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PROCERA NETWORKS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following unaudited discussion and analysis of financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on March 11, 2014. As used in this Quarterly Report on Form 10-Q, references to the "Company," "we," "us," "our" or similar terms include Procera Networks, Inc. and its consolidated subsidiaries. Cautionary Note Regarding Forward-Looking Statements Our disclosure and analysis in this Quarterly Report on Form 10-Q contain certain "forward-looking statements," as such term is defined in Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. These statements set forth anticipated results based on management's plans and assumptions. From time to time, we also provide forward-looking statements in other materials we release to the public as well as oral forward-looking statements. Such statements give our current expectations or forecasts of future events; they do not relate strictly to historical or current facts. We have attempted to identify such statements by using words such as "anticipate," "estimate," "expect," "project," "intend," "plan," "believe," "will," "could," "initial," "future," "may," "predict," "potential," "should" and similar expressions in connection with any discussion of future events or future operating or financial performance or strategies. Such forward-looking statements include, but are not limited to, statements regarding: ? trends related to and management's expectations regarding future results of operations, required capital expenditures, revenues from existing and new products and sales channels, and cash flows, including but not limited to those statements set forth below in this Item 2; ? sales efforts, expenses, interest rates, foreign exchange rates, and the outcome of contingencies, such as legal proceedings; ? our services, including the development and deployment of products and services and strategies to expand our targeted customer base and broaden our sales channels; ? the operation of our Company with respect to the development of products and services; ? our liquidity and financial resources, including anticipated capital expenditures, funding of capital expenditures and anticipated levels of indebtedness; and ? our expectations regarding our financial results for fiscal year 2014 and subsequent periods. We cannot guarantee that any forward-looking statement will be realized. Achievement of future results is subject to risks, uncertainties and potentially inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from past results and those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements. We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. We also provide cautionary discussion of risks and uncertainties related to our businesses which are identified under the caption "Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q. We believe these factors, individually or in the aggregate, as well as general risks and uncertainties such as those relating to general economic conditions and demand for our products and services, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties. 21 -------------------------------------------------------------------------------- Index Overview We are a leading provider of Internet Intelligence solutions designed for network operators worldwide. Our solutions are focused on enhancing the subscriber experience in fixed, mobile and enterprise broadband networks. Our PacketLogic solutions are targeted towards service providers, and enable operators to gain insights and take action to deliver personalized services with a high quality of experience. Telecom and network equipment vendors use our Network Application Visibility Library, or NAVL, solutions to enhance their products by adding application intelligence to their portfolio. We believe that the intelligence our products provide about users and their usage enables our network operator customers to make better business decisions that result in greater profitability and to deliver a better broadband experience. Our network operator customers include service provider customers and enterprises. Our service provider customers include mobile service providers and broadband service providers, which include cable multiple system operators and internet service providers. Our enterprise customers include educational institutions, commercial enterprises and government and municipal agencies. We sell our products directly to network operators through partners, value added resellers and system integrators, and to other network solution suppliers for incorporation into their network solutions. Our Intelligent Policy Enforcement, or IPE, products are part of the high-growth market for mobile packet and broadband core products. The market for IPE products was $1.4 billion in 2013 and is expected to grow to $2.9 billion in 2018, a 2013 to 2018 compounded annual growth rate of 14%. Our bundled products containing hardware and software elements deliver a solution that is a key element of the mobile packet and broadband core ecosystems. Our technology is transitioning to a software-focused solution as the trends in Network Function Virtualization, or NFV, and Software Defined Networking, or SDN, take hold in the service provider network core. Our solutions are often integrated with additional elements in the mobile packet and broadband core, including policy management and charging functions, and are compliant with the widely adopted 3rd Generation Partnership Program standard. In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, network operators are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers. We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products, and the drive for NFV will open up new opportunities for our solutions. Our embedded solutions enable network solutions suppliers to more quickly add Internet Intelligence to their platforms, since our NAVL products have been designed to be highly portable among many platforms and processors. NAVL eliminates the need for network solutions providers to research and develop their own Deep Packet Inspection, or DPI, technology, saving significant time and resources while enabling them to more effectively compete in their market space. Our products are marketed under the PacketLogic and NAVL brand names. We have a broad spectrum of products delivering IPE at the access, edge and core layers of the network. Our products are designed to offer maximum flexibility to our customers and enable differentiated services and revenue-enhancing applications, all while delivering a high quality of service for subscribers. We face competition from suppliers of standalone and integrated IPE and Deep Packet Inspection, or DPI, products, including Allot Communications Ltd., Blue Coat Systems, Brocade Communications Systems, Cisco Systems, Inc., Citrix Systems (acquired Bytemobile), Ericsson, F5 Networks, Huawei Technologies Company, Qosmos, SAIC (acquired Cloudshield Technologies), Sandvine Corporation, and Tektronix (acquired Arbor Networks). Some of our competitors supply platform products with different degrees of DPI functionality, such as switch/routers, routers, session border controllers and VoIP switches. In addition, we face competition from large integrators that package third-party IPE solutions into their products, including Alcatel-Lucent and Nokia Siemens. It is possible that these companies will develop their own IPE solutions or strategically acquire existing competitor IPE vendors in the future. Some of our competitors are also our customers. 22 -------------------------------------------------------------------------------- Index Most of our competitors are larger and more established enterprises with substantially greater financial and other resources. Some competitors may be willing to reduce prices and accept lower profit margins to compete with us. As a result of such competition, we could lose market share and sales, or be forced to reduce our prices to meet competition. However, we do not believe there is a dominant supplier in our market. Based on our belief in the superiority of our technology, we believe that we have an opportunity to increase our market share and benefit from what we believe will be growth in the DPI market. On January 9, 2013, we completed our acquisition of Vineyard, a privately held developer of Layer 7 DPI and application classification technology located in Kelowna, Canada. Vineyard's integrated DPI and application classification technology provides enterprise and service provider networking infrastructure vendors with these capabilities through its integrated software suite, primarily through a variety of subscription-based original equipment manufacturer and partner license agreements. This acquisition complements our hardware and application software-based IPE and DPI solutions, expands the way we sell solutions to customers, and increases our customer base, previously comprised primarily of network operators, thereby allowing us to provide complementary technology and solutions to a greater number of customers. We are headquartered in Fremont, California, and we have key operating entities in Kelowna, Canada and Varberg, Sweden, as well as a geographically dispersed sales force. We sell our products through our direct sales force, resellers, distributors, systems integrators and other equipment manufacturers in the Americas, Asia Pacific and Europe. Critical Accounting Estimates The discussion and analysis of our financial condition and results of operations are based upon financial statements that have been prepared in accordance with United States generally accepted accounting principles, or GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates. We base our estimates on historical experience and on assumptions that are believed to be reasonable. These estimates and assumptions provide a 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, and these differences may be material. We believe the following critical accounting policies reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements: ? Revenue Recognition; ? Valuation of Long-Lived Assets and Goodwill; ? Inventory Valuation; ? Stock-Based Compensation; and ? Accounting for Income Taxes. These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on March 11, 2014. Results of Operations Comparison of Three Months Ended March 31, 2014 and 2013 Revenue Revenue for the three months ended March 31, 2014 and 2013 was as follows (in thousands, except percentages): Three Months Ended March 31, Increase/ 2014 2013 (Decrease) Net product revenue $ 9,504 $ 10,411 (9 )% Net support revenue 5,037 3,760 34 % Total revenue $ 14,541 $ 14,171 3 % 23-------------------------------------------------------------------------------- Index Our revenue is derived from two sources: (1) product revenue, which includes sales of our hardware appliances bundled with software licenses, separate software licenses and software upgrades; and (2) service revenue, which consists primarily of software maintenance and customer support revenue and secondarily of professional services. Maintenance and customer support revenue is recognized over the support period, which is typically 12 months. Our product revenues tend to vary seasonally and are typically higher in the second half of the year as compared to the first half of the year. Total product revenue in the three months ended March 31, 2014 was $9.5 million and decreased 9%, compared with $10.4 million in the three months ended March 31, 2013. The decrease in product revenue in the three months ended March 31, 2014 compared to the comparable prior year period reflected a decrease in revenue from U.S. cable service providers, offset by an increase in revenue from our continued expansion in international markets, including the Middle East, Japan and Latin America. The increase in support revenue in the three months ended March 31, 2014 compared to the comparable prior year period reflected the continued expansion of the installed base of our product to which we have sold ongoing support services. For the three months ended March 31, 2014, no customer accounted for more than 10% of net revenue. For the three months ended March 31, 2013, revenue from Cox Communications, Inc. represented 22% of net revenue and revenue from Shaw Communications, Inc. represented 17% of net revenue with no other single customer accounting for more than 10% of net revenue. Sales to customers located in the United States as a percentage of total revenue were 20% and 56% for the three months ended March 31, 2014 and 2013, respectively. For the year ending December 31, 2014, we expect total revenue to increase approximately 15% compared to total revenue for the year ended December 31, 2013. Cost of Sales Cost of sales includes material costs and direct labor for products sold, amortization of acquired developed technology, costs expected to be incurred for warranty, adjustments to inventory values, including the write-down of slow moving or obsolete inventory, and costs for support and professional services personnel. The following table presents the breakdown of cost of sales by category for the three months ended March 31, 2014 and 2013 (in thousands, except percentages): Three Months Ended March 31, Increase/ 2014 2013 (Decrease) Product costs $ 5,091 $ 6,087 (16 )%Percent of net product revenue 54 % 58 % Support costs $ 1,066 $ 715 49 % Percent of net support revenue 21 % 19 % Total cost of sales Percent of total net revenue $ 6,157 $ 6,802 (9 )% 42 % 48 % 24-------------------------------------------------------------------------------- Index Total cost of sales in the three months ended March 31, 2014 decreased by $0.6 million, compared to the three months ended March 31, 2013. Cost of sales as a percentage of revenue decreased by 6 percentage points for the three months ended March 31, 2014, compared to the same period in the prior year. The decrease in cost of sales in the first quarter of 2014 primarily reflected a decrease in material costs associated with a decrease in product sales, along with the impact of inventory charges of $0.4 million for the three months ended March 31, 2013. The decrease in cost of sales as a percentage of revenue primarily reflected a more favorable revenue mix with a higher proportion of license revenue and increased support revenue in the three months ended March 31, 2014 as compared to the corresponding period of 2013. Stock-based compensation recorded to cost of sales in each of the three months ended March 31, 2014 and 2013 was $0.1 million. Gross Profit Gross profit for the three months ended March 31, 2014 and 2013 was as follows (in thousands, except percentages): Three Months Ended March 31, 2014 2013 Increase Gross profit $ 8,384 $ 7,369 14 %Percent of total net revenue 58 % 52 % Our total gross profit margin for the three months ended March 31, 2014 increased by 6 percentage points, compared to the three months ended March 31, 2013. The increase resulted from a higher proportion of license revenue and increased support revenue in the three months ended March 31, 2014. On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangibles and cost reduction efforts, the gross margin rate for the three months ended March 31, 2014 was 62%, as compared to 55% for the three months ended March 31, 2013. (See page 29 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP financial measure and other important information.) Our gross margin rate in any given period is impacted by the product mix in that period, and we expect variability in our gross margin rate to continue in the future. We expect our gross profit margin to be a higher percentage of total net revenue in 2014 compared to 2013. Operating Expenses Operating expenses for the three months ended March 31, 2014 and 2013 were as follows (in thousands, except percentages): Three Months Ended March 31, 2014 2013 Increase/(Decrease) Research and development $ 4,548 $ 4,401 3 % Sales and marketing 6,877 6,621 4 % General and administrative 3,110 3,637 14 % Total $ 14,535 $ 14,659 (1 )% In the three months ended March 31, 2014, our total operating expenses decreased primarily due to reduced acquisition-related costs, offset by increased costs associated with investment in sales and research and development and cost reduction efforts. Amortization of deferred compensation associated with retention agreements with Vineyard's three founders decreased $1.3 million as the retention agreements became fully amortized and such deferred compensation was paid during the three months ended March 31, 2014. The decrease in total operating expenses in the three months ended March 31, 2014 also reflected the absence of business development costs associated with the Vineyard acquisition, which were $1.0 million in the three months ended March 31, 2013. On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangibles, cost reduction efforts, deferred compensation and business development expenses, operating expenses in the three months ended March 31, 2014 were $12.8 million, an increase of $2.1 million as compared to $10.7 million in the three months ended March 31, 2013. This increase reflects additional investment in the second half of fiscal 2013 in sales and business development and increased investment in product development and quality. (See page 29 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.) 25 -------------------------------------------------------------------------------- Index We took certain cost reduction steps in the three months ended March 31, 2014 to contain spending in order to improve our profitability. These steps consisted of a reduction in workforce of 12 employees, which resulted in severance and other employee-related costs of $0.5 million in the three months ended March 31, 2014, and also included steps to reduce spending on outside professionals. The savings from these steps are expected to be approximately $1.5 million over the remainder of the fiscal year ending December 31, 2014, and approximately $2.0 million on an annualized basis. In total, we anticipate that new employee and contractor hiring in 2014 will be substantially reduced compared with the hiring activity in 2013; therefore, we expect our headcount will be similar or moderately increase to that reported for the year ended December 31, 2013. Research and Development Research and development expenses include costs associated with personnel focused on the development or improvement of our products, prototype materials, initial product certifications, testing equipment and software costs. Research and development costs include sustaining and enhancement efforts for products already released and development costs associated with planned new products. Research and development expenses for the three months ended March 31, 2014 and 2013 were as follows (in thousands, except percentages): Three Months Ended March 31, 2014 2013 Increase Research and development $ 4,548 $ 4,401 3 %As a percentage of net revenue 31 % 31 % Research and development expenses for the three months ended March 31, 2014 increased by $0.1 million, compared to the three months ended March 31, 2013, as a result of increased employee compensation costs of $0.5 million, which included $0.2 million related to employee terminations associated with cost reduction efforts, and increased product development costs of $0.3 million, offset by a reduction in amortization of deferred compensation of $0.6 million. On a non-GAAP basis, after adjusting for stock-based compensation, cost reduction efforts and deferred compensation, research and development expenses for the three months ended March 31, 2014 were $3.9 million, an increase of $0.7 million compared to $3.2 million in the three months ended March 31, 2013. (See page 29 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.) Stock-based compensation recorded to research and development expenses in the three months ended March 31, 2014 and 2013 was $0.4 million and $0.5 million, respectively. Research and development expenses as a percentage of revenue for the three months ended March 31, 2014 remained unchanged as compared to the corresponding periods in 2013. Sales and Marketing Sales and marketing expenses primarily include personnel costs, sales commissions and marketing expenses, such as trade shows, channel development and literature. Sales and marketing expenses for the three months ended March 31, 2014 and 2013 were as follows (in thousands, except percentages): Three Months Ended March 31, 2014 2013 Increase Sales and marketing $ 6,877 $ 6,621 4 %As a percentage of net revenue 47 % 47 % 26 -------------------------------------------------------------------------------- Index Sales and marketing expenses for the three months ended March 31, 2014 increased by $0.3 million, compared to the three months ended March 31, 2013. The increase reflected the hiring of additional sales and marketing employees in the Europe, Middle East and Africa region and corresponding higher compensation costs of $1.1 million, which included $0.1 million related to employee terminations associated with cost reduction efforts, partially offset by a reduction in amortization of deferred compensation of $0.7 million and lower stock-based compensation of $0.2 million. On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangibles, cost reduction efforts and deferred compensation, sales and marketing expenses for the three months ended March 31, 2014 were $6.3 million, which is an increase of $1.0 million, compared to $5.3 million in the three months ended March 31, 2013. (See page 29 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.) Stock-based compensation recorded to sales and marketing expenses in the three months ended March 31, 2014 and 2013 was $0.4 million and $0.6 million, respectively. Sales and marketing expenses as a percentage of revenue remained unchanged for the three months ended March 31, 2014 and 2013 as the increase in sales and marketing expense corresponded with increased revenue. General and Administrative General and administrative expenses consist primarily of personnel and facilities costs related to our executive and finance functions and fees for professional services. Professional services include costs for legal advice and services, accounting and tax professionals, independent auditors and investor relations. General and administrative expenses for the three months ended March 31, 2014 and 2013 were as follows (in thousands, except percentages): Three Months Ended March 31, 2014 2013 Decrease General and administrative $ 3,110 $ 3,637 (14 )%As a percentage of net revenue 21 % 26 % General and administrative expenses for the three months ended March 31, 2014 decreased by $0.5 million, compared to the three months ended March 31, 2013, reflecting the absence of business development costs associated with the Vineyard acquisition, which were $1.0 million in the three months ended March 31, 2013, offset by an increase in accounting and human resource personnel-related costs and an increased use of contractors and outside services. On a non-GAAP basis, after adjusting for stock-based compensation, cost reduction efforts and business development costs, general and administrative expenses for the three months ended March 31, 2014 were $2.7 million, which is an increase of $0.5 million as compared to $2.2 million in the three months ended March 31, 2013. (See page 29 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.) Stock-based compensation recorded to general and administrative expense in each of the three months ended March 31, 2014 and 2013 was $0.4 million. General and administrative expenses as a percentage of revenue decreased 5 percentage points for the three months ended March 31, 2014, compared to the corresponding period in 2013. Interest and Other Income (Expense), Net Three Months Ended March 31, 2014 2013 Increase ($ in thousands) Interest and other income (expense), net $ 28 $ (50 ) 156 % 27 -------------------------------------------------------------------------------- Index Interest and other income (expense), net increased in the three months ended March 31, 2014 compared to the three months ended March 31, 2013. The increase in the three months ended March 31, 2014 was mainly due to a decrease in foreign currency losses offset by a decrease in interest income. Benefit from Income Taxes Three Months Ended March 31, 2014 2013 Decrease ($ in thousands) Benefit from income taxes $ (147 ) $ (623 ) (76 )% We are subject to taxation primarily in the U.S., Australia, Canada, Japan, Singapore and Sweden, as well as in a number of U.S. states, including California. The tax benefit for the three months ended March 31, 2014 primarily reflects the amortization of intangible assets from the Vineyard acquisition, partially offset by earnings taxed in foreign jurisdictions. We have established a valuation allowance for substantially all of our deferred tax assets. We calculated the valuation allowance in accordance with the provisions of Accounting Standards Codification Topic 740, which requires that a valuation allowance be established or maintained when it is "more likely than not" that all or a portion of deferred tax assets will not be realized. We will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal. Important Information Regarding non-GAAP Financial Measures In this Quarterly Report on Form 10-Q, we include non-GAAP financial measures. Our management believes that certain non-GAAP financial measures provide investors with additional useful information and regularly uses these supplemental non-GAAP financial measures internally to understand and manage our business and forecast future periods. In addition, our management believes that these non-GAAP financial measures, when taken together with the corresponding GAAP measures, provide incremental insight into the underlying factors and trends affecting both our performance and our cash-generating potential. Our non-GAAP financial measures include adjustments for stock-based compensation expenses; business development expenses; cost reduction efforts; acquisition-related intangible asset and deferred compensation amortization; and income tax effects. We have excluded the effect of stock-based compensation, the cost of outside professional services for negotiating and performing legal, accounting and tax due diligence for potential mergers and acquisitions, expenses connected with cost reduction efforts, acquisition-related intangible asset and deferred compensation amortization, and income tax effects from our non-GAAP gross profit, operating expenses and net income measures. Stock-based compensation, which represents the estimated fair value of stock options, restricted stock and restricted stock units granted to employees, is excluded since grant activities vary significantly from quarter to quarter in both quantity and fair value. In addition, although stock-based compensation will recur in future periods, excluding this expense allows us to better compare core operating results with those of our competitors who also generally exclude stock-based compensation from their core operating results, who may have different granting patterns and types of equity awards and who may use different option valuation assumptions than we do. Business development expenses are necessary as part of certain growth strategies, such as through mergers and acquisitions, and will occur when such transactions are pursued. We have excluded these expenses because they can vary materially from period-to-period and transaction-to-transaction and expenses associated with these business development activities are not considered a key measure of our operating performance. Cost reduction efforts occur with shifts in objectives and evolving requirements of the business and can result in fluctuating expenses connected with reducing employment in certain areas. We have excluded these expenses because they can vary significantly from period-to-period and are not considered a key measure of our operating performance. Acquisition-related intangible assets and deferred compensation amortization and income tax effects represent non-cash charges and benefits that result from the accounting for acquisitions. We have excluded these items because, in any period, they may not directly correlate to the underlying performance of our business and these items can vary materially from period-to-period and transaction-to-transaction. In addition, we exclude these acquisition-related costs and benefits when evaluating our current operating performance. 28 -------------------------------------------------------------------------------- Index Our non-GAAP financial measures may not reflect the full economic impact of our activities. Further, these non-GAAP financial measures may be unique to the Company as they may differ from non-GAAP financial measures used by other companies, including our competitors. As such, this presentation of non-GAAP financial measures may not enhance the comparability of our results to the results of other companies. Therefore, these non-GAAP financial measures are limited in their usefulness and investors are cautioned not to place undue reliance on our non-GAAP financial measures. In addition, investors are cautioned that these non-GAAP financial measures are not intended to be considered in isolation and should be read in conjunction with our consolidated financial statements prepared in accordance with GAAP. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measure, net loss, is as follows: Three Months Ended March 31, 2014 2013 ($ in thousands) Sales: Product sales $ 9,504 $ 10,411 Support sales 5,037 3,760 Total sales 14,541 14,171 Cost of sales: Product cost of sales, GAAP 5,091 6,087 Non-GAAP adjustments: Stock-based compensation (1) (15 ) (19 ) Amortization of intangibles (2) (262 ) (260 ) Cost reduction efforts (3) (237 ) - Product cost of sales, non-GAAP 4,577 5,808 Support cost of sales, GAAP 1,066 715 Non-GAAP adjustments: Stock-based compensation (1) (82 ) (93 ) Support cost of sales, non-GAAP 984 622 Total cost of sales, non-GAAP 5,561 6,430 Gross profit, non-GAAP 8,980 7,741 Operating expenses: Research and development, GAAP 4,548 4,401 Non-GAAP adjustments: Stock-based compensation (1) (388 ) (500 ) Cost reduction efforts (3) (206 ) - Deferred compensation (4) (65 ) (688 ) Research and development, non-GAAP 3,889 3,213 Sales and marketing, GAAP 6,877 6,621 Non-GAAP adjustments: Stock-based compensation (1) (408 ) (587 ) Amortization of intangibles (2) (113 ) (112 ) Cost reduction efforts (3) (74 ) - Deferred compensation (4) - (654 ) Sales and marketing, non-GAAP 6,282 5,268 General and administrative, GAAP 3,110 3,637 Non-GAAP adjustments: Stock-based compensation (1) (420 ) (399 ) Cost reduction efforts (3) (27 ) - Business development expenses (5) - (1,002 ) General and administrative, non-GAAP 2,663 2,236 Total operating expenses, non-GAAP 12,834 10,717 Loss from operations, non-GAAP (3,854 ) (2,976 ) Interest and other income (expense), net 28 (50 ) Income tax benefit (147 ) (623 ) Non-GAAP adjustment (6): 179 726 Income tax provision, non- GAAP 32 103 Non-GAAP net loss $ (3,858 ) $ (3,129 ) Non-GAAP net loss per common share - diluted $ (0.19 ) $ (0.16 ) Shares used in computing diluted net loss per share 20,329 19,931 Reconciliation of net loss: U.S GAAP as reported $ (5,976 ) $ (6,717 ) Non-GAAP adjustments: Stock-based compensation (1) 1,313 1,598 Amortization of intangibles (2) 375 372 Cost reduction efforts (3) 544 - Deferred compensation (4) 65 1,342 Business development expenses (5) - 1,002 Income tax adjustment (6) (179 ) (726 ) As adjusted $ (3,858 ) $ (3,129 ) Reconciliation of diluted net loss per share: GAAP as reported $ (0.29 ) $ (0.34 ) Non-GAAP adjustments: Stock-based compensation (1) 0.06 0.08 Amortization of intangibles (2) 0.02 0.02 Cost reduction efforts (3) 0.03 - Deferred compensation (4) 0.00 0.07 Business development expenses (5) - 0.05 Income tax adjustment (6) (0.01 ) (0.04 ) As adjusted $ (0.19 ) $ (0.16 ) Shares used in computing diluted net loss per share 20,329 19,931 29 -------------------------------------------------------------------------------- Index (1) Stock-based compensation expense is calculated in accordance with the fair value recognition provisions of Accounting Standards Codification 718. (2) Amortization expense associated with intangible assets acquired in the Vineyard acquisition. (3) Severance and other employee-related costs in connection with our cost-reduction efforts. (4) Deferred compensation includes amortization of amounts paid under retention agreements with Vineyard's three founders. These amounts were paid during the first quarter of 2014, after one year of continuous employment with us. See Note 5 - "Acquisitions" in the Notes to Condensed Consolidated Financial Statements for additional details. (5) Business development expenses include the cost of outside professional services for negotiating and performing legal, accounting and tax due diligence for potential mergers and acquisitions and other significant partnership arrangements. (6) Income tax benefit associated with the following Vineyard acquisition related items: reversal of Vineyard's pre-existing income tax valuation allowance upon acquisition, amortization of acquired intangible assets and book to tax differences on deferred revenue. Liquidity and Capital Resources Cash, Cash Equivalents and Investments The following table summarizes the changes in our cash balance for the periods indicated: Three Months Ended March 31, 2014 2013 ($ in thousands) Net cash provided by (used in) operating activities $ 475 $ (4,580 ) Net cash used in investing activities (58,437 ) (9,414 ) Net cash provided by (used in) financing activities 69 (383 ) Effect of exchange rate changes on cash and cash equivalents (4 ) (20 ) Net decrease in cash and cash equivalents $ (57,897 ) $ (14,397 ) During the three months ended March 31, 2014, we generated $0.5 million in cash from operating activities as compared to $4.6 million in cash used in operating activities for the three months ended March 31, 2013. Cash provided by operating activities during the three months ended March 31, 2014 primarily consisted of net working capital sources of cash of $4.2 million and non-cash charges of $2.3 million, offset by our net loss of $6.0 million. Working capital sources of cash mainly consisted of a decrease in accounts receivable of $12.0 million due to strong collections. Working capital uses of cash consisted primarily of a decrease in accounts payable of $3.7 million associated with payments on inventory purchases, an increase in inventory of $1.7 million resulting from material purchases in anticipation of future sales and a $1.4 million decrease in deferred revenues due to the recognition of product revenues that were deferred in the prior year. Non-cash charges consisted primarily of stock-based compensation of $1.3 million, amortization of intangible assets of $0.4 million, amortization of premium on investments of $0.1 million and depreciation expense of $0.6 million, offset by changes in deferred taxes of $0.2 million. 30 -------------------------------------------------------------------------------- Index Net cash used in investing activities of $58.4 million during the three months ended March 31, 2014 consisted of purchases of short-term investments of $64.6 million offset by proceeds from maturities of short-term investments of $7.0 million and equipment purchases primarily of lab and testing equipment for use in research and development of $0.8 million. Net cash provided by financing activities of $0.1 million during the three months ended March 31, 2014 consisted of proceeds from the exercise of stock options. Our cash, cash equivalents and short-term investments at March 31, 2014 consisted of bank deposits with third party financial institutions, money market funds, U.S. agency securities, commercial paper and corporate bonds. Our investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relationship to our investment guidelines and market conditions. Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase. Short-term investments have a remaining maturity of greater than three months at the date of purchase and the portfolio of short-term investments have a weighted average maturity of less than one year. All investments are classified as available for sale. In January 2013, we acquired Vineyard in Kelowna, Canada. The aggregate total consideration of approximately $20.9 million consisted of $9.8 million in cash and 825,060 shares of our common stock. In addition to the purchase consideration, we recorded deferred compensation of $5.9 million, consisting of approximately $2.7 million in cash consideration and $3.2 million in our common stock, related to retention agreements with Vineyard's three founders, which was disbursed from the escrow account in January 2014 after one year of continuous employment with us. Based on our current cash, cash equivalents and short-term investment balances, and anticipated cash flow from operations, we believe that our working capital will be sufficient to meet the cash needs of our business for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of growth, the expansion of our sales and marketing activities, development of additional channel partners and sales territories, the infrastructure costs associated with supporting a growing business and greater installed base of customers, introduction of new products, enhancement of existing products and the continued acceptance of our products. We may also enter into arrangements that require investment such as entering into complementary businesses, service expansion, technology partnerships or acquisitions. Off-Balance Sheet Arrangements As of March 31, 2014, we had no off-balance sheet items as described by Item 303(a)(4) of Regulation S-K. We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments or other contingent arrangements that expose us to material continuing risks, contingent liabilities or any other obligations under a variable interest in an unconsolidated entity that provide us with financing, liquidity, market risk or credit risk support. Contractual Obligations We lease facility space under non-cancelable operating leases in California, Canada and Sweden that extend through 2024. The details of these contractual obligations are further explained in Note 11 of the Notes to Condensed Consolidated Financial Statements. We use third-party suppliers to assemble and test our hardware products. In order to reduce manufacturing lead-times and ensure an adequate supply of inventories, our agreements with some of these suppliers allow them to procure long lead-time component inventory based on rolling production forecasts provided by us. We may be contractually obligated to purchase long lead-time component inventory procured by certain suppliers in accordance with our forecasts. In addition, we issue purchase orders to our third-party suppliers that may not be cancelable at any time. As of March 31, 2014, we had open non-cancelable purchase orders amounting to approximately $0.9 million, primarily with our third-party suppliers. 31 -------------------------------------------------------------------------------- Index In March 2014, we entered into a lease agreement with B.C. Ltd, as landlord, relating to office space located in Kelowna, British Columbia. Upon completion of tenant improvements, which is expected to be around the end of August 2014, we intend to move our Canadian office to this new location. We will accrue a liability of $0.6 million associated with the construction of the leasehold improvements beginning in the leasehold construction period of May 2014 to August 2014. Payments to reduce the liability will begin around the end of August 2014. 32 -------------------------------------------------------------------------------- Index |