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APPLIED MICRO CIRCUITS CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) This management's discussion and analysis of financial condition and results of operations ("MD&A") is provided as a supplement to the accompanying Condensed Consolidated Financial Statements and footnotes to help provide an understanding of our financial condition, changes in our financial condition and results of our operations. The MD&A is organized as follows: • Caution concerning forward-looking statements. This section discusses how forward-looking statements made by us in the MD&A and elsewhere in this quarterly report are based on management's present expectations about future events and are inherently susceptible to uncertainty and changes in circumstances. • Overview. This section provides an introductory overview and context for the discussion and analysis that follows in the MD&A. • Critical accounting policies. This section discusses those accounting policies that are both considered important to our financial condition and operating results and require significant judgment and estimates on the part of management in their application. • Results of operations. This section provides an analysis of our results of operations for the three months ended June 30, 2014 and 2013. A brief description is provided of transactions and events that impact the comparability of the results being analyzed. • Liquidity and capital resources. This section provides an analysis of our cash position and cash flows, as well as a discussion of our financing arrangements and financial commitments. CAUTION CONCERNING FORWARD-LOOKING STATEMENTS The MD&A should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and notes thereto included in this quarterly report. All statements included or incorporated by reference in this quarterly report, for the three months ended June 30, 2014, other than statements or characterizations of historical fact, are forward-looking statements. Any statement that refers to an expectation, projection or other characterization of future events or circumstances, including the underlying assumptions, is a forward-looking statement. We use certain words and their derivatives such as "anticipate", "believe", "plan", "expect", "estimate", "predict", "intend", "may", "will", "should", "could", "future", "potential" and similar expressions in many of the forward-looking statements. These forward-looking statements include, but are not limited to, statements regarding: anticipated trends and challenges in our business and the markets in which we operate; expectations regarding the growth of next-generation cloud infrastructure and global data center traffic, energy consumption and total cost of ownership; anticipated market penetration by ARM®-based cloud servers and other market and technological trends; our plans and predictions regarding the development, production, performance and market acceptance of our X-Gene™ Server on a Chip™ product family and development platform, our X-Weave™ product family, and other new products; the timing and scope of customer testing and adoption of such products and their total addressable market and total cost of ownership; product development cycles and schedules; design-win pipeline; our strategy, including our focus on the development of our X-Gene and X-Weave product families and our current connectivity investments in highgrowth 10, 40 and 100Gbps (gigabit per second) solutions; the timing and extent of customers' transition away from older connectivity solutions and toward higher performance solutions; our assumptions and forecasts regarding competitors' product offerings, pricing and strategies, and our products' ability to compete; the anticipated amount, form and timing of consideration to be paid in connection with our acquisition of Veloce, and related impact on our share dilution, research and development expense and operating results; our sales and marketing strategy; our expectations regarding adequacy of leased facilities; the impact of seasonal fluctuations and economic conditions on our business; our intellectual property; our expectations as to expenses, liquidity and capital resources, including without limitation our expected sources and uses of cash; our gross margin and efforts to offset reductions in gross margin; our estimates regarding eventual actual costs compared to amounts accrued in our financial statements; factors affecting demand for our products; our ability to attract and retain qualified personnel; our restructuring activities and related expense; and the impact of accounting pronouncements and our critical accounting policies, judgments, estimates and assumptions on our financial results. The forward-looking statements are based on our current expectations, estimates and projections about our industry and our business, management's beliefs, and other assumptions made by us. In addition, the forward-looking statements included below are based upon statements made by industry experts, analysts, and other third party sources. These statements and the expectations, estimates, projections, beliefs and other assumptions on which they are based are subject to many risks and uncertainties and are inherently subject to change. We describe many of the risks and uncertainties that we face in Part II, Item 1A, "Risk Factors" and elsewhere in this report. Our actual results and actual events could differ materially from those 18 -------------------------------------------------------------------------------- anticipated in any forward-looking statement. Readers should not place undue reliance on any forward-looking statement. All forward-looking statements in this report speak only as of the filing date of this report, and except as required by law, we undertake no obligation to update or revise any forward-looking statements to reflect events or circumstances after such date. OVERVIEW The Company Applied Micro Circuits Corporation (the "Company", "we" or "our") is a global leader in silicon solutions for next-generation cloud infrastructure and data centers, as well as connectivity products for edge, metro and long haul communications equipment. Our products include the X-Gene™ ARM® 64-bit Server on a Chip™ solution, or X-Gene. The X-Gene product is targeted to serve existing and emerging hyperscale cloud, high performance computing and enterprise applications. X-Gene began sampling in silicon to current and prospective customers as well as ecosystem partners in March 2013 and we expect to ship production units during the summer of 2014. We expect X-Gene to begin generating meaningful production sales revenue during the second half of our fiscal year 2015. We believe that X-Gene is the first ARM 64-bit server solution to have sampled and to have production units being manufactured. In addition to having a time-to-market advantage, we believe X-Gene will lead the next generation cloud data center silicon market by addressing the need for high performance, lower power and lower total cost of ownership ("TCO"). As part of our current base business, we offer a line of embedded computing products based on Power Architecture. Our future embedded processor products will be based on the ARM Instruction Set Architecture ("ISA"). Our embedded processor products are currently deployed in applications such as control- and data-plane functionality, wireless access points, residential gateways, wireless base stations, storage controllers, network attached storage, network switches and routing products, and multi-function printers. The connectivity portion of our base business includes a broad array of physical layer ("PHY"), framer and mapper solutions that are high-speed, high-bandwidth, high-reliability communications products. Our highly integrated framer-PHY silicon solutions transmit and receive signals and are used in high-speed optical network infrastructure equipment. For Optical Transport Network ("OTN") applications, our framer products incorporate our industry-leading forward error correction ('FEC") technology to significantly improve reach. In July 2013, we announced the X-Weave™ family of products, designed to meet the needs of public cloud, private cloud, and enterprise data centers. The X-Weave family includes products spanning 100Gbps to 240Gbps of connectivity with unique multi-protocol features and high density. Our corporate headquarters are located in Sunnyvale, California. Sales and engineering offices are located throughout the world. As of June 30, 2014, our business had two reporting units, Computing and Connectivity. Since the start of fiscal 2014, we have invested a total of $179.8 million in the Research and Development ("R&D") of new products, including high-speed, high-bandwidth and low-power products that often combine the functions of multiple existing products into single highly-integrated solutions. A considerable portion of this investment is directed to our ARM 64-bit based server product development. Our products and our customers' products are highly complex. Due to this complexity, it often takes several years to complete the development and qualification of a product before it enters into volume production. Accordingly, some major products in development during the last few years have not yet started to generate significant revenues. In addition, demand for our products can be impacted by economic downturns, cyclicality in the telecommunications market, competitive and technological developments, and other factors described elsewhere in this report. Acquisition of Veloce On June 20, 2012, we completed the acquisition of Veloce. Veloce has been developing specific technology for us. The total estimated consideration to be paid is approximately $178.5 million based on the benchmarks achieved during simulations. The consideration that we are obligated to pay upon completion of the respective performance milestones can be settled in cash or our common stock (or a combination of cash and stock), at our election. During the three months ended June 30, 2014 and 2013, as part of the above arrangement, we paid approximately $6.4 million and $25.0 million, respectively, in cash and issued approximately 38,000 shares and 1.4 million shares, respectively, valued at approximately $0.3 million and $10.0 million, respectively. For accounting purposes, the costs to be incurred in connection with the development milestones relating to Veloce are considered compensatory and are recognized as R&D expense. Recognition of these costs as expense occurred when certain 19 -------------------------------------------------------------------------------- development and performance milestones became probable of achievement and were deemed earned. However, the value allocated to Veloce stock equivalents that had not yet been allocated to individuals ("Unallocated Veloce Units") will not be recognized as R&D expense until distribution of the underlying units occurs. As of June 30, 2014, 0.1 million Unallocated Veloce Units remain to be allocated, and the maximum potential additional expense to be recognized associated with these Unallocated Veloce Units is approximately $2.1 million. Veloce completed all three performance milestones relating to the project as of March 31, 2014. Cumulative R&D expenses recognized in connection with the achievement of the three performance milestones through June 30, 2014 were $176.4 million. Total R&D expenses recognized were approximately $7.1 million and $9.3 million during the three months ended June 30, 2014 and 2013, respectively. Veloce consideration that has been accrued as of June 30, 2014, is classified as long-term if payments of the consideration are expected to occur beyond a 12 month period. As of June 30, 2014, we had paid $160.8 million of the total Veloce acquisition consideration, and we expect that approximately an additional $1.4 million will be paid in cash and stock by September 30, 2014. The $160.8 million paid to date includes approximately $86.6 million in cash and the issuance of 9.7 million shares of common stock valued at approximately $74.2 million. Summary Financials The following tables present a summary of our results of operations for the three months ended June 30, 2014 and 2013 (dollars in thousands): Three Months Ended June 30, 2014 2013 % of Net % of Net Increase % Amount Revenue Amount Revenue (Decrease) Change Net revenues $ 50,272 100.0 % $ 54,148 100.0 % $ (3,876 ) (7.2 )% Cost of revenues 20,257 40.3 22,342 41.3 (2,085 ) (9.3 ) Gross profit 30,015 59.7 31,806 58.7 (1,791 ) (5.6 ) Total operating expenses 43,536 86.6 24,556 45.3 18,980 77.3 Operating (loss) income (13,521 ) (26.9 ) 7,250 13.4 20,771 (286.5 ) Interest and other income, net 315 0.6 3,795 7.0 (3,480 ) (91.7 ) (Loss) income before income taxes (13,206 ) (26.3 ) 11,045 20.4 24,251 (219.6 ) Income tax expense (141 ) (0.3 ) 188 0.3 (329 ) (175.0 ) Net (loss) income $ (13,065 ) (26.0 )% $ 10,857 20.1 % $ 23,922 (220.3 )% Net Revenues. We generate revenues primarily through sales of our IC products, embedded processors and printed circuit board assemblies to OEMs, such as Cisco, Huawei, Alcatel-Lucent, Ciena, Fujitsu, Juniper, NEC, Coriant and ZTE, who in turn supply their equipment principally to communications service providers. On a sell-through basis, excluding non-cancelable non-returnable inventory we had approximately 80 days of inventory in the distributor channel at June 30, 2014 as compared to 66 days at June 30, 2013. The increase in inventory days was primarily due to the timing of sell-through of distributor inventory. The gross margins for our solutions have declined from time to time in the past. Factors that have caused downward pressure on gross margins for our products include competitive pricing pressures, unfavorable product mix, the cost sensitivity of our customers particularly in the higher-volume markets, new product introductions by us or our competitors and capacity constraints in our supply chain. From time to time, for strategic reasons, we may accept initial orders at less than optimal gross margins in order to facilitate the introduction and/or market penetration of our new or existing products. We may also accept orders for older products at less than optimal gross margins to encourage customers to order sooner or in larger quantities than previously anticipated. To maintain acceptable operating results, we seek to offset any reduction in gross margins of our products by reducing operating costs, increasing sales volume, developing and introducing new products and developing new generations and versions of existing products on a timely basis. We classify our revenues into two categories based on the markets that the underlying products serve. The categories are Connectivity and Computing. We use the information about these categories to analyze our performance and success in these markets, including our strategy to focus on the transition to the high-growth data center market. 20 -------------------------------------------------------------------------------- For the three months ended June 30, 2014 and 2013, our OTN and 10Gbps or faster Ethernet products represented 90% and 86%, respectively, of our Connectivity revenues, and our SONET/SDH and legacy switch products represented 10% and 14%, respectively, of our Connectivity revenues. We expect our SONET/SDH and legacy switch products to continue to decline, as Connectivity customers continue to transition to higher speed, lower power products. Based on direct shipments, net revenues to customers that were equal to or greater than 10% of total net revenues were as follows: Three Months Ended June 30, 2014 2013 Avnet (distributor) 32 % 38 % Wintec (global logistics provider)** 23 % 18 % Paltek (distributor) 16 % * * Less than 10% of total net revenues for period indicated. ** Wintec provides vendor managed inventory support primarily for Cisco Systems, Inc. We expect that our largest customers will continue to account for a substantial portion of our net revenue for the foreseeable future. Net revenues by geographic region, which are primarily denominated in U.S. dollars, were as follows (in thousands): Three Months Ended June 30, 2014 2013 % of Net % of Net Amount Revenue Amount Revenue United States of America $ 19,006 37.8 % $ 29,161 53.9 % Taiwan 1,694 3.3 3,074 5.7 Hong Kong 10,553 21.0 4,213 7.8 China 139 0.3 745 1.4 Europe 5,157 10.3 7,593 14.0 Japan 10,666 21.2 3,748 6.9 Malaysia 1,276 2.6 1,244 2.3 Singapore 1,712 3.4 3,041 5.6 Other Asia 69 0.1 977 1.8 Other - - 352 0.6 $ 50,272 100.0 % $ 54,148 100.0 % Research and Development. R&D expenses consist primarily of salaries and related costs (including stock-based compensation) of employees engaged in research, design and development activities including amounts relating to Veloce, costs related to engineering licenses and design tools, subcontracting costs and facilities expenses. We believe that a continued commitment to R&D is vital to our goal of maintaining a leadership position with innovative products. In addition to our internal R&D programs, our business strategy includes acquiring products, technologies or businesses from third parties. Selling, General and Administrative. Selling, general and administrative ("SG&A") expenses consist primarily of personnel related expenses (including stock-based compensation), professional and legal fees, corporate branding and facilities expenses. We also assess the performance of our business on a non-GAAP basis. Non-GAAP net income (loss) is derived by excluding certain items required by GAAP, such as stock-based compensation charges, amortization of purchased intangibles, Veloce accrued liability, restructuring charges, impairment of marketable securities, income tax effect related to reconciling items, and other one-time and/or non-cash items. 21 --------------------------------------------------------------------------------The following table reconciles GAAP net (loss) income to the Non-GAAP net income (in thousands except for per share data): Three Months Ended June 30, 2014 2013 GAAP net (loss) income $ (13,065 ) $ 10,857 Adjustments: Stock-based compensation expense 5,216 3,714 Amortization of purchased intangibles 62 296 Restructuring charges, net 1,211 93 Veloce acquisition consideration 7,140 9,255 Impairment of marketable securities (18 ) (3,019 ) Gain on sale of TPack - (19,699 ) Other and income tax adjustment (391 ) (62 ) Total GAAP to Non-GAAP adjustments 13,220 (9,422 ) Non-GAAP net income $ 155 $ 1,435 Diluted non-GAAP income per share $ 0.00 $ 0.02 Shares used in calculating diluted non-GAAP income per share 79,082 70,234 The book-to-bill ratio is another metric commonly used by investors to compare and evaluate technology and semiconductor companies. The book-to-bill ratio is a demand-to-supply ratio that compares the total amount of orders received to the total amount of orders filled. This ratio tells whether the company has more orders than it delivered (if greater than 1), has the same amount of orders that it delivered (equals 1), or has less orders than it delivered (under 1). Though the ratio provides an indicator of whether orders are rising or falling, it does not consider the timing of orders or if the orders will result in future revenues and the effect of changing lead times on bookings. In addition, orders within any given period can fluctuate for a variety of reasons such as product phase-out decisions, which can cause customers to place final, non-recurring "last time buy" orders for the "end of life" product, or other agreements with customers to accelerate, delay, increase or decrease orders in a given period. Our quarterly book-to-bill ratio at June 30, 2014, March 31, 2014 and June 30, 2013 was 0.9, 1.0 and 1.1 respectively. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in accordance with GAAP in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenue and expenses in the reporting period. See Note 1, Summary of Significant Accounting Policies, to the Condensed Consolidated Financial Statements for details. The methods, estimates and judgments we use in applying these critical accounting policies have a significant impact on the results we report in our financial statements. We base our estimates and assumptions on historical experience and on various other factors that we believe to be reasonable under the circumstances, The actual results experienced by us may differ materially and adversely from management's estimates. To the extent there are material differences between our estimates and the actual results, our future results of operations will be affected. We believe the following critical accounting policies require us to make significant judgments and estimates in the preparation of our Condensed Consolidated Financial Statements. Investments We hold a variety of securities that have varied underlying investments. We review our investment portfolio periodically to assess for other-than-temporary impairment. We assess the existence of impairment of our investments in order to determine the classification of the impairment as "temporary" or "other-than-temporary". The factors used to determine whether an impairment is temporary or other-than-temporary involve considerable judgment. The factors considered in determining whether any individual impairment is temporary or other-than-temporary are primarily the length of the time and the extent to 22 -------------------------------------------------------------------------------- which the market value has been less than amortized cost, the nature of underlying assets (including the degree of collateralization) and the financial condition, credit rating, market liquidity conditions and near-term prospects of the issuer. If the fair value of a security is less than its amortized cost basis at the balance sheet date, an assessment would have to be made as to whether the impairment is other-than-temporary. If we do not intend to sell the security, we shall consider available evidence to assess whether it is more likely than not, we will be required to sell the security before the recovery of the amortized cost basis due to cash, working capital requirements, contractual or regulatory obligations indicate that the security will be required to be sold before a forecasted recovery occurs. If it is more likely than not that we are required to sell the security before recovery of the amortized cost basis, an other-than-temporary impairment is considered to have occurred. We use present value cash flow models to determine whether the entire amortized cost basis of the security will be recovered. We will compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security. An other-than-temporary impairment is said to have occurred if the present value of cash flows expected to be collected is less than the amortized cost basis of the security. During the three months ended June 30, 2014 and 2013, we did not record any other-than-temporary impairment charges. During the three months ended June 30, 2014, we did not record an impairment charge in connection with other securities in a continuous loss position (fair value less than carrying value) with unrealized losses of $0.1 million as we believe that such unrealized losses are temporary. In addition, we had $3.8 million in unrealized gains during the three months ended June 30, 2014. Veloce Consideration We periodically evaluated the progress of the development work that was being performed in connection with our contractual arrangement with Veloce. Based on such an evaluation as well as various other qualitative factors, we estimated the total value of the development work being performed and assessed the timing and probability of attaining contractually defined performance milestones. Upon assessing a performance milestone as probable of achievement, R&D expense was recognized based upon the estimated stage of development of that milestone and the estimated value associated with each performance milestone. The amount of R&D costs recognized in connection with the Veloce consideration excludes any value relating to the Unallocated Veloce Units. As of June 30, 2014, the maximum potential additional expense to be recognized associated with the Unallocated Veloce Units was approximately $2.1 million. Payment of the Veloce consideration occurs based upon when a performance milestone is completed and upon satisfaction of vesting requirements, if applicable. As of March 31, 2014, Veloce completed all three performance milestones. The total estimated consideration based on the benchmarks achieved during simulations is approximately $178.5 million of which approximately $176.4 million has been recognized through June 30, 2014. Total R&D expenses recognized were approximately $7.1 million and $9.3 million during the three months ended June 30, 2014 and 2013, respectively. See Note 4, "Veloce", to the Condensed Consolidated Financial Statements. Inventory Valuation Our policy is to value inventories at the lower of cost or market on a part-by-part basis. This policy requires us to make estimates regarding the market value of our inventories, including an assessment of excess or obsolete inventories. We determine excess and obsolete inventories based on an estimate of the future demand for its products within a specified time horizon, generally 12 months. The estimates used for future demand are also used for near-term capacity planning and inventory purchasing and are consistent with revenue forecasts. If our demand forecast is greater than our actual demand, we may be required to take additional excess inventory charges, which would decrease gross margin and net operating results. Any impairment charges taken establishes a new cost basis for the underlying inventory and the cost basis for such inventory is not marked-up on changes in circumstances until a gain is realized upon its eventual sale. This accounting is consistent with the guidance provided by FASB ASC paragraph 330-10-35-14. To illustrate the sensitivity of inventory valuations to future estimates, as of June 30, 2014, reducing our future demand estimate to six months would decrease our current inventory valuation by approximately $0.1 million and increasing our future demand forecast to 18 months would increase our current inventory valuation by approximately $23,000. Goodwill, Purchased Intangible Assets and Other Long-Lived Assets We review our goodwill for impairment at the reporting unit level annually, or more frequently, if changes in facts and circumstances indicate that it is more likely than not that the fair value of our reporting units may be less than its carrying amount. Our long-lived assets consist of property, plant and equipment and other acquired intangibles, excluding goodwill. Property and equipment are stated at cost and depreciated over the estimated useful lives of the assets ranging from 1 to 7 years 23 -------------------------------------------------------------------------------- using the straight line method. Leasehold improvements are stated at cost and amortized over the shorter of the term of the related lease or its estimated useful life. Acquired intangibles with definite lives are amortized on a straight-line basis over the remaining estimated economic life of the underlying products and technologies. We review our definite-lived long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. Recoverability of an asset group is measured by comparison of its carrying amount to the expected future undiscounted cash flows that the asset group is expected to generate. If it is determined that an asset group is not recoverable, an impairment loss is recorded in the amount by which the carrying amount of the asset group exceeds its fair value. In addition, we assess our long-lived assets for impairment if they are abandoned. Revenue Recognition We recognize revenue based on four basic criteria: 1) there is evidence that an arrangement exists; 2) delivery has occurred; 3) the fee is fixed or determinable; and 4) collectability is reasonably assured. We recognize revenue upon determination that all criteria for revenue recognition have been met. In addition, we do not recognize revenue until the applicable customer's acceptance criteria have been met. The criteria are usually met at the time of product shipment. Our standard terms and conditions of sale do not allow for product returns and we generally do not allow product returns other than under warranty or stock rotation agreements. Revenue from shipments to distributors is recognized upon shipment. In addition, we record reductions to revenue for estimated allowances such as returns not pursuant to contractual rights, competitive pricing programs and rebates if actual returns or pricing adjustments exceed our estimates. These estimates are based on our experience with stock rotations and the contractual terms of the competitive pricing and rebate programs. Shipping terms are generally FCA (Free Carrier) shipping point. Royalty revenues are recognized when cash is received, only when royalty amounts cannot be reasonably estimated. Royalty revenues are based upon sales of our customers' products that include our technology. From time to time we generate revenue from the sale of our internally developed intellectual property ("IP"). We generally recognize revenue from the sale of IP when all basic criteria outlined above are met, which is generally when the payments are received. Mask Costs We incur significant costs for the fabrication of masks used by our contract manufacturers to manufacture our products. If we determine, at the time the costs for the fabrication of masks are incurred, that technological feasibility of the product has been achieved, we consider the nature of these costs to be pre-production costs. Accordingly, such costs are capitalized as property and equipment and are amortized as cost of sales over approximately three years, representing the estimated production period of the product. We periodically reassess the estimated product production period for specific mask sets capitalized. If we determine, at the time fabrication mask costs are incurred, that either technological feasibility of the product has not occurred or that the mask is not reasonably expected to be used in production manufacturing or that the commercial feasibility of the product is uncertain, the related mask costs are expensed to R&D in the period in which the costs are incurred. We will also periodically assess capitalized mask costs for impairment. During the three months ended June 30, 2014 and 2013, total mask costs capitalized were $1.4 million and $1.2 million, respectively. Stock-Based Compensation Expense All share-based payments, including grants of stock options, restricted stock units ("RSUs") and employee stock purchase rights, are required to be recognized in our financial statements based on their respective grant date fair values. The fair value of each employee stock option and employee stock purchase right is estimated on the date of grant using the Black-Scholes option pricing model which is affected by our stock price and a number of assumptions, including expected volatility, expected life, risk-free interest rate and expected dividends. Forfeitures are required to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ significantly from those estimated. We evaluate the assumptions used to value stock-based awards on a quarterly basis. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. We currently estimate when and if performance-based grants will be earned. If the awards are not considered probable of achievement, no amount of stock-based compensation is recognized. If we consider the award to be probable, expense is recorded over the estimated service period. To the extent that our assumptions are incorrect, the amount of stock-based compensation recorded will be increased or decreased. To the extent that we grant additional equity securities to employees or we assume unvested securities in connection with any acquisitions, our stock-based compensation expense will be increased by the additional unearned compensation resulting from those additional grants or acquisitions. 24 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS Comparison of the Three Months Ended June 30, 2014 to the Three Months Ended June 30, 2013 Net Revenues. Net revenues for the three months ended June 30, 2014 were $50.3 million, representing a decrease of 7.2% from the net revenues of $54.1 million for the three months ended June 30, 2013. The following table presents revenues for Computing and Connectivity (dollars in thousands): Three Months Ended June 30, 2014 2013 % of Net % of Net Increase % Amount Revenue Amount Revenue (Decrease) Change Computing $ 18,836 37.5 % $ 26,492 48.9 % $ (7,656 ) (28.9 )% Connectivity 31,436 62.5 27,656 51.1 3,780 13.7 $ 50,272 100.0 % $ 54,148 100.0 % $ (3,876 ) (7.2 )% During the three months ended June 30, 2014, our Computing revenues decreased by 28.9% and our Connectivity revenues increased by 13.7%, compared to the same period last year. Our Computing revenues reflected the continuing decline in sales of PowerPC-based products, as the networking industry migrates away from the PowerPC architecture and we continue to focus our resources on products based on the ARM architecture. In addition, the decrease in Computing revenues during the three months ended June 30, 2014 was due in part to a significant end-of-life order placed during the three months ended June 30, 2013 as disclosed previously. The increase in Connectivity revenues was a result of higher demand for our new products due to increasing capital expenditures on OTN and Ethernet in telecom and datacenter infrastructures, as well as agreements with certain customers that led to larger orders during the quarter. Gross Profit. The following table presents net revenues, cost of revenues and gross profit for the three months ended June 30, 2014 and 2013 (dollars in thousands): Three months ended June 30, 2014 2013 % of Net % of Net % Amount Revenue Amount Revenue Decrease Change Net revenues $ 50,272 100.0 % $ 54,148 100.0 % $ (3,876 ) (7.2 )% Cost of revenues 20,257 40.3 22,342 41.3 (2,085 ) (9.3 ) Gross profit $ 30,015 59.7 % $ 31,806 58.7 % $ (1,791 ) (5.6 )% The gross profit percentage for the three months ended June 30, 2014 increased to 59.7%, compared to 58.7% for the three months ended June 30, 2013. The gross profit percentage, excluding the impact of amortization of purchased intangibles, also increased to 59.7% for the three months ended June 30, 2014 as compared to and 59.2% for the three months ended June 30, 2013. The increase in our gross profit percentage was primarily due to favorable product mix. The amortization of purchased intangible assets included in cost of revenues during the three months ended June 30, 2013 was $0.1 million. Purchased intangible assets that were amortized through the cost of revenues were fully amortized as of June 30, 2013. Research and Development and Selling, General and Administrative Expenses. The following table presents R&D and SG&A expenses for the three months ended June 30, 2014 and 2013 (dollars in thousands): Three Months Ended June 30, 2014 2013 % of Net % of Net % Amount Revenue Amount Revenue Decrease ChangeResearch and development $ 33,205 66.1 % $ 34,506 63.7 % $ (1,301 ) (3.8 )% Selling, general and administrative $ 9,058 18.0 % $ 9,526 17.6 % $ (468 ) (4.9 )% Research and Development. The decrease in R&D expenses of 3.8% or $1.3 million during the three months ended June 30, 2014 compared to the three months ended June 30, 2013 was mainly due to a $2.1 million decrease in Veloce consideration 25 -------------------------------------------------------------------------------- related expenses and a $1.8 million decrease in personnel costs, partially offset by a $1.5 million increase in stock compensation expense and a $1.5 million increase in direct project costs. Research and development expense recognized in connection with the Veloce consideration was $7.1 million and $9.3 million during the three months ended June 30, 2014 and 2013, respectively. Refer to Note 4, Veloce, to the Condensed Consolidated Financial Statements for further details. Selling, General and Administrative. The decrease in SG&A expenses of 4.9% or $0.5 million during the three months ended June 30, 2014, compared to the three months ended June 30, 2013 was mainly due to a $0.7 million decrease in personnel costs, partially offset by a $0.1 million increase in stock compensation expense. Stock-Based Compensation. The following table presents stock-based compensation expense for the three months ended June 30, 2014 and 2013, which was included in the tables above (dollars in thousands): Three Months Ended June 30, 2014 2013 % of Net % of Net Increase % Amount Revenue Amount Revenue (Decrease) Change Costs of revenues $ 47 0.1 % $ 96 0.2 % $ (49 ) (51.0 )% Research and development 3,271 6.5 1,798 3.3 1,473 81.9 Selling, general and administrative 1,898 3.8 1,820 3.4 78 4.3 $ 5,216 10.4 % $ 3,714 6.9 % $ 1,502 40.4 % The increase in stock-based compensation of 40.4% during the three months ended June 30, 2014 compared to the three months ended June 30, 2013 was primarily due to the effect of the expense that was recorded relating to new annual RSU grants and RSUs with two year vesting during the three months ended June 30, 2014. Stock-based compensation expense will continue to have a potentially significant adverse impact on our reported results of operations, although it will have no impact on our overall cash flows. Interest and Other Income (expense), net. The following table presents interest income and other income (expense), net for the three months ended June 30, 2014 and 2013 (dollars in thousands): Three Months Ended June 30, 2014 2013 % of Net % of Net % Amount Revenue Amount Revenue Decrease Change Interest income, net $ 336 0.7 % $ 3,666 6.8 % $ (3,330 ) (90.8 )% Other (expense) income, net $ (21 ) - % $ 129 0.2 % $ (150 ) (116.3 )% Interest Income, net. The decrease in interest income, net for the three months ended June 30, 2014 compared to the three months ended June 30, 2013 was primarily due to realized gains from the sale of short-term investments and marketable securities during the three months ended June 30, 2013. Other (Expense) income, net. The decrease in other income, net for the three months ended June 30, 2014 compared to the three months ended June 30, 2013 was primarily due to the rental income during the three months ended June 30, 2013 prior to the sale of our headquarters building in March 2014. FINANCIAL CONDITION AND LIQUIDITY As of June 30, 2014, our principal source of liquidity consisted of $98.6 million in cash, cash equivalents and short-term investments which is approximately $1.26 per share of outstanding common stock as compared to $1.37 per share at March 31, 2014. Working capital, defined as net current assets minus net current liabilities was $108.1 million as of June 30, 2014. Total cash, cash equivalents and short-term investments decreased by $8.0 million during the three months ended June 30, 2014 mainly due to cash used for operations of $6.5 million, purchase of property, equipment and other assets of $4.5 million, funding of taxes withheld upon vesting of restricted stock units of $0.9 million and decrease in net unrealized gains of available-for-sale investments by $0.7 million, partially offset by $3.4 million in proceeds from the sale of TPack and $0.1 million in proceeds from issuance of common stock. At June 30, 2014, we had contractual obligations not included on our 26 -------------------------------------------------------------------------------- balance sheet totaling $75.5 million, primarily related to facility leases, IP licenses, engineering design software tool licenses, non-cancelable inventory purchase commitments and liabilities for uncertain tax positions. Operating Activities For the three months ended June 30, 2014, we used $6.5 million of cash in our operations compared to $17.8 million used for the three months ended June 30, 2013. Our net loss of $13.1 million for the three months ended June 30, 2014 included $14.4 million of non-cash charges consisting of $2.2 million of depreciation, $0.1 million of amortization of purchased intangibles, $5.2 million of stock-based compensation and $7.1 million of additional Veloce compensation cost. Our net income of $10.9 million for the three months ended June 30, 2013 included $3.8 million of non-cash items consisting of $19.7 million of gain on sale of TPack, partially offset by $2.6 million of depreciation, $0.3 million of amortization of purchased intangibles, $3.7 million of stock-based compensation, and $9.3 million of additional Veloce compensation cost. The remaining change in operating cash flows for the three months ended June 30, 2014 primarily reflected the decreases in accounts receivable, other assets, accounts payable and Veloce accrued liability and increase in inventory, accrued payroll and other accrued liabilities and deferred revenue. Our overall quarterly days sales outstanding was 41 days and 44 days for the three months ended June 30, 2014 and March 31, 2014, respectively. The primary reason for the decrease in our days sales outstanding was the decrease in the revenues generated during the last month of the quarter ended June 30, 2014 as compared to the same period for the quarter ended March 31, 2014. Investing Activities Our investing activities used $1.8 million in cash during the three months ended June 30, 2014, compared to $41.0 million provided during the three months ended June 30, 2013. During the three months ended June 30, 2014, we used $4.5 million for the purchase of property and equipment and other assets and $0.6 million for short-term investment activities and received the remaining $3.4 million in proceeds from the sale of TPack. During the three months ended June 30, 2013, we used $0.3 million for the purchase of property and equipment, and received net proceeds of $29.5 million from the sale of TPack and net proceeds of $11.8 million from short-term investment activities. Financing Activities Our financing activities used $0.9 million in cash during the three months ended June 30, 2014 compared to $2.6 million during the three months ended June 30, 2013. Cash used by financing activities in the three months ended June 30, 2014 primarily consisted of $0.9 million in tax withholding payments due to the vesting of restricted stock units, partially offset by proceeds from the issuance of common stock of $0.1 million. The major financing use of cash for the three months ended June 30, 2013 consisted of $2.4 million in tax withholding payments due to the vesting of restricted stock units and other uses of cash of $0.4 million, partially offset by proceeds from the issuance of common stock of $0.2 million. Sale of TPack During the quarter ended June 30, 2013, we completed the sale of TPack and certain intellectual property assets owned by us related to TPack's business for an aggregate consideration of $33.5 million, net of working capital adjustments. The remaining acquisition consideration of $3.4 million was received in April 2014. Refer to Note 12, Sale of TPack A/S, to the Consolidated Financial Statements included in the Company's annual report on Form 10-K for the fiscal year ended March 31, 2014 for details. Acquisition of Veloce On June 20, 2012, we completed our acquisition of Veloce. Veloce has been developing specific technology for us. The total estimated consideration to be paid is approximately $178.5 million based on the benchmarks achieved during simulations. Veloce completed all three performance milestones relating to the project as of March 31, 2014. During the three months ended June 30, 2014 and 2013, as part of the above arrangement, we paid approximately $6.4 million and $25.0 million, respectively, in cash and issued approximately 38,000 shares and 1.4 million shares, respectively, valued at approximately $0.3 million and $10.0 million, respectively. As of June 30, 2014, $160.8 million had been paid and we expect that approximately an additional $1.4 million will be paid in cash and stock by September 30, 2014. The $160.8 million paid to date includes approximately $86.6 million in cash and the issuance of 9.7 million shares of common stock valued at approximately $74.2 million. Payment of the Veloce consideration occurs based upon when a performance milestone is completed and upon satisfaction of vesting requirements, if applicable, and can be settled in cash or our common stock, at the election of management. 27 --------------------------------------------------------------------------------Liquidity We currently believe that our available cash, cash equivalents and short-term investments will be sufficient to meet our capital requirements and fund our operations for at least the next 12 months. We expect to satisfy our remaining Veloce-related payment obligations using a combination of cash and the issuance of shares of common stock. Our available liquidity could be adversely affected, however, if we decide to satisfy the remaining Veloce liability using a greater proportion of cash rather than our common stock or if our normal operations or unforeseen events require us to expend more cash than currently anticipated. If our stock price declines, it could result in greater dilution to our stockholders. As a result of any of the above, we could elect or be required to pursue various options to raise additional capital or generate cash. Our liquidity could also be adversely affected if we are forced to liquidate our investments on short notice and not be able to realize fair market value and realize losses. There can be no assurance that any of the options that we currently believe to be available are now, or in the future will be, viable on commercially reasonable terms or at all. Other Our aggregate fixed commitments payable over the next four years for licensing fees relating to our R&D efforts, including our licensed IP, technology, product design, test and verification tools, are approximately $13.9 million and are included in the table below. The following table summarizes our contractual operating leases and other purchase commitments as of June 30, 2014 (in thousands): Other Operating Purchase Fiscal Years Ending March 31, Leases Commitments Total 2015 (remainder of year) * $ 1,447 * $ 68,094 ** $ 69,541 2016 930 4,196 5,126 2017 504 - 504 2018 369 - 369 Total minimum payments $ 3,250 $ 72,290 $ 75,540 * Includes our headquarters building lease which expires in August 2015, subject to our right to terminate early upon at least 120 days' notice. ** Includes liability for uncertain tax positions of $44.4 million including interest and penalties. Due to the high degree of uncertainty regarding the timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements as of June 30, 2014. 28-------------------------------------------------------------------------------- |