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8X8 INC /DE/ - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) OVERVIEW We are a leading provider of UCC services in the cloud for SMBs and mid-market and distributed enterprises. We deliver a broad suite of UCC services to in-office and mobile devices spanning cloud telephony, virtual contact center and virtual meeting through our proprietary unified SaaS platform. We currently serve approximately 38,000 business customers with over 500,000 subscriptions, making us a leading provider of UCC services in the cloud. Our software abstracts complex networking, redundancy, security and interconnection requirements to provide a seamless and easy-to-use solution for our customers. Our software also integrates with leading ERP, CRM, HCM and other third-party application suites, such as Salesforce.com and NetSuite, to provide organizations an integrated, fully functional business communications and collaboration experience that is critical to operate their businesses. SUMMARY AND OUTLOOK In fiscal year 2014, we displayed continued momentum in four areas. First, we saw an increase in the number of new services added during the year, representing a year-over-year increase of 26%, reflecting demand for our services in our domestic small and medium businesses, or SMBs, and mid-market and distributed enterprise customer market. We intend to continue to pursue opportunities to sell our comprehensive suite of services to SMBs and mid-market and distributed enterprises who wish to consolidate their cloud communications and collaborative service requirements with a single service provider. Second, our continued focus on mid-market and distributed enterprise customers resulted in 34% of our new monthly recurring revenue sold in the fiscal year coming from this the mid-market and channel sales teams that target these customers compared with 25% in fiscal 2013. We continued to show an increase in our average monthly service revenue per customer to $287 in the fourth quarter of fiscal 2014 compared to $256 in the same period of fiscal 2013 which is the result of our success in selling to larger, more established customers. Third, we continued to focus on selling a greater number of services to our existing customer base. Our comprehensive suite of services, combined with our highly scalable service architecture enables our customers to quickly and easily deploy additional 8x8 products and services to distributed locations and remote employees. Fourth, we continued to build on our Global Reach initiative by acquiring Voicenet in the United Kingdom in November 2013. In addition, we installed our services infrastructure in a new Hong Kong data center in January 2014. We are in the process of migrating services for non-US customers to our new overseas infrastructure. Beyond serving the needs of existing customers, it is our intent to penetrate these markets through a variety of additional methods including strategic alliances, partners and acquisitions. To support these initiatives and strengthen our business, we intend to continue investing in research and development and sales and marketing at rates comparable to the third and fourth quarters of fiscal 2014 for the foreseeable future. CRITICAL ACCOUNTING POLICIES & ESTIMATES Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. Note 1 to the consolidated financial statements in Part II, Item 8 of this Report describes the significant accounting policies and methods used in the preparation of our consolidated financial statements. We have identified the policies below as some of the more critical to our business and the understanding of our results of operations. These policies may involve a higher degree of judgment and complexity in their application and represent the critical accounting policies used in the preparation of our consolidated financial statements. Although we believe our judgments and estimates are appropriate, actual future results may differ from our estimates. If different assumptions or conditions were to prevail, the results could be materially different from our reported results. The impact and any associated risks related to these policies on our business operations is discussed throughout Management's Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. 31 -------------------------------------------------------------------------------- Use of Estimates The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and equity and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including, but not limited to, those related to bad debts, valuation of inventories, and litigation and other contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates under different assumptions or conditions. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets, liabilities and equity that are not readily apparent from other sources. Actual results could differ from those estimates under different assumptions or conditions. Additional information regarding risk factors that may impact our estimates is included above under Part I, Item 1A, "Risk Factors." Revenue Recognition Our revenue recognition policies are described in Note 1 to the consolidated financial statements in Part II, Item 8 of this Report. As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments or utilized different estimates. Service and Product Revenue We recognize revenue from product sales for which there are no related services to be rendered upon shipment to customers provided that persuasive evidence of an arrangement exists, the price is fixed, title has transferred, collection of resulting receivables is reasonably assured, there are no customer acceptance requirements, and there are no remaining significant obligations. Gross outbound shipping and handling charges are recorded as revenue, and the related costs are included in cost of goods sold. Reserves for returns and allowances for customer sales are recorded at the time of shipment. In accordance with the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 985-605, we record shipments to distributors, retailers, and resellers, where the right of return exists, as deferred revenue. We defer recognition of revenue on product sales to distributors, retailers, and resellers until the products have been sold to the end customer. We record revenue net of any sales-related taxes that are billed to its customers. We believe this approach results in consolidated financial statements that are more easily understood by users. Under the terms of our typical subscription agreement, new customers can terminate their service within 30 days of order placement and receive a full refund of fees previously paid. We have determined that we have sufficient history of subscriber conduct to make a reasonable estimate of cancellations within the 30-day trial period. Therefore, we recognize new subscriber revenue in the month in which the new order was shipped, net of an allowance for expected cancellations. Multiple Element Arrangements ASC 605-25 requires that revenue arrangements with multiple deliverables be divided into separate units of accounting if the deliverables in the arrangement meet specific criteria. The provisioning of the 8x8 cloud service with the accompanying 8x8 IP telephone constitutes a revenue arrangement with multiple deliverables. For arrangements with multiple deliverables, we allocate the arrangement consideration to all units of accounting based on their relative selling prices. In such circumstances, the accounting principles establish a hierarchy to determine the relative selling price to be used for allocating arrangement consideration to units of accounting as follows: (i) vendor-specific objective evidence of fair value ("VSOE"), (ii) third-party evidence of selling price ("TPE"), and (iii) best estimate of the selling price ("BESP"). VSOE generally exists only when we sell the deliverable separately, on more than a limited basis, at prices within a relatively narrow range. When VSOE cannot be established, we attempt to establish the selling price of deliverables based on relevant TPE. TPE is determined based on manufacturer's prices for similar deliverables when sold separately, when possible. When we are unable to establish selling price using VSOE or TPE, we use BESP for the allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service was sold on a stand-alone basis. BESP is generally used for offerings that are not typically sold on a stand-alone basis or for new or highly 32 -------------------------------------------------------------------------------- customized offerings. We determine BESP for a product or service by considering multiple factors including, but not limited to: º the price list established by its management which is typically based on general pricing practices and targeted gross margin of products and services sold; and º analysis of pricing history of new arrangements, including multiple element and stand-alone transactions. In accordance with the guidance of ASC 605-25, when we enter into revenue arrangements with multiple deliverables we allocate arrangement consideration, including activation fees, among the 8x8 IP telephones and subscriber services based on their relative selling prices. Arrangement consideration allocated to the IP telephones that is fixed or determinable and that is not contingent on future performance or future deliverables is recognized as product revenues during the period of the sale less the allowance for estimated returns during the 30-day trial period. Arrangement consideration allocated to subscriber services that is fixed or determinable and that is not contingent on future performance or future deliverables is recognized ratably as service revenues as the related services are provided, which is generally over the initial contract term. Our ability to enter into revenue generating transactions and recognize revenue in the future is subject to a number of business and economic risks discussed above under Item 1A,"Risk Factors." Collectability of Accounts Receivable We must make estimates of the collectability of our accounts receivable. Management specifically analyzes accounts receivable, including historical bad debts, customer concentrations, customer creditworthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. As of March 31, 2014, the accounts receivable balance was $5,503,000, net of an allowance for doubtful accounts of $629,000, including a reserve for disputed credits, and an estimated returns reserve of $163,000. If the financial condition of our customers deteriorates, our actual losses may exceed our estimates, and additional allowances would be required. Valuation of Inventories We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand, market conditions and replacement costs. If actual future demand or market conditions are less favorable than those projected by us, additional inventory write-downs may be required. Goodwill and Other Intangible Assets Goodwill and intangible assets with indefinite useful lives are not amortized. Goodwill represents the excess fair value of consideration transferred over the fair value of net assets acquired in business combinations. The carrying value of goodwill and indefinite lived intangible assets are not amortized, but are annually tested for impairment and more often if there is an indicator of impairment. We perform an annual impairment assessment in the fourth quarter of each year, or more frequently if indicators of potential impairment exist, to determine whether it is more likely than not that the fair value of a reporting unit in which goodwill resides is less than its carrying value. For reporting units in which this assessment concludes that it is more likely than not that the fair value is more than its carrying value, goodwill is not considered impaired and we are not required to perform the two-step goodwill impairment test. Qualitative factors considered in this assessment include industry and market considerations, overall financial performance, and other relevant events and factors affecting the reporting unit. Income and Other 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 requires us to estimate our actual current tax expense and to assess temporary differences resulting from book-tax accounting differences for items such as accrued vacation. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. In the event that we determine that we would be able to realize deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax asset would reduce income tax expense in the period such determination was made. 33 -------------------------------------------------------------------------------- Significant management judgment is required to determine the valuation allowance recorded against our net deferred tax assets, which include net operating loss and tax credit carry forwards. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. During the fourth quarter of fiscal 2012, we reassessed the need for a valuation allowance against our net deferred tax asset and concluded that it was more likely than not that we would be able to realize a significant portion of our deferred tax assets. Accordingly, we released most of our valuation allowance related to our deferred tax asset which resulted in a credit to the income statement of approximately $62.1 million. We determined that a release of a portion of our valuation allowance was appropriate as a result of the following discrete events: (1) our attainment of three consecutive years of net income, (2) the acquisition of Contactual in the second quarter of fiscal 2012, (3) the completion of the Section 382 ownership analysis under the Internal Revenue Code for Contactual in the fourth quarter of fiscal 2012. During the fourth quarters of fiscal 2014 and 2013, we evaluated the need for a valuation allowance against our net deferred tax asset and concluded that an additional allowance was needed. Therefore, we increased our valuation allowance related to our state and federal net operating loss and tax credit carryovers which resulted in reversals of previous income statement credits of approximately $1.3 million and $1.0 million, respectively. We determined that an increase in our valuation allowance was appropriate as a result of the change in the net income apportionment methodology in California and the acquisition of Voicenet in the third quarter of fiscal 2014. In making this determination, we considered all available positive and negative evidence, including our recent earnings trend and expected continued future taxable income. As of March 31, 2014, the net deferred tax asset on the consolidated balance sheet represented the projected tax benefit we expect to realize. We continue to maintain a valuation allowance against the portion of our deferred tax assets that we believe we will not be able to utilize. We have received inquiries, demands or audit requests from several state, municipal and 9-1-1 taxing agencies seeking payment of taxes that are applied to or collected from the customers of providers of traditional public switched telephone network services. We recorded $0.1 million, $0 and $0 of expense for the years ended March 31, 2014, 2013 and 2012, respectively, for estimated tax exposure for such assessments. Stock-Based Compensation We account for our employee stock options, stock purchase rights, restricted stock units, and restricted performance stock units granted under the 1996 Stock Plan, 1996 Director Option Plan, 1999 Nonstatutory Stock Option Plan, the 2006 Stock Plan, the 2003 Contactual Plan, the 2012 Equity Incentive Plan, the 2013 New Employee Inducement Incentive Plan and stock purchase rights under the 1996 Employee Stock Purchase Plan (collectively "Equity Compensation Plans") under the provisions of ASC 718 - Stock Compensation . Under the provisions of ASC 718, stock-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as an expense over the employee's requisite service period (generally the vesting period of the equity grant), net of estimated forfeitures. Stock-based compensation expense recognized in the Consolidated Statements of Income for fiscal 2014, 2013 and 2012, was measured based on ASC 718 criteria. Compensation expense for stock-based payment awards is recognized using the straight-line single-option method and includes the impact of estimated forfeitures. Compensation expense for restricted stock units with performance and market conditions is recognized over the requisite service period using the straight-line method and includes the impact of estimated forfeitures. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. To value option grants, stock purchase rights and restricted stock units under the Equity Compensation Plans for stock-based compensation, we used the Black-Scholes option valuation model. Fair value determined using the Black-Scholes option valuation model varies based on assumptions used for the expected stock prices volatility, expected life, risk-free interest rates and future dividend payments. For the twelve months ended March 31, 2014 and 2013, we used the historical volatility of our stock over a period equal to the expected life of the options to their fair value. The expected life assumptions represent the weighted-average period stock-based awards are expecting to remain outstanding. These expected life assumptions were established through the review of historical exercise behavior of stock-based award grants with similar vesting periods. The risk-free interest was based on the closing market bid yields on actively traded U.S. treasury securities in the over-the-counter market for the expected term equal to the expected term of the option. The dividend yield assumption was based on our history and expectation of future dividend payout. 34 -------------------------------------------------------------------------------- To value restricted performance stock units under the Equity Compensation Plans, we used a Monte Carlo simulation model. Fair value determined using the Monte Carlo simulation model varies based on the assumptions used for the expected stock price volatility, the correlation coefficient between the Company and the NASDAQ Composite Index, risk free interest rates, and future dividend payments. For the twelve months ended March 31, 2014, we used the historical volatility and correlation of our stock and the Index over a period equal to the remaining performance period as of the grant date. The risk-free interest rate was based on the closing market bid yields on actively traded U.S. treasury securities in the over-the-counter market for the expected term equal to the remaining performance period as of the grant date. The dividend yield assumption was based on our history and expectation of future dividend payout. ASC 718 requires us to calculate the additional paid-in-capital pool, or APIC Pool, available to absorb tax deficiencies recognized subsequent to adopting ASC 718, as if we had adopted ASC 718 at its effective date of January 1, 1995. There are two allowable methods to calculate our APIC Pool: (1) the long form method or (2) the short form method as set forth in ASC 718. We have elected to use the long form method under which we track each award grant on an employee-by-employee basis and grant-by-grant basis to determine if there is a tax benefit or tax deficiency for such award. We then compared the fair value expense to the tax deduction received for each grant and aggregated the benefits and deficiencies to establish the APIC Pool. Due to the adoption of ASC 718, some option exercises result in tax deductions in excess of book deductions based on the option value at the time of grant. We recognize these windfall tax benefits associated with the exercise of stock options directly to stockholders' equity only when realized. We use the "with and without" approach as described in ASC 740, in determining the order in which our tax attributes are utilized. The "with and without" approach results in the recognition of the windfall stock option tax benefits only after all other tax attributes of ours have been considered in the annual tax accrual computation. Also, we have elected to ignore the indirect tax effects of share-based compensation deductions in computing our research and development tax credits and alternative tax credits and as such, we recognize the full effect of these deductions in the consolidated income statement in the period in which the taxable event occurs. SELECTED OPERATING STATISTICS We periodically review certain key business metrics, within the context of our articulated performance goals, in order to evaluate the effectiveness of our operational strategies, allocate resources and maximize the financial performance of our business. The selected operating statistics include the following: Selected Operating Statistics (1) March 31, Dec 31, Sept. 30, June 30, March 31, 2014 2013 2013 2013 2013 Gross business customer additions (2) 3,276 3,001 2,961 2,693 2,800 Number of new services sold (2)(3) 64,312 61,286 52,412 47,318 50,670 Average number of subscribed services per new business customer (4) 19.6 20.4 17.7 17.6 18.1 Business subscriber acquisition cost per service (5) $ 84 $ 92 $ 94 $ 96 $ 91 Total business customers (2)(6) 37,933 36,753 34,674 33,374 32,242 Average number of subscribed services per business customer (7) 13.5 12.6 12.2 12.0 11.6 Business customer average monthly service revenue per customer (8) $ 287 $ 274 $ 268 $ 263 $ 256 Monthly business customer churn (less cancellations within 30 days of sign-up) (9) 1.7% 1.6% 1.5% 1.5% 1.7% Monthly business service revenue churn 1.2% 1.5% 1.2% 1.2% 1.2% Overall service margin 79% 81% 81% 82% 81% Overall product margin -23% -34% -27% -22% -17% Overall gross margin 70% 71% 71% 72% 71% (1) Selected operating statistics table include continuing operations and excludes dedicated server hosting business sold September 30, 2013. (2) Does not include customers of Virtual Office Solo, DNS or Cloud VPS. 35 -------------------------------------------------------------------------------- (3) Number of recurring revenue services sold to business customers during the period. (4) Number of new services sold divided by gross business customer additions. (5) The combined costs of advertising, marketing, promotions, sales commissions and equipment subsidies for new services sold during the period divided by the number of new services sold during the period. (6) Business customers are defined as customers paying for service. Customers that are currently in the 30-day trial period are considered to be customers that are paying for service. Customers subscribing to Virtual Office Solo, DNS or Cloud VPS services are not included as business customers. (7) The simple average number of subscribed services divided by the simple average number of business customers during the period. The simple average number of subscribed services is the number of subscribed services on the first day of the period plus the number of subscribed services on the last day of the period divided by two. The simple average number of business customers is the number of business customers on the first day of the period plus the number of business customers on the last day of the period divided by two. (8) Business customer average monthly service revenue per customer is service revenue from business customers in the period divided by the number of months in the period divided by the simple average number of business customers during the period. (9) Business customer churn is calculated by dividing the number of business customers that terminated (after the expiration of the 30-day trial) by the simple average number of business customers and dividing the result by the number of months in the period. We believe it is useful to monitor these metrics together and not individually, as we do not make business decisions based upon any single metric. RESULTS OF OPERATIONS The following discussion should be read in conjunction with our Consolidated Financial Statements and related notes included elsewhere in this Report. We have minimal seasonality in our business but typically sales of new subscriptions in our fourth fiscal quarter are greater than any of the first three quarters of the fiscal year. We believe this occurs because the customers we target have a tendency to spend a relatively greater portion of their annual capital budgets at the beginning of the calendar year compared with each of the last three quarters of the year. REVENUE Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) Service revenue $ 116,607 $ 94,384 $ 75,951 $ 22,223 23.5% $ 18,433 24.3% Percentage of total revenue 90.7% 90.9% 91.1% Service revenue consists primarily of revenues attributable to the provision of our cloud communication and collaboration services and royalties earned from cloud technology licenses. We expect that cloud communication and collaboration service revenues will continue to comprise nearly all of our service revenues for the foreseeable future. The increase in fiscal year 2014, compared with fiscal year 2013, was primarily attributable to an increase in our business customer subscriber base and an increase in the average monthly service revenue per customer. Our business service subscriber base grew from approximately 32,500 customers at the end of fiscal 2013 to approximately 38,000 customers on March 31, 2014. We expect the trends to continue in future periods. The increase in fiscal year 2013, compared with fiscal year 2012, was primarily attributable to an increase in cloud communications and collaboration service revenues resulting from growth of our business service subscriber base. Our business service subscriber base grew from approximately 28,500 customers at the end of fiscal 2012 to approximately 32,500 customers on March 31, 2013. The increase was partially offset by a decrease in customers of our residential services. Those changes were consistent with the redirection of our marketing efforts toward our business customer service. 36 -------------------------------------------------------------------------------- Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) Product revenue $ 11,990 $ 9,402 $ 7,421 $ 2,588 27.5% $ 1,981 26.7% Percentage of total revenue 9.3% 9.1% 8.9% Product revenue consists primarily of revenues from sales of IP telephones in conjunction with our cloud telephony service. The increase in fiscal year 2014 from fiscal year 2013 resulted from a $2.6 million increase in product revenue attributable to growth in our business customer subscriber base, for which we have been subsidizing equipment purchases. The increase in fiscal year 2013 from fiscal year 2012 resulted from a $2.0 million increase in product revenue attributable to growth in our business customer subscriber base, for which we have been subsidizing equipment purchases. No single customer represented more than 10% of our total revenues during fiscal 2014, 2013 or 2012. The following table illustrates our net revenues by geographic area. Revenues are attributed to countries based on the destination of shipment (in thousands): Years Ended March 31, 2014 2013 2012 Americas (principally US) 97% 99% 99% Europe 2% 0% 0% Asia Pacific 1% 1% 1% 100% 100% 100% COST OF REVENUE Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) Cost of service revenue $ 22,445 $ 19,928 $ 15,974 $ 2,517 12.6% $ 3,954 24.8% Percentage of service revenue 19.2% 21.1% 21.0% Cost of service revenue primarily consists of costs associated with network operations and related personnel, telephony origination and termination services provided by third party carriers and technology license and royalty expenses. The increase in cost of service revenue for fiscal 2014 from fiscal 2013 was primarily due to a $0.9 million increase in payroll and related expenses, a $0.8 million increase in third party network service expenses, a $0.2 million increase in consultant and outside service expenses and a $0.2 million increase in repair and maintenance expenses. The increase in cost of service revenue for fiscal 2013 from fiscal 2012 was primarily due to a $2.5 million increase in third party network service expenses, a $0.9 million increase in payroll and related expenses, a $0.4 million increase in depreciation expenses, a $0.4 million increase in amortization expense due to intangibles acquired in acquisitions, a $0.1 million increase in consultant and outside service expenses. The increase in cost of service revenues was partially offset by a $0.3 million reduction in license and fee expenses. Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) Cost of product revenue $ 15,170 $ 11,801 $ 9,822 $ 3,369 28.5% $ 1,979 20.1% Percentage of product revenue 126.5% 125.5% 132.4% 37 -------------------------------------------------------------------------------- The cost of product revenue consists primarily of IP Telephones, estimated warranty obligations and direct and indirect costs associated with product purchasing, scheduling, shipping and handling. We allocate a portion of service revenues to product revenues but these revenues are less than the cost of the product. The increase in the cost of product revenue for fiscal 2014 from fiscal 2013 was primarily due to a $2.7 million increase in the shipment of equipment to our business customers, a $0.3 million increase in warranty expense, and a $0.2 million increase in freight costs. The increase in the cost of product revenue for fiscal 2013 from fiscal 2012 was primarily due to a $1.8 million increase in the shipment of equipment to our business customers, a $0.1 million increase in warranty expense, and a $0.1 million increase in freight costs. RESEARCH AND DEVELOPMENT EXPENSES Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) Research and development $ 11,633 $ 8,147 $ 6,745 $ 3,486 42.8% $ 1,402 20.8% Percentage of total revenue 9.0% 7.8% 8.1% Historically, our research and development expenses have consisted primarily of personnel, system prototype design, and equipment costs necessary for us to conduct our development and engineering efforts. During the fiscal year ended March 31, 2014, we capitalized $0.8 million of software development costs in accordance with ASC 985-20. We expensed all other research and development costs as they were incurred. The increase in research and development expenses for fiscal 2014 from fiscal 2013 was primarily attributable to a $1.7 million increase in payroll and related expenses and a $1.5 million increase in temporary personnel, consulting and outside service expenses. The increase in research and development expenses for fiscal 2013 from fiscal 2012 was primarily attributable to a $1.1 million increase in payroll and related expenses, a $0.1 million increase in recruiting expenses, and a $0.2 million increase in other research and development expenses. SALES AND MARKETING EXPENSES Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) Sales and marketing $ 60,906 $ 45,573 $ 36,227 $ 15,333 33.6% $ 9,346 25.8% Percentage of total revenue 47.4% 43.9% 43.5% Sales and marketing expenses consist primarily of personnel and related overhead costs for sales, marketing, and customer service. Such costs also include outsourced customer service call center operations, sales commissions, as well as trade show, advertising and other marketing and promotional expenses. The increase in sales and marketing expenses for fiscal 2014 from fiscal 2013 was primarily due to a $10.2 million increase in payroll and related expenses from an increase in our sales force, a $1.1 million increase in advertising expenses, a $0.8 million increase in temporary personnel, consulting and outside service expenses, a $0.5 million increase in third party sales commissions, a $0.5 million increase in travel and meal expenses, a $0.4 million increase in credit card processing fees, a $0.3 million increase in trade show expenses, a $0.3 million increase in amortization expense due to intangibles acquired in acquisitions and a $0.2 million increase in expensed computer, software and light furniture. The increase in sales and marketing expenses for fiscal 2013 from fiscal 2012 was primarily due to a $6.4 million increase in payroll and related expenses from an increase in our sales force, a $0.9 million increase in advertising expenses, a $0.4 million increase in third party sales commissions, a $0.3 million increase in sales promotion expenses, a $0.3 million increase in bad debt expense, a $0.2 million increase in amortization expense due to intangibles acquired in acquisitions, a $0.2 million increase in travel and meal expenses and a $0.7 million net increases in other sales and marketing expenses. 38 -------------------------------------------------------------------------------- GENERAL AND ADMINISTRATIVE EXPENSES Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) General and administrative $ 15,368 $ 8,558 $ 5,973 $ 6,810 79.6% $ 2,585 43.3% Percentage of total revenue 12.0% 8.2% 7.2% General and administrative expenses consist primarily of personnel and related overhead costs for finance, human resources and general management. The increase in general and administrative expenses for fiscal 2014 from fiscal 2013 was primarily due to a $4.8 million increase in payroll and related expenses including a one-time charge of approximately $0.1 million in severance pay and $1.1 million in stock-based compensation related to the resignation of the Company's president in October 2013, a $0.6 million increase in legal expenses, a $0.6 million increase in facility lease and maintenance expenses, a $0.2 million increase in temporary personnel, consulting and outside service expenses, a $0.2 million increase in sales and use tax expense, a $0.2 million increase in property and franchise tax expenses, and a $0.2 million increase in accounting and tax expenses. The increase in general and administrative expenses for fiscal 2013 from fiscal 2012 was primarily due to a $1.0 million increase in payroll and related expenses, a $0.9 million increase in temporary personnel, consulting and outside service expenses, a $0.2 million increase in sales and use tax expense, a $0.2 million increase in recruiting expense and a $0.3 million increase in other general and administrative expenses. GAIN ON PATENT SALE Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) Gain on patent sale $ - $ (12,965) $ - $ 12,965 N/A $ (12,965) N/A Percentage of total revenue 0.0% -12.5% 0.0% In June 2012, we entered into a patent purchase agreement for the sale of a family of United States patents. We recognized a gain of slightly less than $12.0 million, net of transaction costs, in the first fiscal quarter of 2013 and approximately $1.0 million in the fourth fiscal quarter of 2013 due to the third party purchaser entering into a license agreement with its customer. The gain on patent sale has been recorded as a reduction of operating expenses in the consolidated statements of income. INTEREST INCOME (LOSS) AND OTHER, NET Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) Interest income (loss) and other, net $ 742 $ 105 $ (305) $ 637 606.7% $ 410 -134.4% Percentage of total revenue 0.6% 0.1% -0.4% This item primarily consisted of gain on settlement of escrow claim, capital gains distribution and interest income in fiscal 2014 and capital gains distribution and interest income in fiscal 2013. Our interest income (loss) and other, n consists of an impairment charge to write down the strategic investment in Stonyfish, Inc. and interest and investment income earned on our cash, cash equivalents and investment balances in fiscal 2012. The increase in other income (loss) and other, net for fiscal 2014 from fiscal 2013 consists primarily of an increase in gain on settlement of escrow claim, interest income earned on investments and capital gain distributions due on mutual funds. The increase in other income (loss) and other, net for fiscal 2013 from fiscal 2012 consists primarily of an increase in capital gain distributions due on mutual funds and interest income earned. 39 -------------------------------------------------------------------------------- PROVISION (BENEFIT) FOR INCOME TAXES Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) Provision (benefit) for income taxes $ 2,219 $ 9,399 $ (62,354) $ (7,180) -76.4% $ 71,753 -115.1% Percentage of total revenue 1.7% 9.1% -74.8% We recorded an income tax provision of $2.2 million in fiscal year 2014 of which $0.9 million related to net income from operations and $1.3 million due to an increase in our valuation allowance. During the fourth quarter of fiscal 2014, we evaluated the need for a valuation allowance against our net deferred tax asset and determined that an additional $1.3 million was needed for certain net operating loss and research credit carryovers that may expire before utilization. Therefore, we increased the valuation allowance related to the deferred tax asset which resulted in an additional provision for income taxes to the consolidated income statement of approximately $1.3 million. We recorded an income tax provision of $9.4 million in fiscal year 2013 of which $8.4 million related to net income from operations, including the sale of patent under our patent purchase agreement, and $1.0 million due to an increase in our valuation allowance. During the fourth quarter of fiscal 2013, we evaluated the need for a valuation allowance against our net deferred tax asset and determined that an additional $1.0 million was needed for certain net operating loss carryovers that may expire before utilization. Therefore, we increased the valuation allowance related to the deferred tax asset which resulted in a debit to the consolidated income statement of approximately $1.0 million. At March 31, 2014, we had net operating loss carryforwards for federal and state income tax purposes of approximately $149.2 million and $93.5 million, respectively that expire at various dates beginning in 2015 and continuing through 2034. In addition, at March 31, 2014, we had research and development credit carryforwards for federal and state tax reporting purposes of approximately $2.7 million and $4.4 million, respectively. The federal credit carryforwards will begin expiring in 2021 continuing through 2034, while the California credit will carry forward indefinitely. Under the ownership change limitations of the Internal Revenue Code of 1986, as amended, the amount and benefit from the net operating losses and credit carryforwards may be limited in certain circumstances. At March 31, 2014 and 2013, we had net deferred tax assets before valuation allowances of approximately $55.4 million and $55.6 million, respectively. INCOME (LOSS) FROM DISCONTINUED OPERATIONS, NET OF INCOME TAXES Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) Income (loss) from discontinued operations, net of income tax provision $ 320 $ 489 $ (1,452) $ (169) -34.6% $ 1,941 -133.7% Percentage of total revenue 0.2% 0.5% -1.7% On September 30, 2013, we sold our dedicated server hosting business. The current and historical results of our dedicated server hosting business have been reclassified to income (loss) from discontinued operations, net of income tax provision. For the years ended March 31, 2014, 2013 and 2012, income taxes were $0.2, million, $0.3 million and $0 million, respectively. 40 -------------------------------------------------------------------------------- GAIN ON DISPOSAL OF DISCONTINUED OPERATIONS, NET OF INCOME TAXES Years Ended March 31, Year-over-Year Change 2014 2013 2012 2013 to 2014 2012 to 2013 (dollar amounts in thousands) Gain on disposal of discontinued operations, net of income tax provision $ 596 $ - $ - $ 596 N/A $ - N/A Percentage of total revenue 0.5% 0.0% 0.0% For the year ended March 31, 2014, we recorded a gain on disposal of our dedicated server hosting business of $1.1 million, net of a tax provision of $0.5 million. LIQUIDITY AND CAPITAL RESOURCES As of March 31, 2014, we had $178.4 million of cash and cash equivalents and investments. By comparison, at March 31, 2013, we had $52.3 million in cash and cash equivalents and investments. We currently have no borrowing arrangements. We believe we have sufficient liquidity to fund operations for the foreseeable future. In addition, we have a shelf registration statement that would allow us to raise up to an additional $123.7 million from the sale of new securities of ours. Please refer to Part I, Item 1A, Risk Factors "We may need to raise additional capital to support our future operations." 2014 to 2013 Net cash provided by operating activities for fiscal 2014 was $14.9 million, compared with $31.8 million provided by operating activities for fiscal 2013. Cash used in or provided by operating activities has historically been affected by: º the amount of net income; º sales of subscriptions; º changes in working capital accounts, particularly in deferred revenue due to timing of annual plan renewals; º add-backs of non-cash expense items such as depreciation and amortization; and º the expense associated with stock options and stock-based awards. Net cash used in investing activities was $136.5 million in fiscal 2014, compared with $5.9 million used in investing activities in fiscal 2013. The increase in cash used in investing activities during fiscal 2014 was primarily related to the purchase of investments ($141.6 million) and the acquisition of a business ($18.5 million). The increase in cash used in investing activities during fiscal 2014 was partially offset by the sale of investments in fiscal 2014 ($24.2 million). Net cash provided by financing activities was $130.5 million in fiscal 2014, compared with $2.0 million in financing activities in fiscal 2013. Our financing activities for fiscal 2014 provided cash of approximately $125.8 million, net of issuance costs of $0.6 million, related to underwritten registered offering of common stock in which we sold 14,375,000 shares and $5.2 million due to issuance of common stock under our employee stock purchase plan and the issuance of shares related to the exercise of options. The cash provided by financing activities in fiscal 2014 was partially offset by $0.5 million due to repurchase of restricted shares and payment of capital leases. 2013 to 2012 Net cash provided by operating activities for fiscal 2013 was $31.8 million, compared with $9.2 million provided by operating activities for fiscal 2012. The increase in cash provided by operating activities was primarily due to the sale of patent under our patent purchase agreement ($13.0 million) and use of our deferred tax assets to reduce our cash taxes due ($9.3 million). Cash provided by operating activities has historically been affected by: º the amount of net income; º sales of subscriptions; º changes in working capital accounts, particularly in deferred revenue due to timing of annual plan renewals; º add-backs of non-cash expense items such as depreciation and amortization; and º the expense associated with stock-based awards. 41 -------------------------------------------------------------------------------- Net cash used in investing activities was $5.9 million in fiscal 2013, compared with $3.0 million used in investing activities in fiscal 2012. The increase in cash used in investing activities during fiscal 2013 is primarily related to the purchase of additional equipment and leasehold improvements related to our new facility ($3.4 million) offset by a reduction in cash used to purchase businesses in fiscal 2012 ($0.7 million). Net cash provided by financing activities was $2.0 million in fiscal 2013, compared with net cash used of $0.3 million in financing activities in fiscal 2012. Our financing activities for fiscal 2013 provided cash of $2.5 million due to issuance of common stock under our employee stock purchase plan and the issuance of shares related to the exercise of options. The cash provided by financing activities in fiscal 2013 was partially offset by $0.5 million due to repurchase of restricted shares and payment of capital leases. Contractual Obligations Future operating lease payments, capital lease payments and purchase obligations at March 31, 2014 for the next five years were as follows (in thousands): Year Ending March 31, 2015 2016 2017 2018 2019 Thereafter Capital leases $ 139 $ 40 $ - $ - $ - $ - Office leases 1,745 1,803 1,853 1,789 1,843 1,093 Purchase obligations Third party customer support provider 2,158 - - - - - Third party network service providers 1,809 52 - - - - Open purchase orders 48 - - - - - $ 5,899 $ 1,895 $ 1,853 $ 1,789 $ 1,843 $ 1,093 We lease our headquarters facility in San Jose, California under an operating lease agreement that expires in October 2019. The lease is an industrial net lease with monthly base rent of $130,821 for the first 15 months with a 3% increase each year thereafter, and requires us to pay property taxes, utilities and normal maintenance costs. We lease our UK headquarters in Aylesbury UK under an operating lease agreement that expires in March 2017, with a break clause in March 2015 exercisable with six months' notice. The lease has a base monthly rent of $10,700 until March 2015, rising to $11,522 thereafter, and requires us to pay property taxes, service charges, utilities and normal maintenance costs. In the third quarter of 2010, we amended our contract with one of our third party customer support vendors containing a minimum monthly commitment of approximately $430,000. The agreement requires a 150-day notice to terminate. At March 31, 2014, the total remaining obligation under the contract was $2.2 million. We entered into contracts with multiple vendors for third party network service providers which expire on various dates in fiscal 2015 through 2016. At March 31, 2014, the total remaining obligations under these contracts were $1.9 million. At March 31, 2014, we had open purchase orders of $48,000, primarily related to inventory purchases from our contract manufacturers. These purchase commitments are reflected in our consolidated financial statements once goods or services have been received or at such time when we are obligated to make payments related to these goods or services. |