other current assets of $385,000. These uses were partially offset by the following non-cash expenses: stock-based compensation of $5.1 million and depreciation and amortization of $4.1 million. 46 -------------------------------------------------------------------------------- Table of Contents Investing Activities Net cash used in investing activities for year ended December 31, 2013 was $1.4 million and consisted of $1.5 million of purchases of property and equipment partially offset by $160,000 proceeds from sale of property and equipment. Net cash used in investing activities for year ended December 31, 2012 was $1.5 million and consisted of $2.0 million of purchases of property and equipment partially offset by $400,000 proceeds from sale and maturity of investments. Financing Activities Net cash provided by financing activities during the year ended December 31, 2013 was $8.1 million and consisted primarily of $12.3 million of proceeds from our public offering, net of costs, in December 2013, partially offset by a $3.6 million repayment of the line of credit, $194,000 of taxes paid related to net share settlement of equity awards and $405,000 for capital lease payments. Net cash used in financing activities during the year ended December 31, 2012 was $2.1 million and consisted primarily of $2.2 million of treasury stock repurchases from our modified Dutch auction tender offer, $463,000 of taxes paid related to net share settlement of equity awards and $425,000 for capital lease payments partially offset by $600,000 of net borrowings on our line of credit and $400,000 of proceeds from the issuance of stock. Historically we have incurred net losses. For the years ended December 31, 2013 and 2012, we incurred net losses of $1.9 million and $7.0 million, respectively, and cash inflows from operation of $3.3 million and cash outflows from operations of $2.0 million respectively. As of December 31, 2013 and 2012, we had an accumulated deficit of $96.4 million and $94.5 million, respectively. We have incurred significant losses since inception, attributable to our efforts to design and commercialize our products. We have managed our liquidity during this time through a series of cost reduction initiatives, raising cash through the sale of our stock, and through increasing our line of credit with our bank and sales of our securities. During 2013, we successfully raised $12.3 million in cash, net of underwriting discounts, commissions, and related expenses, from our public offering of 9,573,750 newly issued shares of common stock at a price to the public of $1.42 per share. Based on these events and factors we believe our existing cash and cash equivalents, along with the funds available through Silicon Valley Bank, will be sufficient to meet our working capital and capital expenditure needs over the next 12 months. Material Commitments The following table summarizes our future cash obligations for current debt, operating leases, and capital leases, in thousands of dollars, as of December 31, 2013: Less than One One to Three More than Three Contractual Obligations Total Year Years Years Operating lease obligations $ 1,390 $ 643 $ 690 $ 57 Capital lease obligations (including interest) 320 310 7 3 Total $ 1,710 $ 953 $ 697 $ 60 GigOptix did not have any material commitments for capital expenditures as of December 31, 2013. Impact of Inflation and Changing Prices on Net Sales, Revenue and Income Inflation and changing prices have not had a material impact on the materials used in our production process during the periods and at balance sheet dates presented in this report. Off-Balance Sheet Arrangements GigOptix does not use off-balance-sheet arrangements with unconsolidated entities, nor does it use other forms of off-balance-sheet arrangements such as special purpose entities and research and development arrangements. Accordingly, GigOptix is not exposed to any financing or other risks that could arise if it had such relationships. 47-------------------------------------------------------------------------------- Table of Contents |