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PENDRELL CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements and accompanying notes included elsewhere in this quarterly report and the audited consolidated financial statements and notes included in our 2013 Form 10-K. Special Note Regarding Forward-Looking Statements With the exception of historical facts, the statements contained in this management's discussion and analysis are "forward-looking" statements. All of these forward-looking statements are subject to risks and uncertainties that could cause the actual results of Pendrell Corporation ("Pendrell," together with its consolidated subsidiaries, "us" or "we") to differ materially from those contemplated by the relevant forward-looking statements. Factors that might cause or contribute to such a difference include, but are not limited to, those discussed in the section entitled "Risk Factors" (Part II, Item 1A of this Form 10-Q) and elsewhere in this quarterly report. The forward-looking statements included in this document are made only as of the date of this report, and we undertake no obligation to publicly update these forward-looking statements to reflect subsequent events or circumstances. Overview Through our consolidated subsidiaries, we have invested in, acquired and developed businesses with unique technologies that are often protected by intellectual property ("IP") rights, and that present the opportunity to address large, global markets. Our subsidiaries create value from our innovations, both by making our IP available for use by third parties and by developing and bringing to market products using our IP. We regularly evaluate our existing investments to determine whether retention or disposition is appropriate, and frequently investigate new investment and business acquisition opportunities. We also advise clients on various IP strategies and transactions. During the first six months of 2014, certain of our subsidiaries entered into agreements to license patents covering memory and storage technologies, from which we received upfront payments and future royalty rights. During the six months ended June 30, 2013 we did not enter into any new material license agreements. Until 2012, we had never initiated litigation to protect our IP rights. Since then, our majority owned subsidiary, ContentGuard, has filed suit for patent infringement against Amazon, Apple, Blackberry, Google, Huawei, HTC, Motorola Mobility, Samsung and ZTE after negotiations with these companies failed to yield negotiated license agreements. ContentGuard's claims against ZTE prompted ZTE to challenge six of ContentGuard's digital rights management (DRM) patents through inter partes review ("IPR") proceedings at the United States Patent and Trademark Office ("USPTO"). In August 2013 and November 2013, the USPTO's Patent Trial and Appeal Board ("PTAB") terminated the proceedings with respect to two patents, both of which emerged with valid patent claims. The other four patents were the subject of PTAB trials held in February 2014, following which PTAB issued written opinions in late June and early July 2014 rejecting ZTE's remaining challenges, confirming the validity of all claims in the four remaining patents. In May 2014, our ContentGuard subsidiary released an enhanced version of the ContentGuard® mobile digital content protection application that was initially launched in December 2013. During the three months ended June 30, 2014, ContentGuard continued the development of a second generation application designed for social media and messaging users, which is targeted for release in the third quarter of 2014. These mobile applications, based on technologies developed by ContentGuard over the past fifteen years, are designed to address consumer demand for enhanced Internet privacy through solutions that restrict access to and limit the life of content. Our continuing development of these ephemeral content protection solutions reflects our commitment to continued innovation, including the development of products to commercialize our IP rights. While we continue to pursue our IP licensing and litigation initiatives, we also continue to advise some of the most respected technology companies in the world on a variety of IP-related matters. We also continue to evaluate acquisition opportunities, some of which are unrelated to our historical IP monetization activities. 14 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies Critical accounting policies require difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The judgments and uncertainties affecting the application of these policies include significant estimates and assumptions made by us using information available at the time the estimates are made. Actual results could differ materially from those estimates. Our critical accounting policies involve judgments associated with our accounting for the fair value of financial instruments, asset impairment, valuation of goodwill and intangible assets, contract settlements, revenue recognition, stock-based compensation, income taxes, contingencies and business combinations. There have been no significant changes to our critical accounting policies disclosed in our 2013 Form 10-K. Key Components of Results of Operations Revenue-We derive our operating revenue from IP monetization activities, including patent licensing and patent sales, and from IP consulting services, or a combination thereof. Although our revenue may occur in different forms, we regard our IP monetization activities as integrated and not separate revenue streams. For example, a third party relationship could include consulting and licensing activities, or the acquisition of a patent portfolio could lead to licensing, consulting and patent sales revenue. As a result of the unpredictable nature, form and frequency of our transactions, our revenue may fluctuate substantially from period to period. Cost of revenue-Cost of revenue consists of certain costs that are variable in nature and are directly attributable to our revenue generating activities including (i) payments to third parties to whom we have an obligation to share revenue, (ii) commissions, and (iii) success fees. Additionally, in periods when patent sales occur, these costs include the net book value and other related costs associated with the sold patents. Depending on the patents being monetized, revenue share payments as a percentage of revenues may vary significantly. Patent administration and related costs-Patent administration and related costs are comprised of (i) patent-related maintenance and prosecution costs incurred to maintain our patents, (ii) other costs that support our patent monetization efforts, and (iii) costs associated with the abandonment of patents, including the write-off of any remaining net book value. Patent litigation-Patent litigation costs consist of costs and expenses incurred in connection with our patent-related enforcement and litigation activities. These may include non-contingent or contingent fee obligations to external counsel. General and administrative-General and administrative expenses are primarily comprised of (i) personnel costs, (ii) general legal fees, (iii) professional fees, (iv) acquisition investigation costs, and (v) general office related costs. Stock-based compensation-Stock-based compensation expense includes expense associated with the granting of stock options, stock appreciation rights, restricted stock awards, restricted stock units and other stock awards issued to employees, directors, consultants and/or advisors based on the estimated fair value on the date of grant and expensed over the requisite service period for awards expected to vest. Amortization of intangible assets-Amortization of intangible assets reflects the expensing of the cost to acquire intangible assets which are capitalized and amortized ratably over their estimated useful lives. Estimating the economic useful lives of our intangible assets depends on various factors including the remaining statutory life of the underlying assets as well as their expected period of benefit. New Accounting Pronouncements In June 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-12, Compensation-Stock Compensation (Topic 718)-Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (a consensus of the FASB Emerging Issues Task Force). ASU No. 2014-12 requires that a performance target that affects vesting and could be achieved after the requisite service period shall be treated as a performance condition. The adoption of this statement on January 1, 2014 did not have a material impact on our financial position, results of operations or cash flows. In May 2014, the FASB issued ASU No. 2014-09, Revenue (Topic 606): Revenue from Contracts with Customers, which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that 15 -------------------------------------------------------------------------------- Table of Contents reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The standard is effective for annual periods beginning after December 15, 2016, and interim periods therein. Early adoption is not permitted. We are currently assessing the impact, if any, of implementing this guidance on our consolidated financial position and results of operations. Results of Operations In February 2013, we acquired a 68.75% interest in Provitro Biosciences LLC, developer of the Provitro™ proprietary micro-propagation technology designed to facilitate the commercial-scale production of certain plants. Additionally, in March 2013, we acquired from Nokia Corporation 125 patents and patent applications worldwide, 81 of which Nokia declared essential to standards applicable to memory and storage technologies used in electronic devices. Expenses associated with these acquisitions from their respective acquisition dates have been included in our condensed consolidated statement of operations for the three and six months ended June 30, 2014 and 2013. The following table is provided to facilitate the discussion of our results of operations for the three and six months ended June 30, 2014 and 2013 (in thousands): Three months ended Six months ended June 30, June 30, 2014 2013 2014 2013 Revenue $ 2,935 $ 802 $ 41,070 $ 11,794 Cost of revenues 70 93 13,866 7,758 Patent administration and related costs 1,650 1,050 3,048 2,099 Patent litigation 1,931 1,304 3,969 2,091 General and administrative 6,985 7,427 14,834 14,805 Stock-based compensation 1,871 3,648 3,752 7,118 Amortization of intangible assets 3,991 4,019 8,030 7,715 Interest income 24 37 44 80 Interest expense 42 66 106 66 Other expense 7 15 12 45 Income tax expense - - 6,270 - Revenue. Revenue of $2.9 million for the three months ended June 30, 2014 increased by $2.1 million, or more than 200%, as compared to $0.8 million for the three months ended June 30, 2013. The increase was primarily due to a June 2014 license agreement covering memory and storage technologies and the absence of any material licensing revenue earned during the second quarter of 2013. Revenue of $41.1 million for the six months ended June 30, 2014 increased by $29.3 million, or more than 200%, as compared to $11.8 million for the six months ended June 30, 2013. The increase was primarily due to license agreements covering memory and storage technologies entered into during the six months ended June 30, 2014 and the absence of licensing revenue during the six months ended June 30, 2013, partially offset by sales of certain patent portfolios in the first quarter of 2013. Cost of revenues. Cost of revenues of $0.1 million for the three months ended June 30, 2014 were substantially the same as the $0.1 million cost of revenues for the three months ended June 30, 2013. Although we signed a license agreement during the three months ended June 30, 2014, the costs associated with this revenue were minimal. Cost of revenues of $13.9 million for the six months ended June 30, 2014 increased by $6.1 million, or 79%, as compared to $7.8 million for the six months ended June 30, 2013. This increase was primarily due to costs associated with our March 2014 license agreement with Samsung, including payments to third parties to whom we have an obligation to share revenue, partially offset by $7.5 million of costs related to certain patents sold in the first quarter of 2013. Patent administration and related costs.Patent administration and related costs of $1.7 million for the three months ended June 30, 2014 increased by $0.6 million, or 57%, as compared to $1.1 million for the three months ended June 30, 2013. Patent administration and related costs of $3.0 million for the six months ended June 30, 2014 increased by $0.9 million, or 45%, as compared to $2.1 million for the six months ended June 30, 2013. The increases in patent administration and related costs were primarily due to write-offs of the net book value of patents abandoned in 2014, partially offset by a reduction in patent maintenance and prosecution costs. 16 -------------------------------------------------------------------------------- Table of Contents Patent litigation. Patent litigation expenses of $1.9 million for the three months ended June 30, 2014 increased by $0.6 million, or 48%, as compared to $1.3 million for the three months ended June 30, 2013. Patent litigation expenses of $4.0 million for the six months ended June 30, 2014 increased by $1.9 million, or 90%, as compared to $2.1 million for the six months ended June 30, 2013. The increases in patent litigation expenses were primarily due to costs incurred by our subsidiary, ContentGuard, in its litigation efforts against Amazon, Apple, Blackberry, Google, HTC, Huawei, Motorola Mobility and Samsung. General and administrative. General and administrative expenses of $7.0 million for the three months ended June 30, 2014 decreased by $0.4 million, or 6%, as compared to $7.4 million for the three months ended June 30, 2013. The decrease was primarily due to $0.8 million reduction in employment expenses resulting from a lower headcount partially offset by $0.3 million incurred to develop enhanced features and functionality for the ContentGuard digital content protection application. General and administrative expenses of $14.8 million for the six months ended June 30, 2014 were substantially the same as the $14.8 million general and administrative expenses for the six months ended June 30, 2013, as the decrease of $0.7 million in employment expenses, primarily due to lower headcount, was offset by $0.6 million incurred to develop enhanced features and functionality for the ContentGuard digital content protection application and $0.1 million increase in other professional fees. Stock-based compensation. Stock-based compensation of $1.9 million for the three months ended June 30, 2014 decreased by $1.7 million, or 49%, as compared to $3.6 million for the three months ended June 30, 2013. Stock-based compensation of $3.8 million for the six months ended June 30, 2014 decreased by $3.5 million, or 47%, as compared to $7.1 million for the six months ended June 30, 2013. The decrease in stock-based compensation expense was primarily due to the vesting of awards in June 2013 for which no further expense is being incurred and the recapture of expense related to terminated employees. Amortization of intangible assets. Amortization of intangible assets of $4.0 million for the three months ended June 30, 2014 was substantially the same as the $4.0 million amortization of intangible assets for the three months ended June 30, 2013, as the increase in amortization from the March 2013 acquisition of a portfolio of memory and storage technology patents was offset by a decrease in amortization expense due to the abandonment and sales of certain patents during the second quarter of 2014. Amortization of intangible assets of $8.0 million for the six months ended June 30, 2014 increased by $0.3 million, or 4%, as compared to $7.7 million for the six months ended June 30, 2013, primarily due to the March 2013 acquisition of a portfolio of memory and storage technology patents, partially offset by the abandonment of certain patents in 2014. Interest income. Interest income for the three and six months ended June 30, 2014 and 2013 was nominal and primarily related to interest earned on money market funds. Interest expense. Interest expense for the three and six months ended June 30, 2014 and 2013 consisted of interest expense resulting from installment payment obligations associated with intangible assets acquired during 2013. Other expense. Other expense for the three and six months ended June 30, 2014 and 2013 was due to losses on foreign currency transactions. Income tax expense. We anticipate that we will not have a U.S. federal income tax liability for fiscal 2014 and, therefore, we recorded no tax expense in the three months ended June 30, 2014. We recorded a tax provision of $6.3 million for the six months ended June 30, 2014 related to foreign taxes withheld on revenue related to a license agreement executed during the first quarter with a third party licensee domiciled in a foreign jurisdiction. In general, foreign taxes withheld may be claimed as a deduction on future U.S. corporate income tax returns, or as a credit against future U.S. income tax liabilities, subject to certain limitations. At June 30, 2014, we had established a full valuation allowance against the deferred tax assets generated due to uncertainty regarding future realizability. We had no foreign taxes withheld and no U.S. federal income tax liability for fiscal 2013. Liquidity and Capital Resources Overview. As of June 30, 2014, we had cash and cash equivalents of $186.1 million. Our primary expected cash needs for the next twelve months include ongoing operating costs associated with commercialization of our IP assets, product development costs, expenses in connection with legal proceedings, and other general corporate purposes. We also expect to use our cash, and may incur debt or issue equity, to acquire or invest in other businesses or assets. 17 -------------------------------------------------------------------------------- Table of Contents We believe our current balances of cash and cash equivalents and cash flows from operations will be adequate to meet our liquidity needs for the foreseeable future. Cash and cash equivalents in excess of our immediate needs are held in interest bearing accounts with financial institutions. Cash Flows. The following table is provided to facilitate the discussion of our liquidity and capital resources for the six months ended June 30, 2014 and 2013 (in thousands). Six months ended June, 2014 2013 Net cash provided by (used in): Operating activities $ 3,612 $ (2,399 ) Investing activities (63 ) (11,370 ) Financing activities (1,976 ) (2,189 ) Net increase (decrease) in cash and cash equivalents 1,573 (15,958 ) Cash and cash equivalents - beginning of period 184,567 213,753 Cash and cash equivalents - end of period $ 186,140 $ 197,795 The increase in cash and cash equivalents for the six months ended June 30, 2014 of $1.6 million was primarily due to revenue generated by operations of $41.1 million partially offset by $37.5 million of general corporate expenditures and a $2.0 million payment of an accrued obligation associated with the 2013 acquisition of our memory and storage technologies portfolio. The decrease in cash and cash equivalents for the six months ended June 30, 2013 of $16.0 million was primarily due to the acquisition of our memory and storage technologies portfolio and the acquisition of a controlling interest in Provitro. For the six months ended June 30, 2014, the $3.6 million of cash provided by operating activities consisted primarily of revenue generated by operations of $41.1 million, partially offset by foreign taxes paid of $6.3 million and operating expenses of $47.5 million adjusted for various non-cash items, including (i) $8.0 million of amortization expense associated with patents and other intangible assets, (ii) $3.8 million of stock-based compensation expense, (iii) $1.9 million of non-cash loss associated with the abandonment and/or sale of patents, (iv) $1.4 million of amortized prepaid compensation expense associated with the acquisition of Ovidian Group in June 2011, (v) $0.7 million increase in prepaid expenses, and (vi) $0.5 million increase in accounts payable and accrued expenses. For the six months ended June 30, 2013, the $2.4 million of cash used in operating activities consisted primarily of our net loss of $29.8 million adjusted for various non-cash items, including (i) $7.7 million of amortization expense associated with patents and other intangible assets, (ii) $7.1 million of stock-based compensation expense, and (iii) $1.4 million of amortized prepaid compensation expense associated with the acquisition of Ovidian Group in June 2011, partially offset by $9.0 million of cash collected from various receivables and a $2.0 million increase in accrued expenses. For the six months ended June 30, 2014, the $63,000 of cash used in investing activities was primarily due to the acquisition of property and intangible assets. For the six months ended June 30, 2013, the $11.4 million of cash used in investing activities was primarily due to $9.2 million used for our acquisition of Provitro and $2.2 million used for the acquisition of property and intangible assets. For the six months ended June 30, 2014, the $2.0 million of cash used in financing activities consisted of a $2.0 million payment of an accrued obligation associated with the 2013 purchase of property and intangible assets and $0.3 million utilized to pay statutory taxes related to vesting of restricted stock awards, offset by $0.3 million in proceeds from the exercise of stock options. For the six months ended June 30, 2013, the $2.2 million of cash used in financing activities consisted of the payment of statutory taxes related to vesting of restricted stock awards, partially offset by proceeds from the exercise of stock options. 18 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations. Our primary contractual obligations relate to the installment purchase of the memory and storage technologies portfolio in 2013 as well as operating lease agreements for our main office location in Kirkland, Washington, and other offices in California, Texas, Washington, D.C. and Finland. Our contractual obligations as of June 30, 2014 were as follows (in millions): Years ending December 31, 2019 and Total 2014 2015-2016 2017-2018 Thereafter Purchase obligations $ 4.0 $ - $ 4.0 $ - $ - Operating lease obligations 2.8 0.3 1.3 1.0 0.2 Total $ 6.8 $ 0.3 $ 5.3 $ 1.0 $ 0.2 Risks and Uncertainties Certain risks and uncertainties that could materially affect our future results of operations or liquidity are discussed under "Part II-Other Information, Item 1A. Risk Factors" in this quarterly report. Inflation The impact of inflation on our condensed consolidated financial condition and results of operations was not significant during any of the periods presented. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. |