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MRV COMMUNICATIONS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
[August 18, 2014]

MRV COMMUNICATIONS INC - 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 of our financial condition and results of operations should be read in conjunction with the Financial Statements and Notes thereto included elsewhere in this Form 10-Q, and Items 6, 7 and 8 of our 2013 Form 10-K. The discussion in this Form 10-Q contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and may qualify for the safe harbor provided for in Section 21E of the Exchange Act. Forward-looking statements are statements other than statements of historical fact and may be identified by use of such terms as "expects," "anticipates," "intends," "potential," "estimates," "believes," "may," "should," "could," "will," "would," and words of similar import.



Forward-looking statements involve known and unknown risks and uncertainties that could cause actual results to differ materially from those projected. In addition, the statements in this Form 10-Q may involve certain risks, uncertainties and assumptions, the likelihood of which are difficult to assess and may not occur, including risks that each of its business segments may not make the expected progress in its respective market, or that management's long-term strategy may not achieve the expected results. Other risks and uncertainties relate to delayed lead times in receiving components and delayed delivery times to customers due to short-term capacity constraints, potential changes in relationships with MRV's customers and suppliers and their financial condition, MRV's success in developing, introducing and shipping product enhancements and new products, competition in our market segments, market acceptance of new products and our ability to succeed in entering new markets, continued market acceptance of existing products and continued success in selling the products of other companies, product price discounts and general pricing pressure in certain of our markets, the timing and amount of significant orders from customers, obsolete inventory or product returns, warranty and other claims on products, the continued ability of MRV to protect its intellectual property rights and avoid onerous licensing fees, changes in product mix, maturing product life cycles, implementation of operating cost structures that align with revenue growth, political instability in areas of the world in which MRV operates or sells its products and services, currency fluctuations, changes in accounting rules, general economic conditions, as well as changes in such conditions specific to our market segments, maintenance of our inventory and production backlog, supply constraints directly or indirectly caused by natural disasters, litigation, including but not limited to patent infringement claims and litigation related to MRV's historical stock option granting practices.

In light of the risks and uncertainties inherent whenever matters or events expected to occur or not occur in the future are discussed, there can be no assurance that the forward-looking information contained in this Form 10-Q will in fact transpire or prove to be accurate. All subsequent written and oral forward-looking statements attributable to the Company or persons acting on our behalf are expressly qualified in their entirety by this introduction. In light of the risks and uncertainties in all such projected operational matters, the inclusion of forward-looking statements in this Form 10-Q should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved or that any of the Company's operating expectations will be realized. Revenue and results of operations are difficult to forecast and could differ materially from those projected in the forward-looking statements contained in this Form 10-Q for the reasons detailed in Item 1A "Risk Factors" of Part I on the Company's 2013 Form 10-K and as set forth in item 1A of Part II of this Form 10-Q. Readers should not place undue reliance on forward-looking statements, which reflect management's view only as of the date of this Form 10-Q. The Company undertakes no obligation to amend this Form 10-Q or revise publicly these forward-looking statements (other than pursuant to requirements imposed on registrants pursuant to Item 1A under Part II of Form 10-Q) to reflect subsequent events or circumstances. Readers should also carefully review the risk factors described in other documents the Company files from time to time with the SEC and the cautionary statements contained in our press releases when we provide forward-looking information.


17-------------------------------------------------------------------------------- Table of Contents Overview We supply communications equipment and services to carriers, governments and enterprise customers worldwide. We conduct our business along two principal segments: Network Equipment and Network Integration. We evaluate segment performance based on the revenues, gross profit and operating expenses of each segment. We do not evaluate segment performance on additional financial information. As such, there are no separately identifiable Statements of Operations data below operating income. Our Network Equipment segment primarily provides communications equipment that facilitates access, transport, aggregation and management of voice, data and video traffic in communication networks and data centers used by telecommunications service providers, cable operators, enterprise customers and governments worldwide. Our Network Integration segment operates primarily in Italy, servicing Tier One service providers, regional carriers, large enterprises, and government institutions.

Network Integration provides network system design, integration and distribution services that primarily include products manufactured by third party vendors. We market and sell our products worldwide, through a variety of channels, which include a dedicated direct sales force, manufacturers' representatives, value-added-resellers, distributors and systems integrators.

We continue to encounter a highly competitive global marketplace for our product and services, particularly in the Italian market. Our recent introduction of the OptiDriiver and OptiPacket product lines and the enhancement of existing products are to aggressively seek to capture market share and retain our current customers. We expect the competitive landscape to remain dynamic. As technologies migrate toward being software-driven and the network layers converge, we expect to see our competition increase in the future.

As we seek opportunities for our OptiDriver and Optipacket systems in the markets we serve, additional investment in equipment, inventory, and deployment will be required. These initial investments may burden our results before we see begin to see revenues as the sales cycle for these products can extend out over several months.

In the Italian market, securing new opportunities on the Network Integration side of our business often requires less favorable pricing on the third party products that we sell to Tier One service providers. This less favorable pricing combined with the protracted cash conversion cycle inherent in Italy place cash resources at risk. These market conditions can adversely affect our operations and cause fluctuations in our results.

Our business involves reliance on foreign-based offices. Some of our divisions, outside subcontractors and suppliers are located in foreign countries, including Argentina, Australia, Canada, Denmark, Germany, Israel, Italy, Netherlands, Philippines, Poland, Russia, Taiwan, Thailand, and United Kingdom. For the six months ended June 30, 2014, and 2013, foreign revenue constituted 69% and 67% of our total revenue, respectively. The majority of our foreign sales are to customers located in the European region, with the remaining foreign sales primarily to customers in the Asia Pacific region.

As of June 30, 2014, the Company had $22.3 million in cash and cash equivalents, $0.3 million in restricted time deposits, and $6.4 million in short-term debt.

Critical Accounting Policies Our discussion and analysis of the Company's financial condition and results of operations are based upon the financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP").

The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. We believe that the estimates, assumptions and judgments involved in the accounting policies described below have the greatest potential impact on our financial statements, so we consider these to be our critical accounting policies. Because of the uncertainty inherent in these matters, actual results could differ from the estimates we use in applying the critical accounting policies. Certain of these critical accounting policies affect working capital account balances, including the policies for revenue recognition, allowance for doubtful accounts, inventory reserves and income taxes. These policies require that we make estimates in the preparation of our financial statements as of a given date.

Within the context of these critical accounting policies, we are not currently aware of any reasonably likely events or circumstances that would result in materially different amounts being reported.

18-------------------------------------------------------------------------------- Table of Contents Revenue Recognition. Our major revenue-generating products consist of switches and routers, console management, physical layer products, and fiber optic components. We recognize product revenue, net of sales discounts, returns and allowances, when persuasive evidence of an arrangement exists, delivery has occurred and all significant contractual obligations have been satisfied, the fee is fixed or determinable and collection is considered reasonably assured.

Products are generally shipped "FOB shipping point," with no right of return and revenue is recognized upon shipment. If revenue is to be recognized upon delivery, such delivery date is tracked through information provided by the third party shipping company we use to deliver the product to the customer.

Network Integration resells third party products. We recognize revenue on these sales on a gross basis, as a principal, because we are the primary obligor in the arrangement, we are exposed to inventory and credit risk, we negotiate the selling prices, and we sell the products as part of a solution in which we provide services. Sales of services and system support are deferred and recognized ratably over the contract period. Sales to end customers with contingencies, such as rights of return, rotation rights, conditional acceptance provisions and price protection, are infrequent and insignificant and are deferred until the contingencies have been satisfied or the contingent period has lapsed. For sales to distributors, we generally recognize revenue when product is sold to the distributor rather than when the product is sold by the distributor to the end user. In certain circumstances, distributors have limited rights of return, including stock rotation rights, and/or are entitled to price protection, where a rebate credit may be provided to the customer if we lower our price on products held in the distributor's inventory. We estimate and establish allowances for expected future product returns and credits. We record a reduction in revenue for estimated future product returns and future credits to be issued to the customer in the period in which revenue is recognized, and for future credits to be issued in relation to price protection at the time we make changes to our distributor price book. We monitor product returns and potential price adjustments on an ongoing basis and estimate future returns and credits based on historical sales returns, analysis of credit memo data, and other factors known at the time of revenue recognition.

We generally warrant our products against defects in materials and workmanship for 90 days to three year periods. The estimated cost of warranty obligations and sales returns and other allowances are recognized at the time of revenue recognition based on contract terms and prior claims experience.

Accounting for Multiple-Element Arrangements. We allocate arrangement consideration at the inception of the arrangement to all deliverables using the relative selling price method. The selling price we use for each deliverable is based on (a) vendor-specific objective evidence if available; (b) third-party evidence if vendor-specific objective evidence is not available; or (c) estimated selling price if neither vendor-specific objective evidence nor third-party evidence is available. We allocate discounts in the arrangement proportionally on the basis of the fair value of each deliverable.

Allowance for Doubtful Accounts. We make ongoing estimates relating to the collectability of our accounts receivable and maintain a reserve for estimated losses resulting from the inability of customers to meet their financial obligations to us. In determining the amount of the reserve, we consider our historical level of credit losses and make judgments about the creditworthiness of significant customers based on ongoing credit evaluations. Because we cannot precisely predict future changes in the financial stability of our customers, actual future losses from uncollectible accounts may differ from our estimates.

If the financial condition of our customers deteriorates, resulting in their inability to make payments, a larger reserve may be required. In the event we determine that a change in the allowance is appropriate, we would record a credit or a charge to selling, general and administrative expense in the period in which we make such a determination.

Concentration of Credit Risk. Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents placed with high credit quality institutions and accounts receivable due from customers. We perform ongoing credit evaluations of our customers and maintain reserves for potential credit losses.

Inventory. We make ongoing estimates relating to the net realizable value of inventories, based upon our assumptions about future demand and market conditions. If we estimate that the net realizable value of our inventory is less than the cost of the inventory recorded on our books, we record an adjustment to the cost basis equal to the difference between the cost of the inventory and the estimated net realizable market value. This adjustment is recorded as a charge to cost of goods sold, and includes estimates for excess quantities and obsolete inventory. If changes in market conditions result in reductions in the estimated net realizable value of our inventory below previous estimates, we would make further adjustments in the period in which we make such a determination and record a charge to cost of goods sold. At the time of recording the adjustment, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration of, or increase in, that newly established cost basis.

19-------------------------------------------------------------------------------- Table of Contents Software Development Costs. Development costs related to software products are expensed as incurred until the technological feasibility of the product has been established. Technological feasibility occurs when a working model is completed or a detail program design exists. After technological feasibility is established, additional costs are capitalized.

We believe that our process for internally developed software is essentially completed concurrent with the establishment of technological feasibility, and, accordingly, no software development costs for internally developed software have been capitalized to date.

Internal Use Software Development. Any software that we acquire, internally develop, or modify solely to meet our internal needs, and for which we have no substantive plan to market the software externally, is capitalized.

Income Taxes. As part of the process of preparing our interim financial statements, we estimate the income taxes in each of the jurisdictions in which we operate based on the estimated effective tax rate by jurisdiction. This process involves estimating the current income tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for income tax and accounting purposes. These differences result in deferred income tax assets and liabilities, which are included in our Balance Sheets. We assess the likelihood that our deferred income tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we include an expense within the income tax provision in the Statements of Operations.

We utilize significant management judgment to determine the provision for income taxes, deferred income tax assets and liabilities, including uncertain tax positions, and any valuation allowance recorded against net deferred income tax assets. Management periodically evaluates the deferred income tax assets as to whether it is likely that the deferred income tax assets will be realized. We establish a valuation allowance on the deferred income tax asset at the time we determine the asset is not likely to be realized. If we later determine that it is more likely than not that a deferred tax asset will be realized, we release the valuation allowance and record a credit within the Statements of Operations.

Share-Based Compensation. We determine the fair value of stock options using the Black-Scholes valuation model. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates. Our estimates may be impacted by certain variables including stock price volatility, employee stock option exercise behaviors, additional stock option grants, estimates of forfeitures, and the related income tax impact. (See Note 9 "Share-Based Compensation" to the Financial Statements in Item 1, Part 1 of this Form 10-Q for further discussion.) Correction of an Immaterial Error During the quarter ended June 30, 2014, the Company made an out-of-period adjustment to defer previously recognized revenue of $2 million, which resulted in an increase to after-tax net loss of $0.1 million for the three and six months ended June 30, 2014. The Company reduced cost of sales by $1.8 million, gross profit by $0.2 million and the provision for income taxes by $0.1 million related to prior periods to remove the effect of the previously recognized revenue. These out of period adjustments also resulted in an increase in Inventory of $1.9 million, deferred revenue of $2 million and deferred income taxes, net of current portion by $0.1 million. The impact on accumulated deficit and stockholder's equity was a reduction by $0.1 million. The Company evaluated the effects of this adjustment on the Company's consolidated financial statements and concluded that the error was not material to any prior annual or interim periods. Individually and in the aggregate, these out-of-period adjustments did not have a material impact on the Company's consolidated financial statements for the quarter and year to date periods ended June 30, 2014.

20-------------------------------------------------------------------------------- Table of Contents Currency Rate Fluctuations Changes in the relative values of non-U.S. currencies to the U.S. dollar affect our results. We conduct a significant portion of our business in foreign currencies, including the Euro, the Taiwan dollar and the Israeli new shekel.

For the six months ended June 30, 2014 and 2013, 69% and 67% of revenue and 43% and 39% of operating expenses, respectively, were incurred at subsidiaries with a reporting currency other than the U.S. dollar. For the six months ended June 30, 2014, these currencies strengthened slightly against the U.S. dollar compared to the six months ended June 30, 2013, so revenue and expenses in these currencies translated into slightly fewer dollars than they would have in the prior period. The Euro and Israeli new shekel strengthened 4% and 5% respectively against the U.S. dollar in six months ended June 30, 2014 compared to six months ended June 30, 2013. The Company's Taiwan subsidiary, Appointech, Inc., is included in Network Equipment that also includes our Optical Communications Systems ("OCS") division. Relative to OCS, the revenues and related operating gross profit and operating expenses are not material and the change in foreign currency did not have a material impact on the results for the three and six months ended June 30, 2014 compared to the three and six months ended June 30, 2013. Additional discussion of foreign currency risk and other market risk is included in Part I, Item 3 "Quantitative and Qualitative Disclosures About Market Risk" of this Form 10-Q.

Management Discussion Snapshot The following table sets forth, for the periods indicated, certain consolidated and segment Statements of Operations data (dollars in thousands): Three months ended June 30, Six months ended June 30, 2014 2013 2014 2013 $ % (1) $ % (1) $ % (1) $ % (1) Revenue (1) (2) $ 43,124 100 % $ 38,175 100 % $ 85,442 100 % $ 77,080 100 % Network Equipment 21,833 51 21,100 55 44,152 52 42,046 55 Network Integration 21,355 50 17,135 45 41,408 48 35,117 46 Gross profit (3) $ 14,782 34 $ 13,372 35 $ 28,033 33 $ 26,399 34 Network Equipment 11,185 51 11,183 53 21,944 50 21,949 52 Network Integration 3,598 17 2,187 13 6,088 15 4,444 13 Operating $ 33,008 expenses (4) $ 15,908 37 $ 13,907 36 39 $ 30,947 40 Network Equipment 12,688 58 11,480 54 26,287 60 23,364 56 Network Integration 1,894 9 1,511 9 3,538 9 3,078 9 Operating income $ (4,975 ) (loss) (3) (4) $ (1,126 ) (3 ) $ (535 ) (1 ) (6 ) $ (4,548 ) (6 ) Network Equipment (1,503 ) (7 ) (296 ) (1 ) (4,343 ) (10 ) (1,415 ) (3 ) Network Integration 1,704 8 675 4 2,550 6 1,366 4 ___________________________________ (1) Consolidated Statements of Operations data and segment revenue data express percentages as a percentage of consolidated revenue. Other Statements of Operations data by segment express percentages as a percentage of applicable segment revenue.

(2) Revenue information by segment includes intersegment revenue reflecting sales of Network Equipment to Network Integration.

(3) Consolidated gross profit data reflects adjustments for intersegment eliminations.

(4) Consolidated operating expenses include corporate unallocated operating expenses.

21-------------------------------------------------------------------------------- Table of Contents Three months ended June 30, 2014 Compared to the Three months ended June 30, 2013 Revenue The following table summarizes revenue by segment, including intersegment sales (dollars in thousands): Favorable/(Unfavorable) Three months ended June $ % % Change constant 30: 2014 2013 Change Change currency (1) Network Equipment $ 21,833 $ 21,100 $ 733 3 % 3 % Network Integration 21,355 17,135 4,220 25 19 Before intersegment adjustments 43,188 38,235 4,953 13 10 Intersegment adjustments (2) (64 ) (60 ) (4 ) 7 7 Total $ 43,124 $ 38,175 $ 4,949 13 % 10 % ___________________________________ (1) Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.

(2) Adjustments represent the elimination of intersegment revenue.

Consolidated revenue for the second quarter of 2014 increased $4.9 million, or 13%, compared to the second quarter of 2013, due to a $4.2 million, or 25%, increase in Network Integration revenue, and a $0.7 million, or 3%, increase in Network Equipment revenue. The above discussion includes the out-of-period adjustment of $2 million related to deferred revenue which decreased consolidated revenue in the current period.

Network Equipment. Revenue generated from Network Equipment increased $0.7 million, or 3%, in the second quarter of 2014 compared to the second quarter of 2013. The increase is primarily due to higher product revenues that were partially offset by lower service revenue volume. Revenues for our carrier Ethernet networking, optical transport and out of band products increased in the second quarter of 2014 compared to same period in the prior year, which was partially offset by a decrease in network infrastructure management. Service revenues were down 8% in the second quarter of 2014 compared to the same period last year primarily due to the roll off of older deferred service contracts that related to revenues scheduled for recognition prior to the effective date of ASU 2009-13. Geographically, the increase in revenues at Network Equipment was attributable to growth in our Europe and Asia Pacific regions. The improvement in our Europe region was attributable to increased sales to our large customers and channel partners. In Asia Pacific, there was increased order volume over the same period in the prior year from a Tier One carrier. Our Americas region was primarily down due to delays on some orders from some of our larger South American customers. The foreign exchange impact to Network Equipment revenue was not material.

The following table summarizes Network Equipment revenue by geographic region (dollars in thousands): Favorable/(Unfavorable) Three months ended June 30: 2014 2013 $ Change % Change Revenue, excluding intersegment sales: Americas $ 13,554 $ 13,675 $ (121 ) (1 )% Americas (Excluding the U.S.) 126 855 (729 ) (85 ) Europe 5,167 4,734 433 9 Asia Pacific 2,922 1,776 1,146 65 Total external sales 21,769 21,040 729 3 Sales to Network Integration: Europe 64 60 4 7 Total intersegment sales 64 60 4 7Total Network Equipment revenue $ 21,833 $ 21,100 $ 733 3 % 22-------------------------------------------------------------------------------- Table of Contents Network Integration. Revenue generated from Network Integration increased $4.2 million, or 25%, in the second quarter of 2014 compared to the second quarter of 2013. The $4.2 million increase in revenue was due to a $3.3 million, or 41%, increase in product revenue and a $0.9 million, or 10%, increase in service revenues at Tecnonet. Tecnonet has seen an increase in product revenue order volume arising from large orders from the two largest telecommunication carriers in Italy. The increase in service revenue was the result of our continued focus on this aspect of the business that has higher margins. Total revenue from this segment would have been $1.0 million, or 5% lower in the second quarter of 2014, compared to the second quarter of 2013, had foreign currency exchange rates remained the same as they were in the second quarter of 2013. All revenue in Network Integration was generated in Italy. The above discussion includes the out-of-period adjustment of $2 million related to deferred revenue which decreased Network Integration revenue in the current period.

Gross Profit The following table summarizes gross profit by segment (dollars in thousands): Favorable/(Unfavorable) $ % % Change constant Three months ended June 30: 2014 2013 Change Change currency (1) Network Equipment $11,185 $11,183 $2 - % - % Network Integration 3,598 2,187 1,411 65 57 Before intersegment adjustments 14,783 13,370 1,413 11 9 Adjustments (2) (1 ) 2 (3 ) (150 ) (80 ) Total $14,782 $13,372 $1,410 11 % 9 % (1) Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.

(2) Adjustments represent the change in the elimination of intersegment profit in ending inventory in order to reconcile to consolidated gross profit.

Consolidated gross profit increased $1.4 million in the second quarter of 2014 compared to the prior year second quarter, principally due to the 13% increase in revenue that was partially offset by a 70 basis points decline in gross profit as a percentage of revenue (gross margin), which was primarily due to pressure on pricing and revenue mix. Gross margin for the second quarter of 2014 was 34.3%, as compared to 35.0% in the second quarter of 2013. The decrease was due to the shift of segment revenue mix toward a higher percentage of total revenue coming from Network Integration, which has lower gross margins than Network Equipment, and a decrease in Network Equipment gross margins. These decreases in gross margin were partially offset by a more favorable consolidated product to service revenue mix in the second quarter of 2014 as compared to the second quarter of 2013. In the second quarter of 2014, the consolidated effect of the change in constant currency was 9%, due to fluctuation of the Euro. The above discussion includes the out-of-period adjustment of $0.2 million related to deferred revenue which decreased consolidated gross profit in the current period.

Network Equipment. Gross profit for Network Equipment in the second quarter of 2014 decreased compared to the second quarter of the prior year. The effect of higher sales volume was essentially offset by a 180 basis point decrease in gross margins. We had a shift in the mix of product revenue toward our lower gross margin products, a negative effect on costs from lower production volume efficiency, and to a lesser extent, a write down of inventory. These effects partially offset by lower production labor and overhead costs arising from cost saving initiatives implemented during the fourth quarter of 2013.

23-------------------------------------------------------------------------------- Table of Contents Network Integration. Gross profit in the second quarter of 2014 as compared to the second quarter of 2013 for Network Integration increased $1.4 million, or 65%. The increase was essentially the result of the volume impact of the $4.2 million increase in revenue. Gross margins increased 410 basis points in the second quarter compared to the second quarter last year due to an improvement in product revenue gross margins. In first half of 2014, we experienced an easing of the competitive pressure present during the first half of 2013 that resulted in significantly lower product revenue gross margins on second quarter 2013 product revenues. In the second quarter of 2014, the effect of the change in constant currency was $0.2 million, or 5%, compared to the second quarter of 2013. The above discussion includes the out-of-period adjustment of $0.2 million related to deferred revenue which decreased Network Integration gross profit in the current period.

Operating Expenses The following table summarizes operating expenses by segment (dollars in thousands): (Favorable)/Unfavorable $ % % Change constant Three months ended June 30: 2014 2013 Change Change currency (1) Network Equipment $12,688 $11,480 $1,208 11 % 11 % Network Integration 1,894 1,511 383 25 % 19 % Total segment operating expenses 14,582 12,991 1,591 12 % 12 % Corporate unallocated operating expenses and adjustments (2) 1,326 916 410 45 % 45 % Total $15,908 $13,907 $2,001 14 % 14 % (1) Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.

(2) Corporate unallocated operating expenses include unallocated product development, and selling, general and administrative expenses.

Consolidated operating expenses in the second quarter of 2014 were $15.9 million, or 37% of revenue, compared to $13.9 million, or 36% of revenue, in the second quarter of 2013, an increase of $2.0 million. The increase is primarily due to an increase in Network Equipment expenses of $1.2 million and an increase of $0.4 million in expenses at Network Integration and a $0.4 million increase of Corporate unallocated operating expenses as discussed below.

Network Equipment. Operating expenses in Network Equipment for the second quarter of 2014 were $12.7 million, or 58% of revenue, compared to $11.5 million, or 54% of revenue in the second quarter of 2013. The $1.2 million, or 11%, increase was planned for and was due to a $0.8 million increase in salary costs for engineers supporting our product development initiatives, $0.3 million increase in salaries to realign the U.S. sales organization and a $0.3 million increase in administrative labor. These increases were offset by a $0.2 million decrease in external consulting expenses.

Network Integration. Operating expenses in Network Integration for the second quarter of 2014 were $1.9 million, or 9% of revenue, compared to $1.5 million, or 9% of revenue, in the second quarter of 2013. The increase was mainly due to $0.2 million of sales labor support costs to support increased revenue volume and an increase of $0.2 million in administrative overhead. In the second quarter of 2014, the consolidated effect of the increase in constant currency was $0.1 million or 5% compared to the second quarter of 2013.

Corporate. Corporate expenses increased by $0.4 million in the second quarter of 2014 compared to the second quarter of 2013, which included an insurance recovery of $1.0 million for legal fees incurred during the derivative litigation that was settled in June 2013. Other items leading to the $0.4 million remaining variance included $0.3 million in lower labor and consulting fees and $0.3 million in lower legal fees incurred during the period.

24-------------------------------------------------------------------------------- Table of Contents Operating Income (Loss) The following table summarizes operating income (loss) by segment (dollars in thousands): Favorable/(Unfavorable) $ % % Change constant Three months ended June 30: 2014 2013 Change Change currency(1) Network Equipment ($1,503 ) ($296 ) ($1,207 ) 408 % 406 % Network Integration 1,704 675 1,029 152 140 Total segment operating income (loss) 201 379 (178 ) (47 ) (69 ) Corporate unallocated and adjustments (2) (1,327 ) (914 ) (413 ) (45 ) 45 Total ($1,126 ) ($535 ) ($591 ) 110 % 125 % (1) Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.

(2) Adjustments represent the elimination of intersegment revenue and profit in inventory in order to reconcile to consolidated operating income (loss).

Network Equipment. Network Equipment reported an operating loss of $1.5 million and $0.3 million in the second quarter of 2014 and 2013, respectively. The change in operating loss was due to a $1.2 million planned increase in operating expenses. Operating margin was (7)% in 2014 and (1)% in 2013.

Network Integration. Network Integration reported operating income of $1.7 million for the second quarter of 2014, compared to $0.7 million in the second quarter of 2013. Excluding the out-of-period adjustment related to deferred revenue, which would have increased Network Integration operating income by $0.2 million, the increase was primarily due to the $1.4 million increase in gross profit that was partially offset by a $0.3 million increase in operating costs.

Network Integration operating margin was 8% and 4% for the three months ended June 30, 2014 and 2013, respectively.

Interest Expense and Other Expense, Net Interest expense was $0.04 million in the second quarter of 2014 compared to $0.2 million in the second quarter of 2013. Other expense, net, principally includes interest income on cash, cash equivalents and investments and gains and losses on foreign currency transactions and the litigation settlement.

Provision for Income Taxes The tax provision for the three months ended June 30, 2014 and 2013 was $0.7 million and $0.1 million, respectively. Our income tax provision fluctuates based on the amount of pre-tax income or loss generated in the various jurisdictions where we conduct operations and pay income tax. The income tax expense on the loss before provision for income taxes of $1.6 million in the second quarter of 2014 is due to income tax associated with our foreign subsidiaries that do not benefit from our federal net operating loss carryforwards and from the accrual of an income tax liability, including interest and penalties, of $0.3 million on a settlement of a tax audit of a foreign subsidiary.

Italy Tax Audit Settlement In 2013 the Italian Tax Authorities commenced an examination of Tecnonet S.p.A., a wholly owned foreign subsidiary, and proposed a 100% disallowance of the deduction of certain sponsorship and advertising expenses for the years 2006 to 2011. We felt strongly that the deductions were fully supported by Italian tax law and that we would more likely than not prevail if we litigated the disallowance in the Italian tax courts. Therefore, there was no unrecognized benefit or income tax liability accrued in 2013 and the first quarter of 2014 related to this tax audit. During the second quarter of 2014, the Italian tax authorities offered to reduce the 100% disallowance by 45% and then by 60% ("60% offer"). Our local outside tax advisers have advised us that the 60% offer is a good result and that litigating the matter in Italian courts may be a protracted process despite the strong technical merits of our tax position. In consideration of our tax adviser's assessment and our desire to resolve this uncertainty, management accepted the 60% offer and settled with the Italian tax authorities in July 2014.

25-------------------------------------------------------------------------------- Table of Contents In accordance with ASC 740 and our accounting policy the interest and penalties of $0.1 million related to the accrued income tax expense of $0.2 million are recognized in the income tax expense line in the accompanying consolidated statement of operations. Accrued interest and penalties are included in the related income tax liability in the consolidated balance sheet. The interest and penalties of $0.1 million and accrued VAT expense of $0.1 million related to the settlement are recognized in the other expenses line in the accompanying consolidated statement of operations. Accrued interest and penalties are included in the related current accrued liability in the consolidated balance sheet.

Tax Loss Carryforwards As of December 31, 2013, we had net operating losses ("NOLs") of $172.3 million, $93.1 million, and $95.8 million for federal, state, and foreign income tax purposes, respectively. Additionally, the Company has capital loss carryforwards of $110.5 million and $24.0 million for federal and state tax purposes, respectively. The capital loss carry forwards, which were generated by the sale of Source Photonics, expire in 2015. Under the Internal Revenue Code, if a corporation undergoes an "ownership change," the corporation's ability to use its pre-change NOLs, capital loss carry forwards and other pre-change tax attributes to offset its post-change income may be limited. An ownership change is generally defined as a greater than 50% change in its equity ownership by value over a three-year period. We may experience an ownership change in the future as a result of subsequent shifts in our stock ownership. If we were to trigger an ownership change in the future, our ability to use any NOLs and capital loss carry forwards existing at that time could be limited. As of June 30, 2014, the US federal and state NOLs had a full valuation allowance.

Six months ended June 30, 2014 Compared To Six months ended June 30, 2013 Revenue The following table summarizes revenue by segment, including intersegment sales (dollars in thousands): Favorable/(Unfavorable) Six months ended June $ % % Change constant 30: 2014 2013 Change Change currency (1) Network Equipment group $ 44,152 $ 42,046 $ 2,106 5 % 5 % Network Integration group 41,408 35,117 6,291 18 13 Before intersegment adjustments 85,560 77,163 8,397 11 9 Intersegment adjustments (2) (118 ) (83 ) (35 ) 42 41 Total $ 85,442 $ 77,080 $ 8,362 11 % 9 % ___________________________________ (1) Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.

(2) Adjustments represent the elimination of intersegment revenue.

Consolidated revenue for the six months ended June 30, 2014 increased $8.4 million, or 11%, compared to the comparable period of 2013. This increase was due to a $6.3 million increase in Network Integration revenue, a $2.1 million increase in Network Equipment revenue, and a $0.04 million decrease in Intersegment adjustments, which are eliminated in consolidation. Consolidated revenue would have been $1.8 million lower if foreign currency exchange rates had remained the same as they were in the first six months of 2013. The above discussion includes the out-of-period adjustment of $2 million related to deferred revenue which decreased consolidated revenue in the current period.

26-------------------------------------------------------------------------------- Table of Contents Network Equipment Group. Revenue generated from the Network Equipment group increased $2.1 million in the six months ended June 30, 2014 compared to the six months ended June 30, 2013. Revenues increased primarily due to a $2.8 million increase in product revenue offset by a $0.7 million decrease in service revenue. Revenues for our carrier Ethernet networking and out of band products increased during the first six months 2014 compared to the prior year period, which was partially offset by a decrease in optical transport products. Service revenues were down 11% as compared to same period last year primarily due to the roll off of older deferred service contracts that related to revenues scheduled for recognition prior to the effective date of ASU 2009-13. Geographically, Asia Pacific and Europe revenues increased $3.3 million that was partially offset by a $1.2 million decrease in OCS Americas. The decrease in OCS Americas was primarily due to a revenue decline South American portion of the region that was partially offset by modest revenue growth in the North American portion of the region.

The following table summarizes Network Equipment revenue by geographic region (dollars in thousands): Favorable/(Unfavorable) Six months ended June 30: 2014 2013 $ Change % Change Revenue, excluding intersegment sales: Americas $ 26,411 $ 25,800 $ 611 2 % Americas (Excluding the U.S.) 682 2,480 (1,798 ) (73 )% Europe 11,693 10,173 1,520 15 Asia Pacific 5,249 3,510 1,739 50 Total external sales $ 44,035 $ 41,963 $ 2,072 5 Sales to Network Integration group: Europe 117 83 34 41 Total intersegment sales 117 83 34 41 Total Network Equipment revenue $ 44,152 $ 42,046 $ 2,106 5 % Network Integration Group. Revenue generated from the Network Integration group was $6.3 million, or 18% higher for the six months ended June 30, 2014 compared to the six months ended June 30, 2013. This increase was due to a $5 million, or 28% increase in product revenue and $1.3 million, or 8% increase in service revenues at Tecnonet. Tecnonet has seen an increase in product revenue order volume as a result of increasing its market share. The increase in service revenue was a result of our continued focus on this aspect of the business that has higher margins and potential for growth. Revenue would have been $1.8 million lower for the six months ended June 30, 2014 had foreign currency exchange rates remained the same as they were in the six months ended June 30, 2013. All revenue in the Network Integration group was generated in Italy. The above discussion includes the out-of-period adjustment of $2 million related to deferred revenue which decreased Network Integration revenue in the current period.

27-------------------------------------------------------------------------------- Table of Contents Gross Profit The following table summarizes gross profit by segment (dollars in thousands): Favorable/(Unfavorable) $ % % Change constant Six months ended June 30: 2014 2013 Change Change currency (1) Network Equipment group $ 21,944 $ 21,949 $ (5 ) - % - % Network Integration group 6,088 4,444 1,644 37 31 Before intersegment adjustments 28,032 26,393 1,639 6 5 Adjustments (2) 1 6 (5 ) (83 ) (80 ) Total $ 28,033 $ 26,399 $ 1,634 6 % 5 % (1) Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.

(2) Adjustments represent the change in the elimination of intersegment profit in ending inventory in order to reconcile to consolidated gross profit.

Consolidated gross profit increased $1.6 million, or 6% for the six months ended June 30, 2014 from the prior year period, due to the 11% increase in revenue that was partially offset by a decrease in gross margin from 34% to 33%. The decline in gross margins was due to the shift of segment revenue mix toward a higher percentage of total revenue coming from Network Integration, which has lower gross margins than Network Equipment, and due to a decrease in Network Equipment gross margins. These decreases in gross margin were partially offset by a more favorable consolidated product to service revenue mix in the six months ended June 30, 2014 as compared to the six months ended June 30, 2013.

Gross profit would have been $0.3 million lower for the six months ended June 30, 2014 if foreign currency exchange rates had remained the same as they were in the first six months of 2013. The above discussion includes the out-of-period adjustment of $0.2 million related to deferred revenue which decreased consolidated gross profit in the current period.

Network Equipment Group. Gross profit for Network Equipment for the six months ended June 30, 2014 remained unchanged compared to the six months ended June 30, 2013. The effect of higher sales volume was essentially offset by a 250 basis point decrease in gross margins. An increase in sales to our European channel partners, which have lower gross margins and lower pricing of mature products in advance of new products combined to have a negative impact on Network Equipment's gross margins. In addition, we had a shift in the mix of product revenue toward our lower gross margin products, a negative effect from lower volume efficiency within service gross margins, and a write down of inventory being replaced with our newly launched OptiDriver product line. These effects partially offset by lower production labor and overhead costs arising from cost saving initiatives implemented during the fourth quarter of 2013. Gross profit would have been flat in the six months of 2014 had foreign currency exchange rates remained the same as they were in the first six months of 2013.

Network Integration Group. Gross profit for the Network Integration group increased $1.6 million, or 37% for the six months ended June 30, 2014 as compared to six months ended June 30, 2013. Excluding the out-of-period adjustment in gross profit of $0.2, the increase was primarily due to an $6.3 million increase in revenue for the six months ended June 30, 2014 compared to the prior year period as discussed above. In addition, gross margins increased 200 basis points for the six months ended June 30, 2014 compared to the prior year period due to an improvement in product revenue gross margins. In first half of 2014, we experienced an easing of the competitive pressure present during the first half of 2013 that resulted in significantly lower product revenue gross margins on first half 2013 product revenues. Gross profit would have been $0.3 million lower in the first six months of 2014 had foreign currency exchange rates remained the same as they were in the first six months of 2013. The above discussion includes the out-of-period adjustment of $0.2 million related to deferred revenue which decreased Network Integration gross profit in the current period.

28-------------------------------------------------------------------------------- Table of Contents Operating Expenses The following table summarizes operating expenses by segment (dollars in thousands): (Favorable)/Unfavorable $ % % Change constant Six months ended June 30: 2014 2013 Change Change currency (1) Network Equipment group $26,287 $23,364 $2,923 13 % 13 % Network Integration group 3,538 3,078 460 15 % 10 % Total segment operating expenses 29,825 26,442 3,383 13 % 374 % Corporate unallocated operating expenses and adjustments (2) 3,183 4,505 (1,322 ) (29 )% (29 )% Total $33,008 $30,947 $2,061 7 % 6 % (1) Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.

(2) Corporate unallocated operating expenses include unallocated product development, and selling, general and administrative expenses.

Consolidated operating expenses were $33.0 million, or 39% of revenue, for the first six months of 2014 compared to $30.9 million, or 40% of revenue, for the prior year period, an increase of $2.1 million, or 7%, $1.0 million of which was due to insurance proceeds recorded in the second quarter of 2013 in conjunction with a derivative litigation settled that quarter. The remaining increase included a $2.9 million increase in Network Equipment and $0.5 million increase in Network Integration related to investments in the core business offset by a $0.3 million decrease in Corporate, excluding the effect of the insurance proceeds.

Network Equipment Group. Operating expenses in the Network Equipment group for the first six months of 2014 were $26.3 million, or 60% of revenue, compared to $23.4 million, or 56% of revenue in the prior year period of 2013. The $2.9 million or 13% increase was due to $1.9 million in additional costs related to the planned higher investment in engineering and product development to drive future product development, an increase of $1.0 million in sales and back office support costs.

Network Integration Group. Operating expenses in the Network Integration group for the first six months of 2014 were $3.5 million, or 9% of revenue, compared to $3.1 million, or 9% of revenue, for the prior year period. The $0.5 million or 15% increase .in operating expense was primarily due to additional sales and administrative labor costs. Operating expenses would have been $0.1 million lower in the first six months of 2014 had foreign currency exchange rates remained the same as they were in the prior year period.

Corporate. Operating expenses decreased $1.3 million in the first six months of 2014 compared to the first six months of 2013. This decrease partially resulted from $1.1 million in lower labor and consulting fees incurred during the 2013 transition of the corporate office and $0.4 million in lower auditing fees and accounting support fees arising from improved processes and a change in auditing firms. The six months ended June 30, 2013 were also burdened by $1.3 million in legal fees costs arising from the derivative litigation that was settled in June 2013 and costs for an investigation of claims by a former employee that were partially offset by $1.0 million in insurance recovery for legal fees incurred during the derivative litigation that was settled in June 2013. These decreases were partially offset by recording a charge in the first six months of 2014 of $0.4 million for the revaluation of warrants issued in accordance with the June settlement of the derivative litigation.

29-------------------------------------------------------------------------------- Table of Contents Operating Income (Loss) The following table summarizes operating income (loss) by segment (dollars in thousands): Favorable/(Unfavorable) $ % % Change constant Six months ended June 30: 2014 2013 Change Change currency(1) Network Equipment group $ (4,343 ) $ (1,415 ) $ (2,928 ) 207 % 207 % Network Integration group 2,550 1,366 1,184 87 78 Total segment operating income (loss) (1,793 ) (49 ) (1,744 ) 3,559 3,802 Corporate unallocated and adjustments (2) (3,182 ) (4,499 ) 1,317 29 (29 ) Total $ (4,975 ) $ (4,548 ) $ (427 ) 9 % 12 % (1) Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.

(2) Adjustments represent the elimination of intersegment revenue and profit in inventory in order to reconcile to consolidated operating income (loss).

The $1.6 million, or 6%, increase in gross profit and the $2.1 million, or 7%, increase in operating expenses primarily led to a $0.4 million increase in our operating loss. Our operating loss would have been $0.1 million lower in the first six months of 2014 had foreign currency exchange rates remained the same as they were in the prior year period. Operating losses included share-based compensation expense of $0.5 million and $0.3 million in the first six months of 2014 and 2013, respectively. The Company recorded an out-of-period adjustment that increased the consolidated operating loss by $0.2 million for the six months ended June 30, 2014.

Network Equipment Group. The Network Equipment group reported an operating loss of $4.3 million and $1.4 million in the first six months of 2014 and 2013, respectively. The change in operating profit was due to the $2.9 million planned increase in operating expenses. Operating margin was (10)% in the first six months of 2014 and (3)% in 2013, respectively.

Network Integration Group. The Network Integration group reported operating income of $2.6 million for the first six months of 2014, compared to operating income of $1.4 million for the prior year period. The increase in operating profit was primarily due to the 18% increase in Network Integration revenues.

The Network Integration group operating margin was 6% in the first six months of 2014 compared to 4% in the first six months of 2013. The Network Integration group recorded an out-of-period adjustment that increased its operating loss by $0.2 million for the six months ended June 30, 2014.

Interest Expense and Other Expense, Net Interest expense was $0.2 million in the six months ended June 30, 2014 and $0.4 million the six months ended June 30, 2013, respectively. Other expense, net, principally includes interest income on cash, cash equivalents and investments and gains and losses on foreign currency transactions.

Provision for Income Taxes The tax provision for the six months ended June 30, 2014 and 2013 was $0.9 million and $0.4 million, respectively. Our income tax provision fluctuates based on the amount of pre-tax income or loss generated in the various jurisdictions where we conduct operations and pay income tax. The income tax expense on the loss before provision for income taxes of $5.6 million for the six months ended June 30, 2014, is due to income tax associated with our foreign subsidiaries that do not benefit from our federal net operating loss carryforwards and from the accrual of an income tax liability, including interest and penalties, of $0.3 million on a settlement of a tax audit of a foreign subsidiary.

30-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources During the six months ended June 30, 2014, our cash and restricted time deposits decreased from $27.8 million to $22.6 million, a decrease of $5.3 million. Our cash outflows included a net loss adjusted for non-cash expenses of $4.6 million including depreciation and amortization, share-based compensation, provision for doubtful accounts, and deferred taxes. In addition there were cash outflows from working capital of $1.6 million, including a $4.9 million increase in inventory due to higher volumes and timing of shipments, a $2.8 million increase in other assets due to lower factoring of receivables at Tecnonet, a $1.9 million decrease in accrued liabilities due to timing of payments of accrued expenses, offset by a $0.6 million decrease in accounts receivable due to lower factoring of receivables at Tecnonet, a $4.2 million increase in accounts payable due to an increase in materials purchased, and a $3.2 million increase in deferred revenue as a result of the timing of shipments. Cash used in investing activities included $1.2 million in purchases of property, plant, and equipment.

Cash provided by financing activities included additional borrowings of $12.4 million, partially offset by payments on short-term debt of $10.3 million at Tecnonet.

We periodically review our capital position and consider returning capital to stockholders through special dividends or share repurchases when cash on hand exceeds our foreseeable cash needs. We also periodically review the capital needs of our business units. We plan to invest approximately $2.4 million over the next 12 months to upgrade our infrastructure and equipment needed to support the Company's growth objectives in the Carrier Ethernet and optical transport markets among others. The nature of the Tecnonet business requires significant levels of working capital to finance the longer term receivables and the extended acceptance periods for its larger customers. The financing for its working capital needs is met through the use of factoring certain receivables.

Tecnonet has minimal capital requirements and does not conduct research and development. Therefore, we do not anticipate Tecnonet's business to require significant investment to support our strategic objectives in the Italian information technology market. We believe that cash on hand and cash flows from operations and existing financing will be sufficient to satisfy current operating needs, capital expenditures, and product development and engineering requirements for at least the next 12 months. We may seek to obtain additional debt or equity financing if we believe it appropriate. We may limit our ability to use available NOLs and capital loss carryforwards if we seek financing through issuance of additional equity securities.

The following table summarizes MRV's cash position including cash and cash equivalents, restricted time deposits and our short-term debt position (dollars in thousands): June 30, 2014 December 31, 2013 Cash Cash and cash equivalents $ 22,320 $ 27,591 Restricted time deposits 250 249 22,570 27,840 Short-term debt 6,370 4,320 Cash in excess of debt $ 16,200 $ 23,520 Ratio of cash to debt (1) 3.5 6.4 (1) Determined by dividing total cash by total debt.

Short-term Debt Our short-term debt is related to Tecnonet, our Italian Network Integration subsidiary. Customer accounts receivables of Tecnonet have been pledged as collateral on the related borrowings.

The following table summarizes our short-term debt (in thousands): June 30, 2014 December 31, 2013 Increase (decrease) Lines of credit secured by accounts receivable $ 6,370 $ 4,320 $ 2,050 31-------------------------------------------------------------------------------- Table of Contents The increase in short-term debt at June 30, 2014 includes additional borrowings of $12.4 million, offset by payments of $10.3 million and the impact of changes in foreign currency exchange rates.

Working Capital The following table summarizes our working capital position (dollars in thousands).

June 30, 2014 December 31, 2013 Current assets $ 118,751 $ 117,170 Current liabilities 64,260 58,921 Working capital $ 54,491 $ 58,249 Current ratio (1) 1.8 2.0 (1) Determined by dividing total current assets by total current liabilities.

Off-Balance Sheet Arrangements We do not have transactions, arrangements or other relationships with unconsolidated entities that are reasonably likely to affect our liquidity or capital resources. We have no special purpose or limited purpose entities that provided off-balance sheet financing, liquidity or market or credit risk support, engaged in leasing, hedging, research and development services, or other relationships that expose us to liability that is not reflected on the face of the financials.

Contractual Obligations During the quarter ended June 30, 2014, there were no material changes in our contractual obligations.

Internet Access to Our Financial Documents We maintain a website at www.mrv.com. We make available, free of charge, either by direct access or hyperlink, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. Our reports filed with, or furnished to, the SEC are also available directly at the SEC's website at www.sec.gov.

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