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GIGAMON INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended December 28, 2013, as filed with the Securities and Exchange Commission. In addition to historical condensed consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements contained in this Quarterly Report on Form 10-Q other than statements of historical fact, including statements regarding our future results of operations and financial position, our business strategy and plans, and our objectives for future operations, are forward-looking statements. The words "believe," "may," "will," "estimate," "continue," "anticipate," "intend," "expect" and similar expressions are intended to identify forward-looking statements. We have based these forward-looking statements largely on our current expectations and projections about future events and trends that we believe may affect our financial condition, results of operations, business strategy, short-term and long-term business operations and objectives and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in Part II, Item 1A. "Risk Factors" in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible for us to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the future events and trends discussed in this Quarterly Report on Form 10-Q may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. Unless expressly indicated or the context requires otherwise, the terms "Gigamon," "company," "we," "us" and "our" in this document refer to Gigamon Inc., a Delaware corporation, and, where appropriate, its wholly owned subsidiaries. The term "Gigamon" may also refer to our products, regardless of the manner in which they are accessed. Overview We have developed an innovative solution that delivers pervasive and dynamic intelligent visibility of traffic across networks. Our solution, which we refer to as our Traffic Visibility Fabric, consists of distributed network appliances that enable an advanced level of visibility, modification and control of network traffic. Our Traffic Visibility Fabric enables IT organizations to forward traffic from network and server infrastructure to management, analysis, compliance and security tools in a manner that is optimized for specific uses or functions. We generate product revenue primarily from sales of perpetual software licenses installed on physical appliances for our Traffic Visibility Fabric solutions to channel partners, including distributors and resellers, as well as directly to end-user customers. We market and sell our products through a hybrid sales model, which combines a high-touch sales organization and an overlay channel sales team that actively assists our extensive network of channel partners throughout the sales process. We also provide our channel partners with marketing assistance, technical training and support. We generate services revenue primarily from the sale of maintenance and support services for our products. A one-year contract for our maintenance and support services is bundled with the initial contract to purchase our products. Following expiration of this one-year contract, our end-user customers typically purchase maintenance and support contracts that generally have one-year terms. In fiscal 2014, we launched NetFlow Generation, a new GigaSMART application, as well as GigaVUE-HC2, our latest Visibility Fabric platform, which offers increased agility and versatility when combined with our GigaSMART applications. 26 -------------------------------------------------------------------------------- Our revenue increased from $32.4 million in the three months ended June 29, 2013 to $34.9 million in the three months ended June 28, 2014, representing 8% growth from sales of our products and services to existing and new customers. In the three months ended June 28, 2014, we added 84 new customers as compared to 72 new customers in the three months ended June 29, 2013. In the six months ended June 28, 2014, our revenue increased to $66.6 million from $58.2 million in the six months ended June 29, 2013, representing 14% growth. Net loss attributable to common stockholders was $32.5 million and $40.7 million in the three and six months ended June 28, 2014, compared to $9.8 million and $11.0 million in the six months ended June 29, 2013, respectively. We used cash in operations of $3.7 million in the six months ended June 28, 2014 and generated positive net operating cash flows of $15.1 million in the six months ended June 29, 2013. Key Performance Indicators of Our Business We monitor a variety of key performance indicators to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies. These key performance indicators include the following (dollars in thousands): Three Months Ended Six Months Ended June 28, June 29, June 28, June 29, 2014 2013 2014 2013 (As Revised) (As Revised) Key Performance Indicators: Revenue $ 34,851 $ 32,409 $ 66,611 $ 58,222 Gross margin 78 % 72 % 75 % 75 % Loss from operations $ 7,838 $ 32,345 $ 19,776 $ 33,510 Deferred revenue $ 48,043 $ 36,301 $ 48,043 $ 36,301 Revenue. We monitor our revenue to assess the acceptance of our products by our end-user customers and growth in the markets we serve. Gross margin. We monitor our gross margin to assess the impact on our current and forecasted financial results from any changes to the pricing and mix of products we are selling to our end-user customers. Loss from operations. We monitor our operating results to assess how effectively we are conducting our operations as well as controlling our operating expenses, which are primarily driven by headcount. Deferred revenue. Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue. The majority of our deferred revenue balance consists of the unamortized portion of services revenue from maintenance and support contracts. We also defer revenue, and the related costs of product revenue, on sales of products to distributors who stock inventory until the distributors report to us that they have sold the products to end-user customers. We monitor our deferred revenue balance because it represents a significant portion of the revenue that we will recognize in future periods. We assess the change in our deferred revenue balance which, taken together with revenue, is an indication of sales activity in a given period. The financial data presented herein for the three and six months ended June 29, 2013, has been revised to correct immaterial accounting errors as described in Note 2 to the condensed consolidated financial statements. Financial Overview Revenue We generate revenue from the sale of products and related services, including maintenance and support. We present revenue net of discounts, rebates and sales taxes. Our revenue is comprised of the following: Product revenue. We generate product revenue primarily from sales of perpetual software licenses installed on physical appliances for our Traffic Visibility Fabric solutions. We generally recognize product revenue at the time of product delivery, provided that all other revenue recognition criteria have been met. As a percentage of revenue, we expect our product revenue to vary from quarter-to-quarter based on, among other things, the timing of orders and delivery of products and seasonal and cyclical factors discussed under the section titled "Results of Operations." 27 --------------------------------------------------------------------------------We expect our revenue in the third quarter to remain relatively consistent or slightly increase as compared to the three months ended June 28, 2014. Services revenue. We generate service revenue from sales of maintenance and support contracts, which are bundled with sales of products, and from subsequent renewals of those contracts. We offer tiered maintenance and support services under our renewable, fee-based maintenance and support contracts, which includes technical support, hardware repair and replacement parts, bug fixes, patches and unspecified upgrades on a when-and-if-available basis. We recognize services revenue ratably over the duration of the contract, which is typically one year and can be up to five years; as a result, the impact on services revenue will lag any shift in product revenue because product revenue is recognized when a product is sold and revenue criteria are satisfied, whereas services revenue is recognized ratably over the contract term. We expect our services revenue to increase in absolute dollars as we increase our installed base by selling more products and adding more end-user customers. Cost of revenue Our cost of revenue is comprised of the following: Cost of product revenue. Cost of product revenue is comprised primarily of the costs associated with manufacturing our products, including third-party hardware manufacturing costs; personnel costs for salary, benefits, bonuses and stock-based compensation expense; shipping costs; allocated costs of facilities and information technology; any inventory write-downs; and warranty costs and other related expenses. Cost of services revenue. Cost of services revenue is comprised primarily of personnel costs for salary, benefits, bonuses and stock-based compensation expense related to our customer support organization, as well as allocated costs of facilities and information technology. Gross profit and gross margin Gross profit has been and will continue to be affected by a variety of factors including shipment volumes, changes in the mix of products and services sold, changes in our product costs including any excess inventory write-downs, new product introductions and upgrades to existing products, changes in customer mix, changes in pricing and the extent of customer rebates and incentive programs. We expect our gross margin to fluctuate over time depending on a variety of factors, including those described above, and may decrease over the longer-term in the event that we experience additional competitive pricing pressure. Operating expenses Operating expenses consist of research and development, sales and marketing and general and administrative expenses. Personnel costs comprise a significant component of our operating expenses, and consist of salary, benefits, bonuses and stock-based compensation expense; and with respect to our sales organization, personnel costs also include sales commissions. From December 28, 2013 through June 28, 2014, we increased headcount attributable to our operating expenses from 326 to 381. We expect overall operating expenses, excluding stock-based compensation expense, to be relatively consistent in absolute dollars for the third quarter of 2014, as compared to the three months ended June 28, 2014. We expect stock-based compensation expense to increase in absolute dollars for the third quarter of 2014, as compared to the three months ended June 28, 2014. This does not include expenses to be recognized related to employee stock awards that are granted after June 28, 2014. In addition, to the extent forfeiture rates are different from what we have anticipated; stock-based compensation expense related to these awards will be different from our expectations. Research and development. Our research and development efforts are focused on new product development and on developing additional functionality for our existing products. Research and development expenses primarily consist of personnel costs, and to a lesser extent, prototype materials, allocated costs of facilities and information technology and product certification. We expense research and development costs as incurred. Sales and marketing. Sales and marketing expenses are the largest component of our operating expenses and primarily consist of personnel costs, as well as travel expenses, trade shows, marketing and promotional activities, and allocated costs of facilities and information technology. We sell our products through our global sales organization, which is divided into three geographic regions: North America, Europe and Asia Pacific. 28 -------------------------------------------------------------------------------- General and administrative. General and administrative expenses primarily consist of personnel costs and allocated costs of facilities and information technology related to our executive, finance, human resources and legal functions, as well as professional services costs. Professional services costs primarily consist of outside legal and accounting services. We have incurred and expect to continue to incur expenses as a result of operating as a public company, including costs to comply with the rules and regulations applicable to companies listed on a national securities exchange and costs related to compliance and reporting obligations. Interest income and other expense, net Interest income consists primarily of income earned on our invested cash, cash equivalents and short-term investments, which have not been material to date. Other expense, net consists primarily of foreign currency exchange losses related to transactions denominated in currencies other than the U.S. dollar, which have not been material to date. Income tax benefit (provision) On May 31, 2013, we converted from a Delaware limited liability company (a pass through entity not subject to U.S. federal and state income taxes) to a Delaware corporation. Accordingly, following such conversion, we elected to be treated as a corporation under Subchapter C of Chapter 1 of the United States Internal Revenue Code, as amended, and, therefore, have become subject to both federal and state income taxes. The provision for income taxes for the six months ended June 28, 2014, was primarily related to the establishment of a valuation allowance against the deferred tax assets in the United States and the taxes assessed by foreign jurisdictions. As of June 28, 2014 it was assessed that it is more-likely-than-not that it will not realize its federal and state deferred tax assets based on the absence of sufficient positive objective evidence that it would generate sufficient taxable income in our United States tax jurisdiction to realize the deferred tax assets. Accordingly, a valuation allowance was recorded on the federal and state deferred tax assets for an amount of $24.6 million and was charged to the income tax provision. The recording of $24.6 million of valuation allowance was primarily due to ongoing losses and the uncertainty regarding future results adjusted for permanent differences which have resulted in a more likely than not determination that the deferred tax assets would not be realized. In making this determination, we considered all available evidence, both positive and negative. Such evidence included, among others, our history of profitability and losses, jurisdictional income recognition trends, pretax losses adjusted for certain extraordinary and other items, and forecasted income by jurisdiction. The benefit from income taxes for six months ended June 29, 2013 was $25.0 million in the initial recognition of deferred tax assets, upon the conversion of the limited liability company to a corporation, partially offset by current foreign taxes. We are also subject to state taxes in certain states that may assess capital taxes or taxes based on gross receipts. We also have a subsidiary in a foreign jurisdiction, which is subject to income taxes in the jurisdictions in which it operates. Stock-based compensation expense and other charges Prior to our initial public offering (the "IPO"), we granted restricted stock units ("RSUs") and stock option awards (together, the "IPO Awards") that were subject to the completion of our IPO. In addition, upon the completion of our IPO in June 2013, we began offering eligible employees the opportunity to purchase shares under our 2013 Employee Stock Purchase Plan (the "ESPP"). Accordingly, prior to the second quarter of fiscal 2013, we did not record any stock-based compensation associated with the IPO Awards and the ESPP purchase rights. Total stock-based compensation expense, net of estimated forfeitures, in three and six months ended June 28, 2014 and June 29, 2013 was $6.0 million and $13.9 million, respectively, compared to $16.7 million and $18.3 million in the three and six months ended June 28, 2014 and June 29, 2013, respectively. In addition, payroll taxes related to stock-based compensation were $0.8 million in the three and six months ended June 28, 2014. As of June 28, 2014, unrecognized stock-based compensation expense, net of estimated forfeitures, was $32.9 million. 29 --------------------------------------------------------------------------------Results of Operations The following tables set forth our results of operations in dollars and as a percentage of revenue (in thousands, except percentages): Three Months Ended Six Months Ended June 28, June 29, June 28, June 29, 2014 2013 2014 2013 (As Revised) (As Revised) Consolidated Statement of Operations Data: Revenue: Product $ 22,544 $ 23,354 $ 42,624 $ 40,873 Services 12,307 9,055 23,987 17,349 Total revenue 34,851 32,409 66,611 58,222 Cost of revenue: Product 6,281 6,944 13,286 11,668 Services 1,544 1,911 3,124 2,564 Total cost of revenue 7,825 8,855 16,410 14,232 Gross profit 27,026 23,554 50,201 43,990 Operating expenses: Research and development 10,860 17,097 21,798 22,768 Sales and marketing 19,558 26,114 37,728 38,535 General and administrative 4,446 12,688 10,451 16,197 Total operating expenses 34,864 55,899 69,977 77,500 Loss from operations (7,838 ) (32,345 ) (19,776 ) (33,510 ) Interest income 73 1 134 3 Other income (expense), net 6 (18 ) (35 ) (25 ) Loss before provision for income taxes (7,759 ) (32,362 ) (19,677 ) (33,532 ) Income tax (provision) benefit (24,727 ) 22,569 (21,027 ) 22,540 Net loss (32,486 ) (9,793 ) (40,704 ) (10,992 ) Net loss includes Performance Unit Plan (PUP) and stock-based compensation expense allocated as follows: PUP expense: Cost of revenue $ - $ 353 $ - $ 353 Research and development - 5,188 - 5,188 Sales and marketing - 7,991 - 7,991 General and administrative - 6,839 - 6,839 Total PUP expense $ - $ 20,371 $ - $ 20,371 Stock-based compensation expense: Cost of revenue $ 471 $ 2,691 $ 919 $ 2,709 Research and development 2,054 6,069 4,653 6,378 Sales and marketing 2,424 5,263 5,198 5,692 General and administrative 1,090 2,674 3,127 3,511 Total stock-based compensation expense $ 6,039 $ 16,697 $ 13,897 $ 18,290 Percentage of Total Revenue: Revenue: Product 65 % 72 % 64 % 70 % Services 35 % 28 % 36 % 30 % Total revenue: 100 % 100 % 100 % 100 % Cost of revenue 22 % 27 % 25 % 24 % Gross margin 78 % 73 % 75 % 76 % Operating expenses: Research and development 31 % 53 % 33 % 39 % Sales and marketing 56 % 81 % 57 % 66 % General and administrative 13 % 39 % 16 % 28 % Total operating expenses 100 % 172 % 105 % 133 % Loss from operations (24 %) (99 %) (30 %) (58 %) Interest income 0 % 0 % 0 % 0 % Other expense, net 0 % 0 % 0 % 0 % Loss before income tax benefit (provision) (24 %) (99 %) (30 %) (58 %) Income tax benefit (provision) (71 %) 70 % (32 %) 39 % Net loss (95 %) (29 %) (62 %) (19 %) 30 -------------------------------------------------------------------------------- We have revised our consolidated financial statements for the three and six months ended June 29, 2013 to correct for insignificant accounting errors which are described in Note 2, Revision of previously issued Financial Statements, included in Part I - Item I - Financial Statements (unaudited). Comparison of the three and six months ended June 28, 2014 and June 29, 2013 Revenue Three Months Ended Six Months Ended June 28, June 29, Increase/ % Increase June 28, June 29, Increase/ % Increase 2014 2013 (Decrease) (Decrease) 2014 2013 (Decrease) (Decrease) (dollars in thousands) Revenue: Product $ 22,544 $ 23,354 $ (810 ) (3%) $ 42,624 $ 40,873 $ 1,751 4% Services 12,307 9,055 3,252 36% 23,987 17,349 6,638 38% Total revenue $ 34,851 $ 32,409 $ 2,442 8% $ 66,611 $ 58,222 $ 8,389 14% Product revenue decreased $0.8 million in the three months ended June 28, 2014 compared to the three months ended June 29, 2013, primarily due to a decrease in the volume of sales from our G-Series products, partially offset by increased sale of our high density (H-Series) products. Revenue from our H-Series products increased to $18.0 million in the three months ended June 28, 2014, compared to $13.5 million in the three months ended June 29, 2013. Product revenue increased $1.8 million in the six months ended June 28, 2014 compared to the six months ended June 29, 2013, primarily due to an increase in the volume of sales of our H-Series products by $8.5 million offset in part by lower G-Series products sales, primarily due to lower volume of shipments of such products. Services revenue increased $3.3 million and $6.6 million in the three and six months ended June 28, 2014 compared to the three and six months ended June 29, 2013, respectively, primarily due to the growth in our installed base at our existing end-user customers and also due to an increase in the total number of end-user customers under maintenance and support contracts, which was driven by higher product sales. Cost of revenue and gross margin Three Months Ended Six Months Ended June 28, June 29, June 28, June 29, 2014 2013 2014 2013 (As Revised) Decrease % Decrease (As Revised) Increase % Increase (dollars in thousands) Cost of revenue: Product $ 6,281 $ 6,944 $ (663 ) (10%) $ 13,286 $ 11,668 $ 1,618 14% Services 1,544 1,911 (367 ) (19%) 3,124 2,564 560 22%Total cost of revenue $ 7,825 $ 8,855 $ (1,030 ) (12%) $ 16,410 $ 14,232 $ 2,178 15% Gross margin: Product 72 % 70 % 69 % 71 % Services 87 % 79 % 87 % 85 % Total gross margin 78 % 72 % 75 % 75 %PUP expense included in: Cost of revenue $ - $ 353 $ (353 ) * $ - $ 353 $ (353 ) * Stock-based compensation expense included in: Cost of revenue $ 471 $ 2,691 $ (2,220 ) (82%) $ 919 $ 2,709 $ (1,790 ) (66%) 31 --------------------------------------------------------------------------------Three Months Ended June 28, 2014 Compared to Three Months Ended June 29, 2013 Total gross margin increased to 78% in the three months ended June 28, 2014, compared to 72% in the three months ended June 29, 2013, primarily due to reduction of stock based compensation expense in the three months ended June 28, 2014. Stock based compensation expense for the three months ended June 28, 2014 was $0.5 million as compared to $2.7 million for the three months ended June 29, 2013. Product gross margin increased to 72% in the three months ended June 28, 2014 from 70% in the three months ended June 29, 2013, primarily attributable to $1.4 million decrease in stock-based compensation expense in the three months ended June 28, 2014 as compared to June 29, 2013, offset by a $0.3 million net inventory write-down and an increase in the inventory carrying and fulfillment charges of $0.5 million. Services gross margin increased to 87% in the three months ended June 28, 2014 from 79% in the three months ended June 29, 2013, primarily due to a $0.9 million decrease in stock-based compensation expense recorded in the three months ended June 28, 2014 as compared to June 29, 2013; offset by $0.5 million increase in personnel costs and allocated expenses to support the higher number of maintenance and support contracts. Six Months Ended June 28, 2014 Compared to Six Months Ended June 29, 2013 Total gross margin was consistent at 75% in the six months ended June 28, 2014 and to the six months ended June 29, 2013. Product gross margin decreased to 69% in the six months ended June 28, 2014 from 71% in the six months ended June 29, 2013, primarily attributable to a $1.8 million of inventory write-down, net of recovery of previously written-off inventory, increase of $1.1 million in inventory carrying and fulfillment charges offset by $1.2 million decrease in stock-based compensation expense. Services gross margin increased to 87% for the six months ended June 28, 2014 as compared to 85% for the six months ended June 29, 2013 primarily due to $0.6 million decrease in stock-compensation expense, offset in part by higher personnel and other allocated costs. Operating expenses Three Months Ended Six Months Ended June 28, June 29, June 28, June 29, 2014 2013 Increase % Increase 2014 2013 Increase % Increase (dollars in thousands) Operating expenses: Research and development $ 10,860 $ 17,097 $ (6,237 ) (36%) $ 21,798 $ 22,768 $ (970 ) (4%) Sales and marketing 19,558 26,114 (6,556 ) (25%) 37,728 38,535 (807 ) (2%) General and administrative 4,446 12,688 (8,242 ) (65%) 10,451 16,197 (5,746 ) (35%) Total operating expenses $ 34,864 $ 55,899 $ (21,035 ) (38%) $ 69,977 $ 77,500 $ (7,523 ) (10%) PUP expense included in: Research and development $ - $ 5,188 $ (5,188 ) * $ - $ 5,188 $ (5,188 ) * Sales and marketing - 7,991 (7,991 ) * - 7,991 (7,991 ) * General and administrative - 6,839 (6,839 ) * - 6,839 (6,839 ) * Total PUP expense $ - $ 20,018 $ (20,018 ) * $ - $ 20,018 $ (20,018 ) * Stock-based compensation expense included in: Research and development $ 2,054 $ 6,069 $ (4,015 ) (66%) $ 4,653 $ 6,378 $ (1,725 ) (27%) Sales and marketing 2,424 5,263 (2,839 ) (54%) 5,198 5,692 (494 ) (9%) General and administrative 1,090 2,674 (1,584 ) (59%) 3,127 3,511 (384 ) (11%) Total stock-based compensation expense $ 5,568 $ 14,006 $ (8,438 ) (60%) $ 12,978 $ 15,581 $ (2,603 ) (17%) 32 --------------------------------------------------------------------------------Three Months Ended June 28, 2014 Compared to Three Months Ended June 29, 2013 Research and development expenses decreased $6.2 million in the three months ended June 28, 2014 compared to the three months ended June 29, 2013. The decrease in research and development expenses was primarily due to a one-time $5.2 million of PUP expenses in the three months ended June 29, 2013 as compared to zero in the three months ended June 28, 2014 and a $4.0 million decrease in stock-based compensation expense. Excluding these PUP and stock compensation expenses, research and development expenses increased by $3.0 million in the three months ended June 28, 2014, compared to the three months ended June 29, 2013. This increase was due to $2.2 million increase in personnel and allocated expenses primarily driven by increased headcount and a $0.7 million increase in prototype expenses. Sales and marketing expenses decreased $6.6 million in the three months ended June 28, 2014 compared to the three months ended June 29, 2013. The decrease in sales and marketing expenses was primarily due to a one-time $8.0 million charge in the PUP expenses in the three months ended June 29, 2013 as compared to zero in the three months ended June 28, 2014 and a $2.8 million decrease in stock-based compensation expense. Excluding these PUP and stock-based compensation expenses, sales and marketing expenses increased by $4.3 million in the three months ended June 28, 2014 compared to the three months ended June 29, 2013. The increase was due to higher personnel and allocated expenses of $3.6 million primarily driven by increased headcount and a $0.3 million increase in promotional expenses. General and administrative expenses decreased $8.2 million in the three months ended June 28, 2014 compared to the three months ended June 29, 2013. The decrease in general and administrative expenses was primarily due to a one-time $6.8 million charge in PUP related expenses in the three months ended June 29, 2013, as compared to zero in the three months ended June 28, 2014 and a $1.6 million decrease in stock-based compensation expense. Excluding these PUP and stock-based compensation expenses, general and administrative expenses increased by $0.2 million in the three months ended June 28, 2014 compared to the three months ended June 29, 2013. This increase was due to higher personnel expenses of $0.6 million primarily driven by increased headcount offset in part by a $0.3 million decrease in professional services. Six Months Ended June 28, 2014 Compared to Six Months Ended June 29, 2013 Research and development expenses decreased $1.0 million in the six months ended June 28, 2014 compared to the six months ended June 29, 2013. The decrease in research and development expenses was primarily due to a $5.2 million decrease in the PUP related costs and a $1.7 million decrease in stock-based compensation expense, Excluding these PUP and stock-based compensation expenses, research and development expenses increased by $5.9 million in the six months ended June 28, 2014 compared to the three months ended June 29, 2013. This increase was primarily due to a $4.6 million increase in personnel and allocated expenses driven by increased headcount and a $0.9 million increase in prototype expenses. Sales and marketing expenses decreased $0.8 million in the six months ended June 28, 2014 compared to the six months ended June 29, 2013. The decrease in sales and marketing expenses was primarily due to a $8.0 million decrease in the PUP related costs and a $0.5 million decrease in stock-based compensation expense. Excluding these PUP and stock-based compensation expenses, sales and marketing expenses increased by $7.7 million in the six months ended June 28, 2014 compared to the three months ended June 29, 2013. This increase was primarily due to $6.1 million increase in personnel and allocated expenses, a $0.8 million increase in promotional expenses and a $0.5 million increase in travel expenses. General and administrative expenses decreased $5.7 million in the six months ended June 28, 2014 compared to the six months ended June 29, 2013. The decrease in general and administrative expenses was primarily due to a $6.8 million decrease in PUP related costs and a $0.4 million decrease in stock-based compensation expense.. Excluding these PUP and stock-based compensation expenses, general and administrative expenses increased by $1.5 million in the six months ended June 28, 2014 compared to the three months ended June 29, 2013. This increase was primarily due to a $1.5 million increase in personnel and allocated expenses primarily driven by increased headcount. 33 --------------------------------------------------------------------------------Income Tax Benefit (Provision) We account for income taxes under the asset and liability approach. This process involves estimating our actual current tax exposure, including assessing the risks associated with tax audits, and assessing temporary differences resulting from different treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. 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. Significant judgment is required in determining whether the valuation allowance should be recorded against deferred tax assets. In assessing the need for valuation allowance, we consider all available evidence including past operating results and estimates of future taxable income. As of May 31, 2013, we established deferred tax asset of $24.6 million, upon the conversion of limited liability company to a corporation. This deferred tax asset resulted in an income tax benefit of $24.6 million for the three and six months ended June 29, 2013. The provision for income taxes for the six months ended June 28, 2014, was primarily related to the establishment of a valuation allowance against the deferred tax assets in the United States and the taxes assessed by foreign jurisdictions. As of June 28, 2014 management assessed that it is more-likely-than-not that we will not realize our federal and state deferred tax assets based on the absence of sufficient positive objective evidence that we would generate sufficient taxable income in our United States tax jurisdiction to realize the deferred tax assets. Accordingly, we recorded a valuation allowance on our federal and state deferred tax assets for an amount of $24.6 million and was charged to the income tax provision. The recording of $24.6 million of valuation allowance was mainly due to ongoing losses and uncertainty regarding future results adjusted for permanent differences which has resulted in a more likely than not determination that the deferred tax assets would not be realized. In making this determination, we considered all available evidence, both positive and negative. Such evidence included, among others, our history of profitability and losses, jurisdictional income recognition trends, pretax losses adjusted for certain extraordinary and other items, and forecasted income by jurisdiction. The benefit from income taxes for six months ended June 29, 2013 was $25.0 million in the initial recognition of deferred tax assets, upon the conversion of the limited liability company to a corporation, partially offset by current foreign taxes. Three Months Ended Six Months Ended June 28, June 29, Increase/ % Increase June 28, June 29, Increase/ % Increase 2014 2013 (Decrease) (Decrease) 2014 2013 (Decrease) (Decrease) (As Revised) (As Revised) (dollars in thousands) Income tax (provision) benefit $ (24,727 ) $ 22,569 $ (47,296 ) (210% ) $ (21,027 ) $ 22,540 $ (43,567 ) (193% ) Non-GAAP Financial Measures We report all financial information required in accordance with U.S. generally accepted accounting principles ("GAAP"), but we believe that evaluating our ongoing operating results may be difficult to understand if limited to reviewing only GAAP financial measures. Many of our investors have requested that we disclose non-GAAP information because it is useful in understanding our performance as it excludes amounts, primarily non-cash charges that many investors feel may obscure our true operating results. Likewise, management uses non-GAAP measures to manage and assess the profitability of our business going forward and does not consider stock-based compensation expense and related payroll taxes in managing our operations. Specifically, management does not consider these expenses or benefits when developing and monitoring our budgets and spending. As a result, we use calculations of non-GAAP net (loss) income and non-GAAP net (loss) income per share, which exclude these expenses when evaluating our ongoing operations and allocating resources within the organization. 34 --------------------------------------------------------------------------------Reconciliations of our GAAP and non-GAAP financial measures were as follows (in thousands, except per share amounts): Three Months Ended Six Months Ended June 28, June 29, June 28, June 29, 2014 2013 2014 2013 (As Revised) (As Revised) GAAP net loss attributable to common stockholders $ (32,486 ) $ (9,758 ) $ (40,704 ) $ (10,973 ) Stock-based compensation expense 6,039 16,697 13,897 18,290 Stock-based compensation related payroll taxes (20 ) - 757 - Accretion of preferred stock to redemption value and issuance costs - 503 - 1,088 Loss distributable to preferred stockholders - (538 ) - (1,107 ) Performance unit plan compensation expense - 20,371 - 20,371 Tax benefit upon conversion of LLC to a C Corporation** - (14,811 ) - (14,811 ) Income tax effect of non-GAAP adjustments** 25,333 (8,673 ) 22,684 (8,673 ) Non-GAAP net (loss) income $ (1,134 ) $ 3,791 $ (3,366 ) $ 4,185 Basic and diluted GAAP net loss per share attributable to common stockholders $ (1.01 ) $ (0.51 ) $ (1.28 ) $ (0.60 ) Basic Non-GAAP net (loss) income per share $ (0.04 ) $ 0.20 $ (0.11 ) $ 0.23 Diluted Non-GAAP net (loss) income per share $ (0.04 ) $ 0.14 $ (0.11 ) $ 0.16 ** Non-GAAP tax provision excludes the tax benefits upon conversion of LLC to a C corporation, the recording of valuation allowance on the deferred tax assets, the tax benefit relating to stock-based compensation expense as well as uses a long-term projected tax rate for the 2014 annual periods applied to interim results. Liquidity and Capital Resources As of June 28, 2014, our principal sources of liquidity were our cash, cash equivalents and short-term investments of $134.8 million, the majority of which was held in the United States. Our liquidity requirements are primarily to fund our working capital and operating expenses. As of June 28, 2014, we had no material commitments for capital expenditures. We intend to retain any future earnings to finance the operations and expansion of our business, and we do not currently anticipate paying any cash dividends on our common stock. Our future capital requirements will depend on many factors, including our results of operations and the expansion of our research and development, sales and marketing and general and administrative functions. Based on our current operating plan, we believe our existing cash, cash equivalents and short-term investments, combined with cash generated from operations, will be sufficient to fund our working capital and operating expenses for at least the next 12 months. If we require additional capital resources to grow our business internally or to acquire complementary technologies and businesses at any time in the future, we may seek to sell additional equity, or raise funds through debt financing or other sources. Cash flows The following table summarizes our cash flows for the periods indicated (in thousands): Six Months Ended June 28, June 29, 2014 2013 Cash (used in) provided by operating activities $ (3,749 ) $ 15,065 Cash used in investing activities $ (49,964 ) $ (2,200 ) Cash provided by financing activities $ 4,728 $ 89,982 35 --------------------------------------------------------------------------------Cash flows from operating activities Our cash provided by operating activities is generated from sales of our products and, to a lesser extent, by upfront payments from customers under maintenance and support contracts. Our primary uses of cash from operating activities have been for personnel related expenses, manufacturing costs, expenses related to marketing and promotional activities and costs related to our facilities. Our cash flows from operating activities will continue to be affected principally by our working capital requirements and increased spending on personnel, facilities and sales and marketing activities to meet our anticipated business growth. The $40.7 million net loss for the six months ended June 28, 2014, included non-cash charges of $39.4 million. These non-cash charges included primarily changes in the deferred tax assets of $20.9 million and $13.9 million stock based compensation expenses. There was a $2.5 million net use of cash due to changes in operating assets and liabilities primarily due to change in inventory of $8.0 million and accounts payable of $3.3 million, partially offset by change of $7.2 million in accounts receivable and $4.6 million in accrued liabilities. Our days sales outstanding decreased to 45 days as of June 28, 2014 from 52 days as of December 28, 2013, due to the improved shipment linearity. Cash flows from investing activities In the six months ended June 28, 2014, cash used in investing activities was $50.0 million attributable to purchases of marketable securities of $60.6 million and $4.7 million used for capital expenditures, partially offset by cash proceeds of $15.4 million from the maturities and the sales of short-term investments. In the six months ended June 29, 2013, cash used in investing activities was $2.2 million primarily attributable to capital expenditures for property and equipment to support the growth of our business. Cash flows from financing activities In the six months ended June 28, 2014, cash generated from financing activities was $4.7 million primarily due to proceeds of $3.9 million from the issuance of common stock pursuant to our ESPP and $3.6 million from stock option exercises, offset in part by $2.2 million in shares repurchased due to tax withholdings upon vesting of RSUs. We also made the final payout of $0.5 million to Gigamon LLC members pursuant to the limited liability agreement in effect prior to our IPO (the "LLC Agreement"). In the six months ended June 29, 2013, cash generated from financing activities was $90.0 million primarily due to the proceeds from our IPO of $97.1 million offset by $7.1 million distribution to Gigamon LLC members pursuant to the LLC agreement. Contractual Obligations The following summarizes our contractual obligations as of June 28, 2014: Payments Due by Period Less More than 1 1 to 3 4 to 5 than 5 year years years years Total (in thousands) Operating lease obligations (1) $ 1,096 $ 6,473 $ 4,303 $ 82 $ 11,954 Purchase commitments (2) 2,282 - - - 2,282 Total $ 3,378 $ 6,473 $ 4,303 $ 82 $ 14,236 (1) Operating lease obligations represent our obligations to make payments under the lease agreements for our facilities and office equipment leases. (2) Purchase commitments primarily represent our purchase orders issued to suppliers to purchase inventories and related components. We record a liability for firm, non-cancelable and unconditional purchase commitments for quantities in excess of our future demand forecasts consistent with the valuation of our excess and obsolete inventory. 36 --------------------------------------------------------------------------------Off-Balance Sheet Arrangements We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Recent Accounting Pronouncements See Note 2, Significant Accounting Policies, in Notes to the Condensed Consolidated Financial Statements in Item 1 of Part I of this Report, for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on financial condition and results of operations, which is incorporated herein by reference. Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in accordance with GAAP. The preparation of these condensed financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, operating expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. We base our estimates and assumptions on historical experience and on various other factors that we believe to be reasonable under the circumstances. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows would be affected. An accounting policy is considered to be critical if the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and the effect of the estimates and assumptions on financial condition or operating performance is material. The accounting policies we believe to reflect our more significant estimates, judgments, and assumptions and are most critical to understanding and evaluating our reported financial results are as follows: · Revenue Recognition; · Stock-Based Compensation; · Inventory Valuation; · Warranty Reserves; and · Income Taxes. There have been no material changes to our critical accounting policies and estimates as compared to the critical accounting policies and estimates described in our Annual Report on Form 10-K for the fiscal year ended December 28, 2013. |