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WESTELL TECHNOLOGIES INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Overview The following discussion should be read together with the Consolidated Financial Statements and the related Notes thereto and other financial information appearing elsewhere in this Form 10-K. All references herein to the term "fiscal year" shall mean a year ended March 31 of the year specified. Westell Technologies, Inc., (the Company) is a global leader of intelligent site management, in-building wireless, cell site optimization, and outside plant solutions focused on innovation and differentiation at the edge of telecommunication networks, where end users connect. The comprehensive set of products and solutions the Company offers enable telecommunication service providers, cell tower operators, and other network operators to reduce operating costs and improve network performance. With millions of products successfully deployed worldwide, the Company is a trusted partner for transforming networks into high quality, reliable systems. The Company designs, develops, assembles and markets a wide variety of products and solutions. Intelligent site management solutions include a suite of Remote monitoring and control devices which, when combined with the Company's Optima management system, provides comprehensive machine-to-machine (M2M) communications that enable operators to remotely monitor, manage, and control site infrastructure and support systems. In-building wireless solutions include distributed antenna systems (DAS) interface panels, high-performance digital repeaters and bi-directional amplifiers (BDAs), and system components and antennas, all used by wireless service providers and neutral-party hosts to fine tune radio frequency (RF) signals that helps extend coverage to areas not served well or at all by traditional cell sites. Cell site optimization solutions consist of tower mounted amplifiers (TMAs), small outdoor-hardened units mounted next to antennas on cell towers, enabling wireless service providers to improve the overall performance of a cell site, including increasing data throughput and reducing dropped connections. Outside plant solutions, which are sold to wireline and wireless service providers as well as industrial network operators, consist of a broad range of offerings, including cabinets, enclosures, and mountings; synchronous optical networks/time division multiplexing (SONET/TDM) network interface units; power distribution units; copper and fiber connectivity panels; hardened Ethernet switches; and systems integration services. In fiscal year 2014, the Company operated under three reportable segments: Westell, Kentrox and CSI. Westell Segment The Westell segment consisted of all product offerings under our cell site optimization and outside plant network solutions, as well as our internally-developed passive DAS interface panels. For fiscal year 2014, Westell segment product offerings were developed at the Company's design centers in Aurora, Illinois; Goleta, California; and Regina, Canada; and operations were managed centrally at our Aurora facility where all products were assembled, tested, packaged, and shipped to customers. Kentrox Segment The Kentrox segment consisted of our intelligent site management solutions, which were acquired with the Kentrox acquisition on April 1, 2013. For fiscal year 2014, Kentrox segment product and service offerings were developed primarily at the Company's design center in Dublin, Ohio, where Kentrox was previously headquartered, and operations were managed centrally at the Dublin facility where all products were assembled, tested, packaged, and shipped to customers. CSI Segment The CSI segment included our in-building wireless solutions acquired with the CSI acquisition on March 1, 2014. For fiscal year 2014, CSI segment products were developed at the Company's design center in Manchester, New Hampshire, where CSI is headquartered, and operations were managed centrally at the Manchester facility where all products were assembled, tested, packaged, and shipped to customers. Customers The Company's customer base for its products is highly concentrated and comprised primarily of major telecommunications service providers, cell tower operators, and other network operators. Due to the stringent customer quality specifications and the regulated environment in which its customers operate, the Company must undergo lengthy approval and procurement processes prior to selling most of its products. Accordingly, the Company must make significant up-front investments in product and market development prior to actual commencement of sales of new products. The prices for the Company's -17--------------------------------------------------------------------------------- Table of Contents products vary based upon volume, customer specifications, and other criteria, and they are subject to change for a variety of reasons, including cost and competitive factors. To remain competitive, the Company must continue to invest in new product development and in targeted sales and marketing efforts to launch new product lines. Failure to increase revenues from new products, whether due to lack of market acceptance, competition, technological change meeting technical specifications or otherwise, could have a material adverse effect on the Company's business and results of operations. The Company expects to continue to evaluate new product opportunities and invest in product research and development activities. In view of the Company's reliance on the telecommunications market for revenues, the project nature of the business and the unpredictability of orders and pricing pressures, the Company believes that period-to-period comparisons of its financial results are not necessarily meaningful and should not be relied upon as an indication of future performance. The Company has experienced quarterly fluctuations in customer ordering and purchasing activity due primarily to the project-based nature of the business and to budgeting and procurement patterns toward the end of the calendar year or the beginning of a new year. While these factors can result in the greatest fluctuations in the Company's third and fourth fiscal quarters this is not always consistent and may not always correlate to financial results. The Kentrox segment business is driven by specific customer projects. The Company believes that two of those customer projects ramped down toward completion in the third quarter of fiscal year 2014. Critical Accounting Policies The preparation of financial statements in accordance with GAAP requires management to make use of certain estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and that affect the reported amounts of revenue and expenses during the reported periods. The Company bases estimates on historical experience and on various other assumptions that management believes are reasonable under the circumstances. These estimates and assumptions form the basis for judgments about carrying values of assets and liabilities that may not be readily apparent from other sources. Actual results could differ from the amounts reported. In Note 3 to the consolidated financial statements, the Company includes a discussion of its significant accounting policies. The Company believes the following are the most critical accounting policies and estimates used in the preparation of the financial statements. The Company considers an accounting policy or estimate to be critical if it requires assumptions to be made concerning uncertainties, and if changes in these assumptions could have a material impact on financial condition or results of operations. Business Combinations The Company applies the guidance of ASC topic 805, Business Combinations. The Company recognizes the fair value of assets acquired and liabilities assumed in transactions; establishes the acquisition date fair value as the measurement objective for all assets acquired and liabilities assumed; expenses transaction and restructuring costs; and discloses the information needed to evaluate and understand the nature and financial effect of the business combination. Inventories and Inventory Valuation Inventories are stated at the lower of first-in, first-out (FIFO) cost or market value. Market value is based upon an estimated average selling price reduced by estimated costs of disposal. Should actual market conditions differ from the Company's estimates, the Company's future results of operations could be materially affected. Reductions in inventory valuation are included in cost of goods sold in the accompanying Consolidated Statements of Operations. The Company reviews inventory for excess quantities and obsolescence based on its best estimates of future demand, product lifecycle status and product development plans. The Company uses historical information along with these future estimates to reduce the inventory cost basis. Subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. Prices anticipated for future inventory demand are compared to current and committed inventory values. Inventory Purchase Commitments In the normal course of business, the Company enters into non-cancellable commitments for the purchase of inventory. The commitments are negotiated to be at market rates. Should there be a significant decline in revenues the Company may absorb excess inventory and subsequent losses as a result of these commitments. The Company establishes reserves for potential losses on at-risk commitments. Income Taxes The Company accounts for income taxes under the provisions of ASC topic 740, Income Taxes (ASC 740). ASC 740 requires an asset and liability based approach in accounting for income taxes. Deferred income tax assets, including net operating loss (NOL) and certain tax credit carryovers and liabilities, are recorded based on the differences between the financial statement -18--------------------------------------------------------------------------------- Table of Contents and tax bases of assets and liabilities, applying enacted statutory tax rates in effect for the year in which the tax differences are expected to reverse. Valuation allowances are provided against deferred tax assets which are assessed as not likely to be realized. On a quarterly basis, management evaluates the recoverability of deferred tax assets and the need for a valuation allowance. This evaluation requires the use of estimates and assumptions and considers all positive and negative evidence and factors, such as the scheduled reversal of temporary differences, the mix of earnings in the jurisdictions in which the Company operates, and prudent and feasible tax planning strategies. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the dates of enactment. The Company accounts for unrecognized tax benefits based upon its assessment of whether a tax benefit is more likely than not to be sustained upon examination by tax authorities. The Company reports a liability for unrecognized tax benefits resulting from unrecognized tax benefits taken or expected to be taken in a tax return and recognizes interest and penalties, if any, related to its unrecognized tax benefits in income tax expense. See Note 4 for further discussion of the Company's income taxes. Goodwill and Other Intangibles Goodwill is the excess of the total purchase consideration transferred over the amounts allocated to identifiable assets acquired and liabilities assumed at the acquisition date. Goodwill is not amortized, but it is tested for impairment at the reporting unit level by first performing a qualitative approach to test goodwill for impairment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If it is concluded that this is the case, it is necessary to perform the two-step, quantitative, goodwill impairment test. Otherwise, the two-step goodwill impairment test is not required. Goodwill is reviewed for impairment at least annually in accordance with ASC 350, Intangibles-Goodwill and Other, or when an event occurs or circumstances change between annual tests that would more likely than not reduce the fair value of the reporting unit below its carrying value. The Company performs its annual impairment test in the fourth quarter of each fiscal year and begins with a qualitative assessment to determine if it is more likely than not that the fair value of a reporting unit is less than its carrying value. If the Company concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying value, it is necessary to perform a two-step goodwill impairment test. The first step tests for impairment by applying fair value-based tests at the reporting unit level. Fair value of a reporting unit is determined by using both an income approach and a market approach, because this combination is considered to produce the most reasonable indication of fair value in an orderly transaction between market participants. Under the income approach, the Company determines fair value based on estimated future cash flows of a reporting unit, discounted by an estimated weighted-average cost of capital, which reflects the level of risk inherent in a reporting unit and its associated estimates of future cash flows as well as the rate of return an experienced investor might expect to earn. Discount rate assumptions are considered Level 3 inputs in the fair value hierarchy defined in ASC 820, Fair Value Measurements and Discounts. Under the market approach, the Company utilizes valuation multiples derived from publicly available information for comparable companies to provide an indication of how much a knowledgeable investor in the marketplace might be willing to pay for a company. The second step (if necessary) measures the amount of impairment by applying fair-value-based tests to individual assets and liabilities within each reporting unit. If the Company concludes that it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying value, a quantitative fair value assessment is performed and compared to the carrying value. If the fair value is less than the carrying value, impairment is recorded. Intangible assets with determinable lives are amortized on a straight-line basis over their respective estimated useful lives. If the Company were to determine that a change to the remaining estimated useful life of an intangible asset was necessary, then the remaining carrying amount of the intangible asset would be amortized prospectively over that revised remaining useful life. On an ongoing basis, the Company reviews intangible assets with a definite life and other long-lived assets other than goodwill for impairment whenever events and circumstances indicate that carrying values may not be recoverable. If such events or changes in circumstances occur, the Company will recognize an impairment loss if the undiscounted future cash flow expected to be generated by the asset is less than the carrying value of the related asset. Any impairment loss would adjust the asset to its implied fair value. Revenue Recognition and Deferred Revenue The Company's revenue is derived from the sale of products, software, and services. The Company records revenue from product sales transactions when title and risk of loss are passed to the customer, there is persuasive evidence of an arrangement for sale, delivery has occurred and/or services have been rendered, the sales price is fixed or determinable, and collectability is reasonably assured. Revenue recognition on equipment where software is incidental to the product as a whole, or where software is essential to the equipment's functionality and falls under software accounting scope exceptions, generally occurs when products are shipped, -19--------------------------------------------------------------------------------- Table of Contents risk of loss has transferred to the customer, objective evidence exists that customer acceptance provisions have been met, no significant obligations remain, collection is reasonably assured and warranty can be estimated. Revenue recognition where software that is more than incidental to the product as a whole or where software is sold on a standalone basis is recognized when the software is delivered and ownership and risk of loss are transferred. The Company also recognizes revenue from deployment services, maintenance agreements, training and professional services. Deployment services revenue results from installation of products at customer sites. Deployment services, which generally occur over a short time period, are not services required for the functionality of products, because customers do not have to purchase installation services from the Company, and may install products themselves, or hire third parties to perform the installation services. Revenue for deployment services, training and professional services are recognized upon completion. Revenue from maintenance agreements is recognized ratably over the service period. When a multiple element arrangement exists, the fee from the arrangement is allocated to the various deliverables so that the proper amount can be recognized as revenue as each element is delivered. Based on the composition of the arrangement, the Company analyzes the provisions of the accounting guidance to determine the appropriate model that is applied towards accounting for the multiple element arrangement. If the arrangement includes a combination of elements that fall within different applicable guidance, the Company follows the provisions of the hierarchal literature to separate those elements from each other and apply the relevant guidance to each. If deliverables do not fall within the software revenue recognition guidance, the fair value of each element is established using the relative selling price method, which requires the Company to use vendor-specific objective evidence (VSOE), reliable third-party objective evidence or management's best estimate of selling price, in that order. If deliverables fall within the software revenue recognition guidance, the fee is allocated to the various elements based on VSOE of fair value. If sufficient VSOE of fair value does not exist for the allocation of revenue to all the various elements in a multiple element arrangement, all revenue from the arrangement is deferred until the earlier of the point at which such sufficient VSOE of fair value is established or all elements within the arrangement are delivered. If VSOE of fair value exists for all undelivered elements, but does not exist for one or more delivered elements, the arrangement consideration is allocated to the various elements of the arrangement using the residual method of accounting. Under the residual method, the amount of the arrangement consideration allocated to the delivered elements is equal to the total arrangement consideration less the aggregate fair value of the undelivered elements. Using this method, any potential discount on the arrangement is allocated entirely to the delivered elements, which ensures that the amount of revenue recognized at any point in time is not overstated. Under the residual method, if VSOE of fair value exists for the undelivered element, generally maintenance, the fair value of the undelivered element is deferred and recognized ratably over the term of the maintenance contract, and the remaining portion of the arrangement is recognized as revenue upon delivery, which generally occurs upon delivery of the product. The Company has established VSOE based on its historical pricing practices. The application of VSOE methodologies requires judgment, including the identification of individual elements in multiple element arrangements and whether there is VSOE of fair value for some or all elements. The Company's product return policy allows customers to return unused equipment for partial credit if the equipment is non-custom product, returned within specified time limits, and currently being manufactured and sold. Credit is not offered on returned products that are no longer manufactured and sold. The Company's reserve for returns is not significant. The Company records revenue net of taxes in accordance with ASC topic 605, Revenue Recognition (ASC 605). Stock-Based Compensation The Company recognizes stock-based compensation expense for all employee stock-based payments based upon the fair value on the award's grant date over the requisite service period. If the awards are performance based, the Company must estimate future performance attainment to determine the number of awards expected to vest. Determining the fair value of equity-based options requires the Company to estimate the expected volatility of its stock, the risk-free interest rate, expected option term, expected dividend yield and expected forfeitures. Product Warranties Most of the Company's products carry a limited warranty of up to seven years. The Company accrues for estimated warranty costs as products are shipped based on historical sales and cost of repair or replacement trends relative to sales. -20--------------------------------------------------------------------------------- Table of Contents Results of Operations Fiscal Years Ended March 31, 2014, 2013 and 2012 Revenue Fiscal Year Ended March 31, Increase (Decrease) 2014 vs. 2013 vs. (in thousands) 2014 2013 2012 2013 2012 Westell $ 52,223 $ 38,808 $ 43,629 $ 13,415 $ (4,821 ) Kentrox 46,174 N/A N/A 46,174 N/A CSI 3,676 N/A N/A 3,676 N/A Consolidated revenue $ 102,073 $ 38,808 $ 43,629 $ 63,265 $ (4,821 ) In fiscal year 2014, consolidated revenue increased $63.3 million compared to fiscal year 2013 due primarily to the acquisition of Kentrox which accounted for $46.2 million of the increase. Kentrox revenue was subject to purchase accounting adjustments which effectively reduced revenue by $2.1 million to fair value the performance obligation related to deferred revenue. The CSI acquisition added $3.7 million of revenue in fiscal year 2014. The Westell segment revenue increased 35% due primarily to sales of new products for wireless networks, including distributed antenna systems (DAS) products, and tower-mounted amplifiers. These new products accounted for 43% of the Westell segment revenue in fiscal year 2014 compared to 6% in fiscal year 2013. TDM/SONET, the segment's legacy products, decreased 23% in fiscal year 2014 compared to fiscal year 2013. This decrease is a result of a shift from T1 to Ethernet technology for the backhaul of cellular traffic and customer programs to constrain spending through the management of inventory levels and reuse of decommissioned products. In fiscal year 2013, Westell segment revenue decreased 11% compared to fiscal year 2012 resulting primarily from lower demand for legacy products, noted above. Gross profit and margin Fiscal Year Ended March 31, Increase (Decrease) 2014 vs. 2013 vs. (in thousands) 2014 2013 2012 2013 2012 Westell $ 17,077 $ 13,325 $ 17,172 $ 3,752 $ (3,847 ) 32.7 % 34.3 % 39.4 % (1.6 )% (5.1 )% Kentrox 23,517 N/A N/A 23,517 N/A 50.9 % N/A N/A 50.9 % N/A CSI 1,364 N/A N/A 1,364 N/A 37.1 % N/A N/A 37.1 % N/A Consolidated gross profit $ 41,958 $ 13,325 $ 17,172 $ 28,633 $ (3,847 ) Consolidated gross margin 41.1 % 34.3 % 39.4 % 6.8 % (5.1 )% In fiscal year 2014, consolidated margin increased 6.8% compared to fiscal year 2013 due primarily to the Kentrox acquisition. Westell segment gross margin decreased 1.6% year-over-year. The decrease was primarily because of higher excess and obsolete inventory charges offset by better absorption of overhead costs due to higher revenue. Fiscal year 2014 included a $2.5 million charge for excess and obsolete inventory compared to a $1.0 million charge in fiscal year 2013. The inventory charges resulted primarily from the technology shift to Ethernet that decreased demand for T1-related products, which had a more significant decline than the Company expected. Gross margins in the Kentrox and CSI segments, were negatively impacted by the purchase accounting adjustments for the fair value. Kentrox revenue was effectively reduced by $2.1 million to fair value the performance obligation related to deferred revenue. The Kentrox and CSI segment inventory valuation step-up included in cost of sales was $1.6 million and $0.5 million, respectively. In fiscal year 2013, Westell gross margin decreased 5.1% compared to fiscal year 2012. The decrease was primarily because of higher excess and obsolete inventory charges and lower absorption of overhead costs due to lower revenue. Fiscal year 2013 included a $1.0 million charge for excess and obsolete inventory compared to a $0.6 million charge in fiscal year 2012. The inventory charges resulted primarily from the technology shift to Ethernet that decreased demand for T1-related products. -21--------------------------------------------------------------------------------- Table of Contents Sales and marketing (S&M) Fiscal Year Ended March 31, Increase (Decrease) 2014 vs. 2013 vs. (in thousands) 2014 2013 2012 2013 2012 Consolidated S&M expense $ 14,663 $ 7,492 $ 5,843 $ 7,171 $ 1,649 Percentage of Revenue 14 % 19 % 13 % In fiscal year 2014, sales and marketing expenses increased by $7.2 million compared to fiscal year 2013 due primarily to the acquisition of Kentrox, which added $6.4 million of expense. The CSI acquisition added $0.3 million of expense. The remaining increase resulted primarily from increased commission expense of $0.4 million. Sales and marketing expenses in fiscal years 2013 and 2012 consisted of the Westell segment only and increased 28% primarily due to higher compensation and related expenses which resulted from the addition of employees hired with the ANTONE acquisition, the addition of a Senior Vice President of Sales and Marketing and increased commission expense. Research and development (R&D) Fiscal Year Ended March 31, Increase (Decrease) 2014 vs. 2013 vs. (in thousands) 2014 2013 2012 2013 2012 Westell $ 6,936 $ 5,928 $ 5,460 $ 1,008 $ 468 Kentrox 3,778 N/A N/A 3,778 N/A CSI 625 N/A N/A 625 N/AConsolidated R&D expense $ 11,339 $ 5,928 $ 5,460 $ 5,411 $ 468 Percentage of Revenue 11 % 15 % 13 % In fiscal year 2014, consolidated research and development expenses increased $5.4 million resulting from the acquisition of Kentrox which added $3.8 million of expense and the acquisition of CSI which added $0.6 million of expense. Research and development expenses in the Westell segment increased $1.0 million or 17% compared to the prior fiscal year. The increase was due primarily to higher compensation related expense of $0.9 million and the Company's focus on DAS and Cell Site Optimization product development. Fiscal years 2013 and 2012 consisted entirely of the Westell segment. Research and development expenses increased 9% or $0.5 million in fiscal year 2013 from fiscal year 2012. The increase was due primarily to the addition of development costs for ANTONE products and increased investment in DAS and Ethernet product development. General and administrative (G&A) Fiscal Year Ended March 31, Increase (Decrease) 2014 vs. 2013 vs. (in thousands) 2014 2013 2012 2013 2012 Consolidated G&A expense $ 14,027 $ 9,310 $ 6,996 $ 4,717 $ 2,314 Percentage of Revenue 14 % 24 % 16 % In fiscal year 2014, general and administrative expenses increased $4.7 million resulting primarily from the acquisition of Kentrox, which added $2.5 million of expense, the acquisition of CSI, which added $0.4 million of expense. In addition, there were increased compensation costs of $0.9 million, increased professional service fees of $0.3 million resulting from increases in audit and tax compliance and $0.3 million of expense related to the Antone contingent consideration time value of money. In fiscal year 2013, general and administrative expenses increased $2.3 million. The increase resulted primarily from: increased personnel costs resulting from higher bonus and stock-based compensation expense; the addition of a Vice President of Corporate Development; legal costs and acquisition costs relating to the Kentrox and ANTONE acquisitions; legal costs associated with an indemnification claim; and increased net expense for building rent resulting from a sublease that had reduced rent expense in fiscal year 2012. Restructuring Fiscal Year Ended March 31, Increase (Decrease) 2014 vs. 2013 vs. (in thousands) 2014 2013 2012 2013 2012 Consolidated restructuring expense $ 335 $ 149 $ 276 $ 186 $ (127 ) -22--------------------------------------------------------------------------------- Table of Contents In fiscal year 2014, the Company recorded restructuring charges related to termination awards for transitional employees associated with the Kentrox acquisition. In fiscal years 2013 and 2012, the Company's Westell business segment recorded restructuring charges related to the relocation of Noran Tel production from Canada to the Company's headquarters in Aurora, IL, primarily for employee termination benefits. Intangible amortization Fiscal Year Ended March 31, Increase (Decrease) 2014 vs. 2013 vs. (in thousands) 2014 2013 2012 2013 2012 Consolidated intangible amortization $ 4,908 $ 887 $ 544 $ 4,021 $ 343 The intangibles assets consist of product technology, customer relationships, trade names, and backlog derived from acquisitions. The increase in fiscal year 2014 amortization compared to fiscal year 2013 was due primarily to the April 1, 2013, acquisition of Kentrox, which added $3.3 million of expense and the acquisition of CSI, which added $0.3 million of expense. In addition, an impairment charge of $245,000 was taken in fiscal year 2014 for a product technology asset acquired in the acquisition of NoranTel. The increase in intangible amortization in fiscal year 2013 compared to fiscal year 2012 resulted from the ANTONE acquisition. Goodwill impairment The Company recognized goodwill impairment of $2.9 million in fiscal year 2013 that was the result of the Company's annual impairment testing. The goodwill impairment was the result of the Company's annual impairment testing which was significantly influenced by continuing operating losses and challenges in forecasting demand for the Company's products. The goodwill related to the Westell reporting unit and included $0.8 million relating to the acquisition of Noran Tel and $2.1 million relating to the acquisition of ANTONE. Other income (expense) Other income (expense), net was an expense of $0.1 million, and income of $0.2 million, and $0.3 million for fiscal years 2014, 2013, and 2012, respectively. Other income (expense), net contains interest income earned on short-term investments and foreign currency gains and losses. Income tax (expense) benefit Income tax in fiscal year 2014 and 2012 was a benefit of $8.8 million and $0.7 million, respectively. The Company recorded income tax expense in fiscal year 2013 of $29.4 million. In fiscal year 2014, deferred tax liabilities of $9.1 million resulted from the acquisitions relating primarily to acquired intangible assets. The Company's anticipated ability to realize deferred tax assets from the reversal of these deferred tax liabilities resulted in a reversal of valuation allowance. Income tax expense, excluding the impact of the acquisitions noted above, was $0.4 million primarily from state income tax expense in non-unitary states and state taxes based on gross margin, not taxable income. In fiscal year 2013, the Company considered both the positive and negative evidence available to assess the realizability of its deferred tax assets. The Company considered negative factors which included recent losses and a forecasted three-year cumulative loss position, as well as positive evidence consisting primarily of projected future earnings. The Company concluded that the negative evidence outweighed the objectively verifiable positive evidence. As a result, the Company increased the valuation allowance against deferred income tax assets by $34.0 million, which taken together with the liability for uncertain tax positions, had the effect of reserving in full all of the Company's deferred tax assets as of March 31, 2013. In fiscal year 2012, the Company sold its ConferencePlus subsidiary and completed the CNS asset sale which changed the outlook for future taxable income, positively with regards to the CNS business which contributed to the majority of the Company's historical losses and negatively in certain states where income generated by ConferencePlus was apportioned. In addition, certain states for which the Company has net operating loss carryforwards, such as Illinois, suspended the use of those carryforwards. The Company therefore was not able to utilize those carryforwards to offset fiscal year 2012 taxable income. The Company considered both the positive and negative evidence and established a forecast of future taxable income to evaluate the deferred tax assets for realizability. On this basis, the Company concluded that it was more likely than not that it would be able to utilize the majority of its deferred tax assets, but that certain state net operating loss carryforwards would expire prior to utilization. As a result, the Company increased the valuation allowance reserve by $1.7 million to $2.3 million in fiscal year 2012. In addition, the Company recognized $2.1 million of net tax benefits relating to the change in uncertain tax positions. Discontinued operations Net loss from discontinued operations was $45,000 and $1.5 million in fiscal years 2014 and 2013, respectively. Net income from discontinued operations was $42.9 million in fiscal year 2012. -23--------------------------------------------------------------------------------- Table of Contents The Company sold a portion of the CNS segment and the entire ConferencePlus subsidiary in fiscal year 2012. The Company discontinued the operations of ConferencePlus at the time of the sale and discontinued the CNS segment operations in the first quarter of fiscal year 2014. The results of operations of CNS and ConferencePlus along with the gains on the sales have been classified as income from discontinued operations. In fiscal year 2014, the loss from discontinued operations resulted from ongoing legal costs related to indemnity claims from the discontinued operations. In fiscal year 2013, the loss from discontinued operations resulted from a charge taken for an indemnification claim that related to the ConferencePlus sale transaction, partially offset by associated tax effects and unrelated discrete tax items. In fiscal year 2012, the income from discontinued operations resulted primarily from the gain on the sale of ConferencePlus. Net income (loss) Net income was $5.4 million and $42.0 million in fiscal years 2014 and 2012, respectively. Net loss was $44.0 million in fiscal year 2013. The changes were due to the cumulative effects of the variances identified above. Quarterly Results of Operations The Company has experienced, and may continue to experience, fluctuations in quarterly results of operations. Such fluctuations in quarterly results may correspond to substantial fluctuations in the market price of the Class A Common Stock. Some factors which have had an influence on and may continue to influence the Company's results of operations in a particular quarter include, but are not limited to, the size and timing of customer orders and subsequent shipments, customer order deferrals in anticipation of new products, timing of product introductions or enhancements by the Company or its competitors, market acceptance of new products, technological changes in the telecommunications industry, competitive pricing pressures, accuracy of customer forecasts of end-user demand, write-offs for excess or obsolete inventory, changes in the Company's operating expenses, personnel changes, foreign currency fluctuations, changes in the mix of products sold, quality control of products sold, disruption in sources of supply, regulatory changes, capital spending, delays of payments by customers, working capital deficits and general economic conditions. Sales to the Company's customers typically involve long approval and procurement cycles and can involve large purchase commitments. Accordingly, cancellation or deferral of orders could cause significant fluctuations in the Company's quarterly results of operations. As a result, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and caution should be used when placing reliance upon such comparisons as indications of future performance. For a detailed comparison of the eight quarters ended March 31, 2014, see Note 16, Quarterly Results of Operations (Unaudited), in the Notes to the consolidated financial statements. Liquidity and Capital Resources Overview At March 31, 2014, the Company had $35.8 million in cash and cash equivalents and $15.6 million in short-term investments, consisting of bank deposits, money market funds, certificates of deposit and pre-refunded municipal bonds. The Company believes that the existing sources of liquidity and cash from operations will satisfy cash flow requirements for the foreseeable future. Cash Flows The Consolidated Statements of Cash Flows include discontinued operations. The Company's operating activities provided cash of $1.6 million in fiscal year 2014 and used cash of $12.1 million and $5.0 million in fiscal years 2013 and 2012, respectively. Cash generated in fiscal year 2014 resulted primarily from $5.4 million of net income that includes $7.4 million of depreciation, amortization and stock-based compensation expense, a $9.3 million decrease in deferred tax assets and a $2.2 million decrease in working capital. Cash used in fiscal year 2013 resulted primarily from a net loss of $44.0 million that includes $5.7 million of depreciation, goodwill impairment, amortization and stock-based compensation expense, a $29.9 million decrease in deferred tax assets and a $3.8 million decrease in working capital. Cash used in fiscal year 2012 resulted primarily from net income of $42.0 million that includes $3.3 million of depreciation, amortization and stock-based compensation expense, a $12.4 million increase in deferred tax assets and an $11.4 million increase in working capital. The changes in working capital in fiscal year 2012 resulted predominantly from the sale of the CNS business combined with the wind-down of that business. -24--------------------------------------------------------------------------------- Table of Contents The Company's investing activities used cash of $55.3 million and $7.8 million in fiscal years 2014 and 2013, respectively, and generated cash of $55.2 million in fiscal year 2012. In fiscal year 2014, the Company had net sales of short-term investments of $8.8 million, used $66.2 million for the acquisitions of Kentrox and CSI and had a $2.5 million reduction of restricted cash. In fiscal year 2013, the Company had net purchases of short-term investments of $9.9 million, used $2.5 million for the acquisition of ANTONE and had an increase of $5.0 million of restricted cash. In fiscal year 2012, the Company had $69.6 million from the CNS asset sale and the ConferencePlus business exclusive of cash held in escrow. In addition, the Company used $14.0 million to purchase short-term investments and $0.8 million to make capital expenditures. Approximately half of the capital expenditures were in the Westell segment and half were in the discontinued ConferencePlus segment. The Company's financing activities generated cash of $1.3 million in fiscal year 2014 and used cash of $12.6 million and $15.7 million in fiscal years 2013 and 2012, respectively. The Company purchased $0.4 million, $12.7 million, and $17.4 million of its outstanding stock, which is recorded as treasury stock, and received proceeds from the exercise of stock options of $1.7 million, $0.1 million, and $1.7 million in fiscal years 2014, 2013 and 2012, respectively. Purchase obligations consist of inventory that arises in the normal course of business operations. Future obligations and commitments as of March 31, 2014 consisted of the following: Payments due by fiscal year (in thousands) 2015 2016 2017 2018 2019 Thereafter Total Purchase obligations $ 12,158 $ - $ - $ - $ - $ - $ 12,158 Future minimum lease payments for operating leases 3,011 2,510 2,503 887 64 - 8,975 Contingent Consideration $ 2,067 $ 574 $ - $ - $ - $ - $ 2,641 Future obligations and commitments $ 17,236 $ 3,084 $ 2,503 $ 887 $ 64 $ - $ 23,774 As of March 31, 2014, the Company had net deferred tax assets of approximately $28.7 million before a valuation allowance of $28.5 million, resulting in a net deferred tax liability of $0.2 million. Also, as of March 31, 2014, the Company had a $3.0 million tax contingency reserve related to uncertain tax positions. Federal net operating loss carryforwards begin to expire in fiscal year 2023. Realization of deferred tax assets associated with the Company's future deductible temporary differences, net operating loss carryforwards and tax credit carryforwards is dependent upon generating sufficient taxable income prior to their expiration, among other factors. The Company weighed positive and negative evidence to assess the need for a valuation allowance against deferred tax assets and whether a tax benefit should be recorded when taxable losses are incurred. The existence of a valuation allowance does not limit the availability of tax assets to reduce taxes payable when taxable income arises. Management periodically evaluates the recoverability of the deferred tax assets and may adjust the valuation allowance against deferred tax assets accordingly. Off-Balance Sheet Arrangements The Company has a 50% equity ownership in AccessTel Kentrox Australia PTY LTD (AKA). AKA distributes network management solutions provided by the Company and the other 50% owner to one customer. The Company holds equal voting control with the other owner. All actions of AKA are decided at the board level by majority vote. The Company also has an unlimited guarantee for the performance of the other 50% owner in AKA, who primarily provides support and engineering services to the customer. This guarantee was put in place at the request of the AKA customer. The guarantee which is esimated to have a maximum potential future payment of $0.7 million, will stay in place as long as the contract between AKA and the customer is in place. The Company would have recourse against the other 50% owner in AKA in the event the guarantee is triggered. The Company determined that it could perform on the obligation it guaranteed at a positive rate of return and therefore did not assign value to the guarantee. |