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CAVIUM, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
[October 31, 2014]

CAVIUM, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations


(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and the related notes that appear elsewhere in this document.

The information in this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended ("Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended ("Exchange Act"), which are subject to the "safe harbor" created by those sections. Forward-looking statements are based on our management's beliefs and assumptions and on information currently available to our management. In some cases, you can identify forward-looking statements by terms such as "may," "will," "should," "could," "would," "estimate," "project," "predict," "potential," "continue," "strategy," "believe," "anticipate," "plan," "expect," "intend" and similar expression intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this Quarterly Report on Form 10-Q in greater detail under the heading "Risk Factors." Given these risks, uncertainties and other factors, you should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this filing. You should read this Quarterly Report on Form 10-Q completely and with the understanding that our actual future results may be materially different from what we expect. We hereby qualify our forward-looking statements by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.



OCTEON ®, OCTEON® PlusTM, OCTEON Fusion®, FusionStackTM, NITROX®, NEURONTM, CelestialTM , ECONA®, PureVu® and WiVuTM are trademarks or registered trademarks of Cavium, Inc.

18 -------------------------------------------------------------------------------- Overview We are a provider of highly integrated semiconductor processors that enable intelligent processing for networking, communications, storage, wireless, security, video and connected home and office applications. Our product allows our customers to develop networking, wireless, storage and electronic equipment that is application-aware and content-aware and securely processes voice, video and data traffic at high speeds. Our products are systems on a chip, or SoCs, which incorporate single or multiple processor cores, a highly integrated architecture and customizable software that is based on a broad range of standard operating systems. We focus our resources on the design, sales and marketing of our products, and outsource the manufacturing of our products.


Following summarizes our product timeline introduction throughout the period: Timeline History2000 through 2003 - We were incorporated and commenced product development.

- We began shipping NITROX security processors commercially.

2004 - We introduced and commenced commercial shipments of NITROX Soho.

2006 - We commenced our first commercial shipments of OCTEON multi-core processors.

2007 - We introduced our new line of OCTEON based storage services processors designed to address the specific needs in the storage market, as well as other new products in the OCTEON and NITROX families.

2008 - We expanded our OCTEON and NITROX product families with new products including wireless services processors to address the needs for wireless infrastructure equipment.

2009 - We announced the OCTEON II Internet ApplicationProcessor, or IAP, family multi-core MIPS64 processors.

- We acquired MontaVista Software, Inc. in December 2009. This acquisition complemented our broad portfolio of multi-core processors to deliver integrated and optimized embedded solutions to the market.

2010 - We announced the next generation NITROX III, a processor family with 16 to 64-cores that delivers security and compression processors for application delivery, cloud computing and wide area network optimization.

2011 - We introduced NEURON, a new search processor product family that targets a wide range of high performance, L2-L4 network search applications in enterprise and service provider infrastructure equipment.

- We also introduced another new product family, the OCTEON Fusion, a single chip SoCs with up to 6x MIPS64 cores and up to 8x LTE/3G baseband DSP cores which enable macro base station class features for small cell base stations.

2012 - We introduced OCTEON III, Cavium's 48-core 2.5GHz multi-core processor family that can deliver up to 100Gbps of application processing, up to 120GHz of 64-bit compute processing per chip and can be connected in multi-chip configurations.

- We announced Project Thunder, the development of a new family of 64-bit ARMv8 scalable multi-core processors for cloud and datacenter applications.

2013 - We introduced the LiquidIO family of 10 Gigabit Server Adapters which provide high-performance, programmable adapter platform to enable software defined networks for cloud service providers and datacenters.

2014 - We introduced the ThunderX family of 64-bit ARMv8 processors incorporated into a highly differentiated SoC architecture optimized for cloud and datacenter applications.

The following summarizes our acquisitions in the last five years: - We acquired MontaVista Software, Inc. in December 2009. This acquisition complemented our broad portfolio of multi-core processors to deliver integrated and optimized embedded solutions to the market.

- We acquired Celestial Systems, Inc. in October 2010. With the acquisition of Celestial Systems, we gained additional professional services such as Digital Media product development and Android commercialization and support.

- We completed the acquisition of substantially all of the assets and assumed certain liabilities of Wavesat, Inc. in January 2011. This acquisition added multicore wireless digital system processing to our embedded processor product line.

19 -------------------------------------------------------------------------------- - We completed the acquisition of substantially all of the assets and assumed certain liabilities of Celestial Semiconductor, Ltd. in March 2011. With the acquisition of Celestial Semiconductor, we added capabilities to enable a processor family targeted for the large and growing market of converged media, gateway and wireless display applications.

- We entered into an Agreement and Plan of Merger and Reorganization with Xpliant, Inc. in July 2014. The transaction contemplated by the Agreement and Plan of Merger and Reoganization is expected to be completed before April 15, 2015, subject to certain closing conditions.

Since inception, we have invested heavily in new product development and our net revenue has grown from $7.4 million in 2004 to $304.0 million in 2013 driven primarily by demand in the enterprise network and data center markets. Our net revenue for the nine months ended September 30, 2014 was $271.8 million. We expect sales of our products for use in the enterprise network and data center markets to continue to represent a significant portion of our revenue in the foreseeable future, however, we do not expect the same growth in the broadband and consumer as well as the access and service provider markets.

We primarily sell our products to OEMs, either directly or through their contract manufacturers. Contract manufacturers purchase our products only when an OEM incorporates our product into the OEM's product, not as commercial off-the-shelf products. Our customers' products are complex and require significant time to define, design and ramp to volume production. Accordingly, our sales cycle is long. This cycle begins with our technical marketing, sales and field application engineers engaging with our customers' system designers and management, which is typically a multi-month process. If we are successful, a customer will decide to incorporate our product in its product, which we refer to as a design win. Because the sales cycles for our products are long, we incur expenses to develop and sell our products, regardless of whether we achieve the design win and well in advance of generating revenue, if any, from those expenditures. We do not have long-term purchase commitments from any of our customers, as sales of our products are generally made under individual purchase orders. However, once one of our products is incorporated into a customer's design, it is likely to remain designed in for the life cycle of the product. We believe this to be the case because a redesign would generally be time consuming and expensive. We have experienced revenue growth due to an increase in the number of our products, an expansion of our customer base, an increase in the number of average design wins within any one customer and an increase in the average revenue per design win.

We also earn revenue from the sale of software subscriptions of embedded Linux operating system, related development tools, support and professional services.

The net revenue for our software and services operations are primarily derived from the sale of time-based software licenses, software maintenance and support, and from professional services arrangements and training.

Key Business Metrics Design Wins. We closely monitor design wins by customer and end market on a periodic basis. We consider design wins to be a key ingredient in our future success, although the revenue generated by each design win can vary significantly. Our long-term sales expectations are based on internal forecasts from specific customer design wins based upon the expected time to market for end customer products deploying our products and associated revenue potential.

Pricing and Margins. Pricing and margins depend on the features of the products we provide to our customers. In general, products with more complex configurations and higher performance tend to be priced higher and have higher gross margins. These configurations tend to be used in high performance applications that are focused on the enterprise network, data center, and access and service provider markets. We tend to experience price decreases over the life cycle of our products, which can vary by market and application.

Sales Volume. A typical design win can generate a wide range of sales volumes for our products, depending on the end market demand for our customers' products. This can depend on several factors, including the reputation, market penetration, the size of the end market that the product addresses, and the marketing and sales effectiveness of our customer. In general, our customers with greater market penetration and better branding tend to develop products that generate larger volumes over the product life cycle. In addition, some markets generate large volumes if the end market product is adopted by the mass market.

Customer Product Life Cycle. We typically commence commercial shipments from nine months to three years following a design win. Once our product is in production, revenue from a particular customer may continue for several years.

We estimate our customers' product life cycles based on the customer, type of product and end market. In general, products that go into the enterprise network and data center take longer to reach volume production but tend to have longer lives. Products for other markets, such as broadband and consumer, tend to ramp relatively quickly, but generally have shorter life cycles. We estimate these life cycles based on our management's experience with network equipment providers and data centers as well as the semiconductor market as a whole.

20-------------------------------------------------------------------------------- Results of Operations Our net revenue, cost of revenue, gross profit and gross margin for the periods presented were: Three Months Ended Nine Months Ended September September 30, 30, 2014 2013 change % 2014 2013 change % (in thousands) (in thousands) Net revenue $ 97,833 $ 79,124 $ 18,709 23.6 % $ 271,755 $ 222,858 $ 48,897 21.9 % Cost of revenue 35,710 28,516 7,194 25.2 % 99,957 85,620 14,337 16.7 % Gross Profit $ 62,123 $ 50,608 $ 11,515 22.8 % $ 171,798 $ 137,238 $ 34,560 25.2 % Gross Margin 63.5 % 64.0 % -0.5 % 63.2 % 61.6 % 1.6 % Net Revenue. Our net revenue consists primarily of sales of our semiconductor products to network equipment providers and data centers and their contract manufacturers and distributors. Initial sales of our products for a new design are usually made directly to network equipment providers and data centers as they design and develop their product. Once their design enters production, they often outsource their manufacturing to contract manufacturers that purchase our products directly from us or from our distributors. We price our products based on market and competitive conditions and periodically reduce the price of our products, as market and competitive conditions change, and as manufacturing costs are reduced. We do not experience different margins on direct sales to network equipment providers and data centers and indirect sales through contract manufacturers because in all cases we negotiate product pricing directly with the network equipment providers and data centers. To date, substantially all of our revenue has been denominated in U.S. dollars.

Three customers together accounted for 45.0% and 43.8% of our net revenue for the three and nine months ended September 30, 2014, respectively, and two customers accounted for 29.3% and 28.6% of our net revenue for the three and nine months ended September 30, 2013, respectively. No other customer accounted for more than 10.0% of our revenues for the three and nine months ended September 30, 2014 and 2013.

Revenue and costs relating to sales to distributors are deferred if we grant more than limited rights of returns and price credits or if we cannot reasonably estimate the level of returns and credits issuable. We had an agreement with a distributor to distribute our products primarily in the United States. Given the terms of the distribution agreement, for sales to this distributor, we deferred revenue and costs until products were sold to our end customers. Revenue recognition depended on notification from this distributor that product had been sold to its end customers. In April 2014, we terminated the distribution agreement with this distributor effective May 2014. We had no revenue from this distributor in the three months ended September 30, 2014. In the three months ended September 30, 2013, 6.7%, and for the nine months ended September 30, 2014 and 2013, 2.1% and 6.5%, respectively, of our net revenues were from products sold by this distributor.

We use our distributors, other than the distributor discussed above, primarily to support international sale logistics in Asia, including importation and credit management. Total net revenue through these distributors accounted for 28.7% and 22.4% of net revenue for the three months ended September 30, 2014 and 2013, respectively, and 28.1% and 29.0% for the nine months ended September 30, 2014 and 2013, respectively. The inventory at these distributors at the end of the period may fluctuate from time to time mainly due to the OEM production ramps or new customer demands. While we have purchase agreements with our distributors, the distributors do not have long-term contracts with any of the equipment providers. Our distributor agreements limit the distributor's ability to return product up to a portion of purchases in the preceding quarter. Given our experience, along with our distributors' limited contractual return rights, we believe we can reasonably estimate expected returns from our distributors.

Accordingly, we recognize sales through distributors at the time of shipment, reduced by our estimate of expected returns.

Our net revenue increased by $18.7 million or 23.6% in the three months ended September 30, 2014 and $48.9 million or 21.9% in the nine months ended September 30, 2014 compared to the same periods in 2013. The increase in net revenue was attributable mainly to the increase in sales in our enterprise network; data center and access and service provider markets, combined of $20.6 million and $59.0 million for the three and nine months ended September 30, 2014, respectively compared to the same periods in 2013. The increase was partially offset by the decrease in sales in our broadband and consumer market of $1.9 million and $10.1 million for the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013. The overall increase in sales in our enterprise networks; data center; and access and service provider markets was mainly due to the fluctuation in demand for our products in those respective markets as a result of the timing of our customers' volume production of our design wins. The decrease in sales of our broadband and consumer market was mainly due to the fluctuation in demand for our products in those respective markets and to a certain extent, due to lesser focus on certain consumer product markets.

21 -------------------------------------------------------------------------------- The following table is based on the geographic location of our customers including the original equipment manufacturers, contract manufacturers or the distributors who purchased our products and services. For sales to our distributors, their geographic location may be different from the geographic locations of the ultimate end customers. Sales by geography for the periods presented were: Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 (in thousands) (in thousands) United States $ 25,335 $ 22,391 $ 79,139 $ 69,605 China 23,102 20,574 68,014 54,243 Finland 12,225 6,051 35,130 12,117 Taiwan 7,777 5,822 22,106 18,530 Korea 12,670 8,671 22,255 23,311 Mexico 8,410 7,135 17,662 16,700 Other countries 8,314 8,480 27,449 28,352 Total $ 97,833 $ 79,124 $ 271,755 $ 222,858 Cost of Revenue and Gross Margin. We outsource wafer fabrication, assembly and test functions of our products. A significant portion of our cost of revenue consists of payments for the purchase of wafers and for assembly and test services, amortization of acquired intangibles and amortization related to capitalized mask costs. To a lesser extent, cost of revenue includes expenses relating to our internal operations that manage our contractors, stock-based compensation, the cost of shipping and logistics, royalties, inventory valuation expenses for excess and obsolete inventories, warranty costs and changes in product cost due to changes in sort, assembly and test yields. In general, our cost of revenue associated with a particular product declines over time as a result of yield improvements, primarily associated with design and test enhancements.

We use third-party foundries and assembly and test contractors, which are primarily located in Asia, to manufacture, assemble and test our semiconductor products. We purchase processed wafers on a per wafer basis from our fabrication suppliers, which are currently Samsung, TSMC, Global Foundries, and Fujitsu. We also outsource the sort, assembly, final testing and other processing of our product to third-party contractors, primarily ASE Electronics in Taiwan, Malaysia and Singapore, as well as ISE Labs, Inc., in the United States. We negotiate wafer fabrication on a purchase order basis. There are no long-term agreements with any of these third-party contractors. A significant disruption in the operations of one or more of these third-party contractors would impact the production of our products for a substantial period of time, which could have a material adverse effect on our business, financial condition and results of operations.

Our gross margin has been and will continue to be affected by a variety of factors, including the product mix, average sales prices of our products, the amortization expense associated with the acquired intangible assets, the timing of cost reductions for fabricated wafers and assembly and test service costs, inventory valuation charges, the cost of fabrication masks that are capitalized and amortized, and the timing and changes in sort, assembly and test yields.

Overall gross margin is impacted by the mix between higher performance, higher margin products and services and lower performance, lower margin products and services. In addition, we typically experience lower yields and higher associated costs on new products, which improve as production volumes increase.

Cost of revenue increased by $7.2 million or 25.2% in the three months ended September 30, 2014 and $14.3 million or 16.7% in the nine months ended September 30, 2014 compared to the same periods in 2013 primarily due to the increase in net revenue. Gross margin decreased by 0.5 percentage points from 64.0% in the three months ended September 30, 2013 to 63.5% in the three months ended September 30, 2014 and increased by 1.6 percentage points from 61.6% in the nine months ended September 30, 2013 to 63.2% in the nine months ended September 30, 2014. The decrease in gross margin for the three months ended September 30, 2014 compared to the same period in 2013 was a result of a small shift of product sales mix from our higher to lower performance products. The increase in gross margin for the nine months ended September 30, 2014 compared to the same period in 2013 was mainly due to the inventory write-down of $3.9 million in the second quarter of 2013 associated with discontinued consumer products, which was partially offset by the small shift of product sales mix of our higher and lower performance products. Higher performance products yields higher gross margins compared to our lower performance products.

22 -------------------------------------------------------------------------------- Research and Development Expenses. Research and development expenses primarily include personnel costs, engineering design development software and hardware tools, allocated facilities expenses and depreciation of equipment used in research and development and stock-based compensation. We expect research and development expenses to continue to increase in total dollars to support the development of new products and improvement of existing products. Additionally, as a percentage of revenue, these costs fluctuate from one period to another.

Total research and development expenses for the periods presented were: Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 change % 2014 2013 change % (in thousands) (in thousands)Research and development expenses $ 40,459 $ 33,630 $ 6,829 20.3 % $ 116,582 $ 98,469 $ 18,113 18.4 % Percent of total net revenue 41.4 % 42.5 % -1.1 % 42.9 % 44.2 % -1.3 % Research and development expenses increased by $6.8 million or 20.3% in the three months ended September 30, 2014 and increased by $18.1 million or 18.4% in the nine months ended September 30, 2014 compared to the same periods in 2013. Research and development expense included expenses of our variable interest entity, or VIE of $4.8 million and $4.5 million for the three months ended September 30, 2014 and 2013, respectively and $13.5 million and $11.6 million in the nine months ended September 30, 2014 and 2013, respectively.

The remaining research and development expense increased by $6.5 million or 22.2% and $16.2 million or 18.8% in the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013. This increase was mainly due to higher salaries and employee benefits and stock-based compensation expense and related taxes of $4.0 million and $11.7 million for the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013 mainly resulting from the increase in research and development headcount and increase in stock option and RSU grants. The cost incurred for severance and other benefits was flat and increased by $0.4 million in the three and nine months ended September 30, 2014, respectively, compared to the same period in 2013, due to the timing of restructuring activities. Outsourced engineering services increased by $1.3 million and $0.6 million in the three months ended September 30, 2014, respectively, compared to the same periods in 2013, mainly due to the timing of research and development work for our new product families, which was partially offset by the decrease in our research and development for certain consumer products. Facilities expense, design tools and other miscellaneous research and development increased by $1.5 million and $4.3 million for the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013 as a result of the increase in research and development activities to support the development of our new products. The increases as discussed above were partially offset by the decrease in depreciation and amortization expense of $0.3 million and $0.8 million for the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013 mainly due to the acceleration of estimated useful life of certain consumer product related intangible assets in 2013. Research and development headcount was 668 at September 30, 2014 compared to 594 at September 30, 2013.

Sales, General and Administrative Expenses. Sales, general and administrative expenses primarily include personnel costs, accounting and legal fees, information systems, sales commissions, trade shows, marketing programs, depreciation, allocated facilities expenses and stock-based compensation. We expect sales, general and administrative expenses to increase in absolute dollars to support our growing sales and marketing activities resulting from our expanded product portfolio. Total sales, general and administrative costs for the periods presented were: Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 change % 2014 2013 change % (in thousands) Sales, general and administrative expenses $ 18,141 $ 14,833 $ 3,308 22.3 % $ 51,090 $ 46,217 $ 4,873 10.5 % Percent of total net revenue 18.5 % 18.7 % -0.2 % 18.8 % 20.7 % -1.9 % Sales, general and administrative expenses increased by $3.3 million or 22.3% in the three months ended September 30, 2014 and $4.9 million or 10.5% in the nine months ended September 30, 2014 compared to the same periods in 2013. Sales, general and administrative expenses in the three and nine months ended September 30, 2014 included $0.9 million and $1.5 million, respectively, from our VIE.

23 -------------------------------------------------------------------------------- The remaining sales, general and administrative expenses increased by $2.4 million or 16.2% and $3.4 million or 7.3% in the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013. Salaries and employee benefits and stock-based compensation expense and related taxes increased by $2.0 million and $4.3 million, respectively, and facilities expense and other miscellaneous sales, general and administrative expenses, combined increased by $0.3 million and $0.6 million, respectively, for the three and nine months ended September 30, 2014 compared to the same periods in 2013 mainly due to the increase in headcount. Outside services increased by $0.3 million and $0.2 million in the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013 mainly due to increase in legal services related to acquisition and intellectual property related matters.

In the first quarter of 2013, we recorded a credit of $0.7 million associated with the gain on sale of held for sale assets. The cost incurred for severance and other benefits was flat in the three months ended September 30, 2014 and decreased by $0.6 million in the nine months ended September 30, 2014, compared to the same periods in 2013, due to the timing of restructuring activities.

Depreciation and amortization expense decreased by $0.2 million and $0.5 million for the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013 mainly due to the acceleration of amortization of certain acquired intangible asset in 2013. In the second quarter of 2013, we recorded a contractual settlement to a customer of approximately $1.3 million.

Sales, general and administrative headcount was 176 at September 30, 2014 compared to 160 at September 30, 2013.

Other income (expense), net. Other income (expense), net primarily includes interest income on cash and cash equivalents, foreign currency gains and losses, financing expenses, change in the estimated fair value of notes payable and other, interest expense associated with capital lease and technology license obligations and interest expense associated with the notes payable of the VIE.

Total other income (expense), net for the periods presented were: Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 change % 2014 2013 change % (in thousands) (in thousands) Interest expense $ (387 ) $ (390 ) $ 3 -0.8 % $ (1,179 ) $ (1,107 ) $ (72 ) 6.5 % Change in estimated fair value of notes payable and other (103 ) - (103 ) -100.0 % (14,888 ) - (14,888 ) -100.0 % Other, net (116 ) (126 ) 10 -7.9 % (34 ) (805 ) 771 -95.8 % Total other expense, net $ (606 ) $ (516 ) $ (90 ) 17.4 % $ (16,101 ) $ (1,912 ) $ (14,189 ) 742.1 % Other expense, net, increased by $0.1 million and $14.2 million in the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013. The increase was mainly due to the recognition of the change in the estimated fair value of notes payable and other of $0.1 million and $14.9 million in the three and nine months ended September 30, 2014. The significant change in the estimated fair value of notes payable and other resulted from the change in the probability assumption used in the fair value measurement. See Note 5 of Notes to Condensed Consolidated Financial Statements for more detailed discussions. In addition, interest expense increased associated with long-term capital and technology lease obligations and notes payable of the VIE. The increases were partially offset by other, net which consists mainly of net foreign exchange gains in the three and nine months ended September 30, 2014 compared to net foreign exchange losses in the three and nine months ended September 30, 2013.

Provision for Income Taxes. For the three and nine months ended September 30, 2014 and 2013, the provision for income taxes was based on our estimated annual effective tax rate, plus any discrete items, and taking into account valuation allowance, as necessary, in compliance with applicable guidance. We update our estimate of our annual effective tax rate at the end of each quarterly period.

Our estimate takes into account estimations of annual pre-tax income, the geographic mix of pre-tax income and our interpretations of tax laws and the possible outcomes of current and future audits.

The following table presents the provision for income taxes and the effective tax rates for the respective periods presented: Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 change % 2014 2013 change % (in thousands) (in thousands) Income (loss) before income taxes $ 2,917 $ 1,629 $ 1,288 79.1 % $ (11,975 ) $ (9,360 ) $ (2,615 ) 27.9 % Provision for income taxes 811 714 97 13.6 % 1,365 1,817 (452 ) -24.9 % Effective tax rate 27.8 % 43.8 % -16.0 % -11.4 % -19.4 % 8.0 % 24 -------------------------------------------------------------------------------- The provision for income taxes for the three and nine months ended September 30, 2014 was primarily related to earnings in foreign jurisdictions. The difference between the provision for or benefit from income taxes that would be derived by applying the statutory rate to our income (loss) before income taxes and the provision for income taxes recorded for the three and nine months ended September 30, 2014 was primarily attributable to the valuation allowance, the difference in foreign tax rates and an increase in indefinite lived intangible related deferred tax liability. The provision for income taxes for the three and nine months ended September 30, 2013 was primarily related to earnings in foreign jurisdictions and additional establishment of unrecognized tax benefits in foreign jurisdictions. The difference between the provision for or benefit from income taxes that would be derived by applying the statutory rate to our income (loss) before income taxes and the provision for income taxes recorded for the three and nine months ended September 30, 2013 was primarily attributable to the impact of losses that are not benefited, the difference in foreign tax rates and an increase in indefinite lived intangible related deferred tax liability.

Liquidity and Capital Resources Following is a summary of our working capital and cash and cash equivalents as of the periods presented: As of As of September 30, December 31, 2014 2013 (in thousands) Working capital $ 175,600 $ 151,071 Cash and cash equivalents 156,330 127,763 Following is a summary of our cash flows from operating activities, investing activities and financing activities for the periods presented: Nine Months Ended September 30, 2014 2013 (in thousands) Net cash provided by operating activities $ 38,992 $ 38,270 Net cash used in investing activities (14,452 ) (4,996 ) Net cash provided by financing activities 4,027 2,902 Cash Flows from Operating Activities Net cash flows from operating activities increased by $0.7 million from net cash provided by operating activities of $38.3 million in the nine months ended September 30, 2013 to $39.0 million in the nine months ended September 30, 2014.

Total cash inflow from operations after adjustment of non-cash items in the nine months ended September 30, 2014 and 2013 were $56.3 million and $40.3 million, respectively. The increase resulted mainly from higher net revenue which generated higher cash flows from operations. Changes in assets and liabilities resulted in net cash outflow of $17.3 million in the nine months ended September 30, 2014 compared to $2.0 million in the nine months ended September 30, 2013.

The significant changes in assets and liabilities in nine months ended September 30, 2014 were higher inventories due to the timing of inventory build-up in anticipation on an increase in revenue, lower accounts payable and accrued expenses due to the timing of payments to the vendors and higher accounts receivable resulting from higher revenue and timing of collections from customers. The significant changes in assets and liabilities in the nine months ended September 30, 2013 were higher accounts receivable resulted from higher revenue, lower inventories due to the timing of inventory build-up, lower deferred revenue resulted from lower subscription licenses and professional services billings to customers and higher accounts payable due to the timing of payments to the vendors.

Cash Flows from Investing Activities Net cash used in investing activities in the nine months ended September 30, 2014 was $14.5 million compared to $5.0 million in the nine months ended September 30, 2013. Net cash used in investing activities in the nine months ended September 30, 2014 resulted from the cash payments made to purchase property and equipment of $12.0 million and intangible assets of $3.2 million, which was partially offset by the proceeds received from the disposition of certain consumer product assets of $0.8 million. Net cash used in investing activities in the nine months ended September 30, 2013 resulted from cash payments made to purchases of property and equipment of $5.5 million and intangible assets of $3.6 million, which was partially offset by the cash proceeds received of $3.4 million related to the sale of held for sale assets and $0.8 million related to the disposition of certain consumer product assets.

25-------------------------------------------------------------------------------- Cash Flows from Financing Activities Net cash provided by financing activities in the nine months ended September 30, 2014 was $4.0 million compared to $2.9 million in the nine months ended September 30, 2013. Net cash provided by financing activities in the nine months ended September 30, 2014 resulted mainly from the proceeds received from issuance of common stock upon the exercise of options of $13.6 million, proceeds from notes payable from non-controlling interest of the VIE of $1.4 million and tax withholdings for stock option exercises on behalf of employees of $0.3 million, which were partially offset by the principal payments of capital lease and technology license obligations of $11.3 million. Net cash provided by financing activities in the nine months ended September 30, 2013 resulted from the proceeds received from issuance of common stock upon exercise of options of $9.5 million, proceeds from notes payable from non-controlling interest of the VIE of $6.0 million and tax withholdings for stock option exercises on behalf of employees of $0.7 million, partially offset by the principal payments of capital lease and technology license obligations of $13.4 million.

Capital Resources Cash equivalents consist of an investment in a money market fund. We believe that our $156.3 million of cash and cash equivalents at September 30, 2014, and expected cash flow from operations, if any, will be sufficient to fund our projected operating requirements for at least 12 months, including the acquisition of the VIE. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our engineering, sales and marketing activities, the timing and extent of our expansion into new territories, the timing of introductions of new products and enhancements to existing products and the continuing market acceptance of our products. Although we currently are not a party to any agreement with respect to potential material investments in, or acquisitions of, complementary businesses, services or technologies, other than disclosed in Note 5 of Notes to Condensed Consolidated Financial Statements, we may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing.

Additional funds may not be available on terms favorable to us or at all.

Indemnities In the ordinary course of business, we have entered into agreements with customers that include indemnity provisions. Based on historical experience and information known through the filing of this report, we believe our exposure related to the above indemnities of September 30, 2014, is not material. We also enter into indemnification agreements with our officers and directors and our certificate of incorporation and bylaws include similar indemnification obligations to our officers and directors. It is not possible to determine the amount of our liability related to these indemnification agreements and obligations to our officers and directors due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement.

Off-Balance Sheet Arrangements During the periods presented, we did not have, nor do we currently 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.

Contractual Obligations The table below describes our commitments to settle contractual obligations in cash as of September 30, 2014: Payments Due By Period Remainder of More Than 5 Total 2014 1 to 3 Years 3 to 5 Years Years (inthousands) Operating lease obligations $ 66,955 $ 1,696 $ 15,616 $ 17,660 $ 31,983 Capital lease and technology license obligations 28,326 11,073 17,253 - - Total $ 95,281 $ 12,769 $ 32,869 $ 17,660 $ 31,983 As of September 30, 2014, the liability for uncertain tax positions was $0.7 million. The timing of any payments which could result from these unrecognized tax benefits will depend upon a number of factors. Accordingly, the timing of payment cannot be estimated.

26 -------------------------------------------------------------------------------- In September 2013, the VIE entered into a purchase agreement with a third party vendor to purchase certain test equipment amounting to $6.1 million, payable in installments over two years. The equipment was received and recorded in the fourth quarter of 2013. In January 2014, the VIE purchased and recorded additional parts to the test equipment amounting to $1.0 million, payable in installment over two years. In June 2014, the VIE entered into a non-cancellable purchase order with the same third party vendor to purchase additional test equipment amounting to $4.0 million, due and payable in September 2014. The related test equipment was received and recorded in August 2014. We have an agreement with the VIE and third party vendor, whereby we guaranteed the payment and will assume the ownership of the test equipment in the event the VIE defaults such payment obligation.

We have a funding commitments in relation to the merger agreement entered on July 30, 2014, as amended on October 8, 2014, for the acquisition of the VIE.

See Note 5 of Notes to Condensed Consolidated Financial Statements for related discussions.

In addition, we have other obligations for goods and services entered into in the normal course of business. These obligations, however, are either not enforceable or legally binding or are subject to change based on our business decisions.

Critical Accounting Policies and Estimates The preparation of our financial statements and accompanying disclosures in conformity with GAAP requires estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and the accompanying notes. The SEC has defined a company's critical accounting policies as policies that are most important to the portrayal of a company's financial condition and results of operations, and which require a company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified our most critical accounting policies and estimates to be as follows: (1) revenue recognition; (2) stock-based compensation; (3) inventory valuation; (4) accounting for income taxes; (5) mask costs; (6) business combinations and (7) valuation of goodwill and purchased intangible assets and related estimated useful lives of intangible assets.

Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information not presently available. Actual results may differ significantly from these estimates if the assumptions, judgments and conditions upon which they are based turn out to be inaccurate.

Management believes that there have been no significant changes to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations, in our Annual Report on Form 10-K for the year ended December 31, 2013 filed on February 24, 2014.

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