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IXIA - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of many factors. The results of operations for the three and nine months ended September 30, 2014 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2014, or for any other future period. The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and the notes thereto included in Part II, Item 1 of this Form 10-Q and in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2013 ("2013 Form 10-K"), including the "Risk Factors" section and the consolidated financial statements and notes included therein. BUSINESS OVERVIEW We are a leading provider of converged Internet Protocol (IP) network test and network visibility solutions. Equipment manufacturers, service providers, enterprises, and government agencies use our solutions to design, verify, and monitor a broad range of Ethernet, Wi-Fi, 3G and 4G/LTE equipment and networks. Our product solutions consist of our hardware platforms, such as our chassis, interface cards and appliances, software application tools, and services, including our warranty and maintenance offerings and professional services. Our cash, cash equivalents and investments in the aggregate increased by $16.6 million to $113.6 million at September 30, 2014 from the $97.0 million reported three months earlier at June 30, 2014, and increased $27.9 million from the $85.7 million reported at December 31, 2013. Total revenues increased 0.7% to $114.0 million during the three months ended September 30, 2014, from $113.2 million during the three months ended September 30, 2013. The increase was due mostly to incremental revenues recognized from the sale of Net Optics, Inc. ("Net Optics") visibility products following our acquisition of Net Optics in December 2013 and an increase in revenues recognized on technical support, warranty and software maintenance services, which were partially offset by lower shipments of our legacy network test and other visibility products. While we remain confident in our competitive position and our opportunities for long-term growth in both network test and visibility, we are concerned that there continues to be some near term uncertainty and weakness in the market, such as the capital spending plans of large service providers and equipment manufacturers as they plan and prepare for the technological developments in networking (e.g., Virtualization, Software Defined Networks (SDN), and Network Functions Virtualization (NFV)). This uncertainty and weakness may adversely impact our sales, results of operations and financial position over the near term. Acquisition of Net Optics. On December 5, 2013, we completed our acquisition of all of the outstanding shares of common stock and other equity interests of Net Optics. The aggregate cash consideration paid totaled $187.7 million, or $185.7 million net of Net Optics' existing cash and investment balances at the time of the acquisition. The aggregate purchase price reflects certain post-closing adjustments, related to the final determination of the Net Optics' closing working capital under the purchase agreement. The acquisition was funded from our existing cash and sale of investments. Net Optics is a leading provider of total application and network visibility solutions. The acquisition of Net Optics solidifies our position as a market leader with a comprehensive product offering that includes network packet brokers, comprehensive physical and virtual taps and application aware capabilities. Additionally, the acquisition has expanded our product portfolio, strengthens our service provider and enterprise customer base and broadens our sales channel and partner programs. These factors, among others, contributed to a purchase price in excess of the estimated fair value of Net Optics' net identifiable assets acquired, and, as a result, we have recorded goodwill in connection with this transaction. The results of operations of Net Optics have been included in our condensed consolidated statements of operations and cash flows since the date of the acquisition. See Note 3 to the condensed consolidated financial statements included in this Form 10-Q for additional information regarding the Net Optics acquisition. Restructuring Activities. During the third quarter of 2014, our management approved, committed to and implemented a Company-wide restructuring initiative ("2014 Corporate Restructuring") to restructure our operations to better align the Company's operating costs with its business opportunities. The restructuring includes a reduction in force of approximately 96 positions across multiple business functions, which represented approximately 5% of our worldwide work force. The 2014 Corporate Restructuring is estimated to cost approximately $5.4 million in restructuring costs related to employee termination benefits and our facilities in India and Romania, which are included in the Restructuring expense line item in the condensed consolidated statement of operations. The 2014 Corporate Restructuring is estimated to provide future cost savings of approximately $17.0 million on an annualized basis, once fully completed in calendar year 2015, with the cost savings principally driven by headcount-related costs, and to a lesser extent, facilities-related savings, which would favorably impact the Company's future earnings and cash flows. 22 -------------------------------------------------------------------------------- During the first quarter of 2014, our management approved, committed to and initiated a plan to restructure our operations following our December 5, 2013 acquisition of Net Optics ("Net Optics Restructuring"). The Net Optics Restructuring included a net reduction in force of approximately 45 positions (primarily impacting our research and development team in Israel and Santa Clara, California), which represented approximately 2.3% of our worldwide work force. The Net Optics Restructuring cost approximately $4.1 million in restructuring costs related to employee termination benefits and other costs required to terminate the Net Optics facility lease in Israel, which are included in the Restructuring expense line item in the condensed consolidated statement of operations.. The Net Optics Restructuring was substantially completed during the second quarter of 2014. Significant future costs savings were not expected from the Company's existing operations as the restructuring was executed in conjunction with the acquisition of Net Optics. During the fourth quarter of 2013, our management approved, committed to and initiated a plan to restructure our Test operations ("Test Restructuring"). The Test Restructuring included a net reduction in force of approximately 120 positions (primarily impacting our research and development team in Bangalore, India), which represented approximately 6.5% of our worldwide work force. The Test Restructuring cost approximately $2.0 million in one-time restructuring costs related to employee termination benefits, which are included in the Restructuring expense line item in the condensed consolidated statement of operations.. The Test Restructuring was substantially completed during the fourth quarter of 2013 and all associated costs have been paid out. Significant future costs savings were not expected from the Test Restructuring as the restructuring served to realign our resources. Revenues. Our revenues are principally derived from the sale and support of our test and visibility solutions. Our network test hardware products primarily consist of traffic generation and analysis hardware platforms containing multi-slot chassis and interface cards. Our primary network test hardware platform is enabled by our operating system software that is essential to the functionality of the hardware platform. Sales of our network visibility hardware products typically include an integrated, purpose-built hardware appliance with essential proprietary software. Our software products consist of a comprehensive suite of technology-specific applications for certain of our network test hardware platforms. Our software products are typically installed on and work with these hardware products to further enhance the core functionality of the overall network test system, although some of our software products can be operated independently from our network test platforms. Our service revenues primarily consist of technical support, warranty and software maintenance services revenues related to our network test and visibility hardware and software products. Most of our products include up to one year of these services with the initial product purchase, and our customers may separately purchase extended services for annual or multi-year periods. Our technical support, warranty and software maintenance services include assistance with the set-up, configuration and operation of our products, repair or replacement of defective products, bug fixes, and unspecified when and if available software upgrades. For certain network test products, our technical support and software maintenance service revenues also include our Application and Threat Intelligence (ATI) service, which provides a comprehensive suite of application protocols, software updates and technical support. Our ATI service provides full access to the latest security attacks and application updates for use in real-world test and assessment scenarios. Our customers may purchase the ATI service for annual or multi-year periods. Service revenues also include training and other professional services revenues. Sales to our two largest customers, AT&T and Cisco Systems, accounted for $14.0 million, or 12.3%, and $28.3 million, or 25.1%, of our total revenues for the three months ended September 30, 2014 and 2013, respectively and $50.6 million, or 15.0%, and $92.8 million, or 26.7%, of our total revenues for the nine months ended September 30, 2014 and 2013, respectively. To date, we have generated the majority of our revenues from sales to network equipment manufacturers, but this percentage has been declining over the past several years. While we expect to continue to have some customer concentration with network equipment manufacturers for the foreseeable future, we expect to continue to see further declines as a percentage of total revenues, from sales to such customers, which will be mitigated by selling our products to a wider variety and increasing number of service provider, enterprise and government customers. To the extent that we develop a broader and more diverse customer base, our reliance on any one customer or customer type should diminish. We also expect that our 2013 acquisition of Net Optics will continue to further diversify our customer base. From a geographic perspective, we generated revenues from shipments to international locations of $48.4 million, or 42.5%, and $138.7 million, or 41.1%, of our total revenues for the three and nine months ended September 30, 2014, respectively, and $41.7 million, or 36.8%, and $125.4 million, or 36.2%, of our total revenues for the three and nine months ended September 30, 2013, respectively. The increase in the percentage of our revenues from shipments to international locations was primarily due to lower shipments to service providers in the U.S. during the nine months ended September 30, 2014. 23 -------------------------------------------------------------------------------- Stock-Based Compensation. Share-based payments, including grants of stock options, restricted stock units and employee stock purchase rights, are required to be recognized in our financial statements based on the estimated fair values for accounting purposes on the grant date. For the three months ended September 30, 2014 and 2013, stock-based compensation expense was $3.2 million and $5.6 million, respectively. The decline in stock-based compensation in the three months ended September 30, 2014 compared to the three months ended September 30, 2013 resulted from the departure of certain employees associated with the 2014 Corporate Restructuring and the related cancellation of their stock-based awards during the period. For the nine months ended September 30, 2014 and 2013, stock-based compensation expense was $11.1 million and $17.0 million, respectively. The decline in stock-based compensation in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013 resulted from the departure of our former CFO and certain other employees associated with the 2014 Corporate Restructuring and the related cancellation of their stock-based awards during the period. The aggregate amount of gross unrecognized stock-based compensation to be expensed in the years 2014 through 2018 related to unvested share-based awards as of September 30, 2014 was approximately $15.6 million. To the extent that we grant additional share-based awards, future expense will increase by the additional unearned compensation resulting from those grants. We anticipate that we will continue to grant share-based awards in the future as part of our long-term incentive compensation programs. The impact of future grants cannot be estimated at this time because it will depend on a number of factors, including the amount of share-based awards granted and the then current fair values of such awards for accounting purposes. Cost of Revenues. Our cost of revenues related to the sale of our hardware and software products includes cost of materials, payments to third-party contract manufacturers, royalties, and salaries and other expenses related to our manufacturing and supply operations personnel. We outsource the majority of our manufacturing operations, and we conduct supply chain management, quality assurance, documentation control, shipping and some final assembly and testing at our facilities in Calabasas, California; Austin, Texas; and Penang, Malaysia. Accordingly, a significant portion of our cost of revenues related to our products consists of payments to our contract manufacturers. Cost of revenues related to the provision of services includes salaries and other expenses associated with technical support services, professional services, and extended warranty and maintenance services. Cost of revenues does not include the amortization of purchased technology related to our acquisitions of certain businesses, product lines and technologies of $6.4 million and $22.5 million for the three and nine months ended September 30, 2014, respectively, and $6.4 million and $19.4 million for the three and nine months ended September 30, 2013, respectively, which are included within our Amortization of intangible assets line item on our condensed consolidated statements of operations included in this Form 10-Q. Our cost of revenues as a percentage of total revenues is primarily affected by the following factors: ? our pricing policies and those of our competitors; ? the pricing we are able to obtain from our component suppliers and contract manufacturers; ? the mix of customers and sales channels through which our products are sold; ? the mix of our products sold, such as the mix of software versus hardware product sales; ? new product introductions by us and by our competitors; ? demand for and quality of our products; and ? shipment volume. In the near term, although we anticipate that our cost of revenues as a percentage of total revenues will remain relatively flat to current levels, we expect to continue to experience pricing pressure on larger transactions and from larger customers as a result of competition. 24 -------------------------------------------------------------------------------- Operating Expenses. Our operating expenses are generally recognized when incurred and consist of research and development, sales and marketing, general and administrative, amortization of intangible assets, acquisition and other related costs and restructuring expenses. In dollar terms, we expect total operating expenses, excluding stock-based compensation expense discussed above and amortization of intangible assets, acquisition and other related and restructuring costs discussed below, to increase slightly for the fourth quarter of 2014 when compared to the third quarter of 2014. ? Research and development expenses consist primarily of salaries and other personnel costs related to the design, development, testing and enhancement of our products. We expense our research and development costs as they are incurred. We also capitalize and depreciate over a five-year period costs of our products used for internal purposes. ? Sales and marketing expenses consist primarily of compensation and related costs for personnel engaged in direct sales, sales support and marketing functions, as well as promotional and advertising expenditures. We also capitalize and depreciate over a two-year period costs of our products used for sales and marketing activities, including product demonstrations for potential customers. ? General and administrative expenses consist primarily of salaries and related expenses for certain executive, finance, legal, human resources, information technology and administrative personnel, as well as professional fees (e.g., legal and accounting), facility costs related to our corporate headquarters, insurance costs, and other general corporate expenses. ? Amortization of intangible assets consists of the purchase price of various intangible assets over their estimated useful lives. We evaluate our identifiable definite-lived intangible assets and other long-lived assets for impairment when events or changes in circumstances indicate that a potential impairment may exist. An impairment charge would be recorded to the extent that the carrying value of the intangible asset exceeds its undiscounted cash flows and its estimated fair value in the period that the impairment circumstances occurred. The future amortization expense of acquired intangible assets depends on a number of factors, including the extent to which we acquire additional businesses, technologies or product lines or are required to record impairment charges related to our acquired intangible assets. ? Acquisition and other related costs are expensed as incurred and consist primarily of transaction and integration related costs such as success-based banking fees, professional fees for legal, accounting, tax, due diligence, valuation and other related services, change in control payments, amortization of deferred compensation, consulting fees, required regulatory costs, certain employee, facility and infrastructure transition costs, and other related expenses. We expect our acquisition and other related expenses to fluctuate over time based on the timing of our acquisitions and related integration activities. ? Restructuring expenses consist primarily of employee severance costs and other related charges, as well as facility-related charges to exit certain locations. See Note 4 to the condensed consolidated financial statements included in this Form 10-Q. ? Goodwill Impairment. We evaluate the recoverability of our goodwill on an annual basis or if events or changes in circumstances indicate that an impairment in the value of goodwill recorded on our balance sheet may exist. We have determined that we have one reporting unit for goodwill impairment testing purposes. The fair value of the Company's reporting unit is determined using the market capitalization of Ixia, which considers the observed market price of the Company's publicly-traded equity securities on the impairment test date. The fair value of the Company's reporting unit is then compared to the carrying amount of the Company's reporting unit under "step 1" of the impairment testing model. If the carrying value of the reporting unit exceeds its fair value, then the fair value of goodwill is determined and compared to its carrying value under "step 2." Impairment losses are recorded to the extent that the carrying value of the goodwill exceeds its estimated fair value. Currently management believes that it is not at risk of failing the "step 1" impairment test because the Company's market capitalization is significantly in excess of the carrying value of the reporting unit. However, management will conduct its annual impairment test of goodwill in the fourth quarter of 2014. Interest Income and Other, Net. Our interest income and other, net represents interest on cash and a variety of securities, including money market funds, U.S. Treasury government and government agency debt securities, corporate debt securities and auction rate securities, realized gains/losses on the sale of investment securities, certain foreign currency gains and losses, and other non-operating items. Interest Expense. Our interest expense consists of interest due to the holders of our 3.00% Convertible Senior Notes due December 15, 2015 in the aggregate principal amount of $200 million that were issued in December 2010, as well as the amortization of the associated debt issuance costs. See Note 5 to the condensed consolidated financial statements included in this Form 10-Q. Income tax. Our income tax is determined based on the amount of earnings and enacted federal, state and foreign tax rates, adjusted for allowable credits and deductions, and for other effects of equity compensation plans. Our income tax provision may be significantly affected by changes to our estimates for tax in jurisdictions in which we operate and other estimates utilized in determining the global effective tax rate. Actual results may also differ from our estimates based on changes in economic conditions. Such changes could have substantial impact on the income tax provision. Our income tax provision could also be significantly impacted by estimates surrounding our uncertain tax positions and changes to valuation allowance set against certain deferred tax assets. We reevaluate the judgments surrounding our estimates and make adjustments as appropriate each reporting period. 25 -------------------------------------------------------------------------------- Our effective tax rate differs from the federal statutory rate of 35% due primarily to benefits associated with the differential in tax rates for certain foreign operations, state taxes, and significant permanent differences. Significant permanent differences arise primarily due to research and development credits and certain stock-based compensation expenses that are not expected to generate a tax deduction, such as stock-based compensation expense on grants to foreign employees, offset by tax benefits from disqualifying dispositions, intercompany royalties and amortization. Federal research credits were not available to be recorded in our Annual Report on Form 10-K for the year ended December 31, 2012. During the 2013 first quarter, the federal research credit was retroactively renewed for 2012, and such benefits for the 2012 fiscal year were recorded at that time. The federal research credit expired on December 31, 2013, and is therefore not available to be recorded in our 2014 financial statements. Realization of our deferred tax assets is dependent primarily on the generation of future taxable income. In considering the need for a valuation allowance we consider our historical, as well as future, projected taxable income along with other objectively verifiable evidence. Management has concluded it is more likely than not that all of the Company's U.S. deferred tax assets, with the exception of its deferred tax assets for capital loss carryforwards, will be realized. Any reversal of our valuation allowance will favorably impact our results of operations in the period of the reversal. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management's discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements included in this Form 10-Q which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, allowance for doubtful accounts, write-downs for obsolete or excess inventory, income taxes, acquisition purchase price allocation, impairments of long-lived assets, goodwill and marketable securities, stock-based compensation, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. None of these accounting policies and estimates has significantly changed from those reflected in our 2013 Form 10-K. Critical accounting policies and estimates are more fully described in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our 2013 Form 10-K. Actual results may differ from these estimates under different assumptions or conditions. 26 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS The following table sets forth certain statement of operations data as a percentage of total revenues for the periods indicated. Three months ended Nine months ended September 30, September 30, 2014 2013 2014 2013 Revenues: Products 69.0 % 73.4 % 70.1 % 75.7 % Services 31.0 26.6 29.9 24.3 Total revenues 100.0 100.0 100.0 100.0 Costs and operating expenses:(1) Cost of revenues - products (2) 21.2 18.0 21.7 18.1 Cost of revenues - services 3.5 3.7 3.6 3.0 Research and development 24.2 26.0 26.0 25.4 Sales and marketing 31.3 28.6 33.9 29.0 General and administrative 12.9 10.5 14.6 10.2 Amortization of intangible assets 9.6 8.9 10.7 8.7 Acquisition and other related 0.5 0.6 1.0 0.9 Restructuring 4.1 - 2.6 - Total costs and operating expenses 107.3 96.3 114.1 95.3 (Loss) income from operations (7.3 ) 3.7 (14.1 ) 4.7 Interest income and other, net (0.1 ) 1.8 0.2 1.6 Interest expense (1.7 ) (1.7 ) (1.7 ) (1.7 ) (Loss) income before income taxes (9.1 ) 3.8 (15.6 ) 4.6 Income tax (benefit) expense (2.7 ) 0.1 (3.2 ) 0.2 Net (loss) income (6.4 )% 3.7 % (12.4 )% 4.4 % -------------------------------------------------------------------------------- (1) Stock-based compensation included in: Cost of revenues - products 0.1 % 0.1 % 0.1 % 0.1 % Cost of revenues - services 0.0 0.0 0.0 0.0 Research and development 1.4 1.8 1.5 1.7 Sales and marketing 0.6 1.5 1.2 1.5 General and administrative 0.7 1.5 0.5 1.4 (2) Cost of revenues - products excludes amortization of intangible assets related to purchased technologies of $6.4 million and $22.5 million for the three and nine months ended September 30, 2014, respectively, and $6.4 million and $19.4 million for the three and nine months ended September 30, 2013, respectively, which is included in Amortization of intangible assets. Comparison of Three and Nine Months Ended September 30, 2014 and 2013 As result of our acquisition of Net Optics in the fourth quarter of 2013, our 2014 results of operations include the financial results of Net Optics from its acquisition date. To assist the readers of our financial statements in reviewing our year-over-year consolidated operating results, we have included the impacts of this acquisition for the applicable periods in the related statement of operations sections below. 27 -------------------------------------------------------------------------------- Revenues. During the three months ended September 30, 2014, total revenues increased 0.7% to $114.0 million from the $113.2 million recorded in the three months ended September 30, 2013. Revenues for the three months ended September 30, 2014 included $17.3 million related to the 2013 acquisition of Net Optics. Excluding the revenues of Net Optics, total revenues decreased by $16.5 million, or 14.6%, to $96.7 million in the three months ended September 30, 2014, from $113.2 million in the three months ended September 30, 2013. Revenues from our Network Test Solutions product line decreased 11.7% to $84.1 million in the three months ended September 30, 2014 from the $95.3 million recorded in the three months ended September 30, 2013. The year-over-year decrease in revenue for Network Test Solutions was principally driven by a decrease in product revenues primarily due to a $10.6 million decrease in shipments of our hardware products (primarily our network test Ethernet interface cards). Revenues from our Network Visibility Solutions product line increased 67.0% to $29.9 million in the three months ended September 30, 2014 from the $17.9 million recorded in the three months ended September 30, 2013. The year-over-year increase in revenue for Network Visibility Solutions was principally the result of the revenues from our acquisition of Net Optics (i.e., Net Optics revenue included in the third quarter of 2014, with no comparable amount in the same period in the prior year.) During the nine months ended September 30, 2014, total revenues decreased 2.7% to $337.3 million from the $346.6 million recorded in the nine months ended September 30, 2013. Revenues for the nine months ended September 30, 2014 included $41.2 million related to the 2013 acquisition of Net Optics. Excluding the revenues of Net Optics, total revenues decreased by $50.6 million, or 14.6%, to $296.1 million in the nine months ended September 30, 2014 from $346.6 million in the nine months ended September 30, 2013. Revenues from our Network Test Solutions product line decreased 8.6% to $257.3 million in the nine months ended September 30, 2014 from the $281.6 million recorded in the nine months ended September 30, 2013. The year-over-year decrease in revenue for Network Test Solutions was principally driven by a decrease in product revenues primarily due to a $26.7 million decrease in shipments of our Network Test Solutions hardware products (primarily our network test Ethernet interface cards), partially offset by an $8.9 million increase in services revenues recognized on technical support, warranty and software maintenance services. Revenues from our Network Visibility Solutions product line increased 23.0% to $79.9 million in the nine months ended September 30, 2014 from the $65.0 million recorded in the nine months ended September 30, 2013. The year-over-year increase in revenue for Network Visibility Solutions was principally the result of the revenues from our acquisition of Net Optics in the nine months ended September 30, 2014 of $41.2 million, with no comparable amount in the same period in the prior year, and a $2.7 million increase in services revenues recognized on technical support, warranty and software maintenance services. This year-over-year increase was partially offset by a decrease in Network Visibility Solutions product revenues of $28.9 million as a result of a decrease in shipments of our legacy Network Visibility Solutions hardware products. Cost of Revenues. As a percentage of total revenues, our total cost of revenues increased to 24.7% during the three months ended September 30, 2014 from 21.7% in the three months ended September 30, 2013. This increase was primarily due to the increase in our cost of product revenues as a percentage of total revenues, which was 21.2% in the three months ended September 30, 2014 as compared to 18.0% in the three months ended September 30, 2013. The increase in cost of product revenues as a percentage of total revenues was primarily driven by an increase in compensation and related employee costs of approximately $905,000, higher material-related costs relative to the sales price for certain products, and higher costs for excess and obsolete inventory of $1.5 million. The increase in compensation and related employee costs was primarily due to increased headcount in operations personnel related to our acquisition of Net Optics. As a percentage of total revenues, our total cost of revenues increased to 25.3% in the nine months ended September 30, 2014 from 21.1% in the nine months ended September 30, 2013. This increase was primarily due to the increase in our cost of product revenues as a percentage of total revenues, which was 21.7% in the nine months ended September 30, 2014 as compared to 18.1% in the nine months ended September 30, 2013. The increase in cost of product revenues as a percentage of total revenues was primarily driven by an increase in compensation and related employee costs of $3.6 million, higher material-related costs relative to the sales price for certain products, and higher costs for excess and obsolete inventory of $3.7 million. The increase in compensation and related employee costs was primarily due to increased headcount in operations personnel related to our acquisition of Net Optics. Research and Development Expenses. During the three months ended September 30, 2014, research and development expenses decreased 6.1% to $27.6 million from $29.4 million in the three months ended September 30, 2013. Research and development expenses attributable to Net Optics were approximately $2.0 million for the three months ended September 30, 2014. Research and development costs included stock-based compensation expense of $1.6 million and $2.0 million during the three months ended September 30, 2014 and 2013, respectively. Excluding the activities of Net Optics and stock-based compensation, research and development expenses in the three months ended September 30, 2014 decreased 12.3% to $24.0 million compared to $27.4 million in the three months ended September 30, 2013. This decrease was primarily driven by a decrease in compensation and related employee costs of $1.9 million, a reduction in costs to develop prototypes, and lower expenses for depreciation and amortization. The decrease in compensation and related employee costs was primarily a result of headcount reductions from our various restructuring activities. During the nine months ended September 30, 2014, research and development expenses decreased 0.6% to $87.7 million from $88.2 million in the nine months ended September 30, 2013. Research and development expenses attributable to Net Optics were approximately $7.7 million for the nine months ended September 30, 2014. Research and development costs included stock-based compensation expense of $4.9 million and $6.1 million during the nine months ended September 30, 2014 and 2013, respectively. 28 -------------------------------------------------------------------------------- Excluding the activities of Net Optics and stock-based compensation, research and development expenses in the nine months ended September 30, 2014 decreased 8.6% to $75.1 million compared to $82.1 million in the nine months ended September 30, 2013. This decrease was primarily due to a decrease in compensation and related employee costs of $4.4 million, a reduction in costs to develop prototypes of $1.6 million and lower expenses for depreciation and amortization. The decrease in compensation and related employee costs was primarily a result of headcount reductions from our various restructuring activities. Sales and Marketing Expenses. During the three months ended September 30, 2014, sales and marketing expenses increased 10.1% to $35.6 million from $32.4 million in the three months ended September 30, 2013. Sales and marketing expenses attributable to Net Optics were approximately $2.9 million for the three months ended September 30, 2014. Sales and marketing costs included stock-based compensation expense of approximately $719,000 and $1.7 million for the three months ended September 30, 2014 and 2013, respectively. Excluding the activities of Net Optics and stock-based compensation, sales and marketing expenses in the three months ended September 30, 2014 increased 4.5% to $32.0 million compared to $30.7 million in the three months ended September 30, 2013. This increase was primarily due to an increase in net compensation and related employee costs of $1.3 million, partially offset by lower trade show and recruiting costs. The increase in compensation and related employee costs was primarily due to increased headcount in sales and marketing personnel. During the nine months ended September 30, 2014, sales and marketing expenses increased 13.9% to $114.4 million from $100.4 million in the nine months ended September 30, 2013. Sales and marketing expenses attributable to Net Optics were approximately $9.1 million for the nine months ended September 30, 2014. Sales and marketing costs included stock-based compensation expense of $4.1 million and $5.3 million for the nine months ended September 30, 2014 and 2013, respectively. Excluding the activities of Net Optics and stock-based compensation, sales and marketing expenses in the nine months ended September 30, 2014 increased 6.4% to $101.1 million compared to $95.0 million in the nine months ended September 30, 2013. This increase was primarily due to an increase in net compensation and related employee costs, including travel, of $5.0 million and higher trade show costs. The increase in compensation and related employee costs was primarily due to increased headcount in sales and marketing personnel. General and Administrative Expenses. During the three months ended September 30, 2014, general and administrative expenses increased 23.4% to $14.7 million from $11.9 million in the three months ended September 30, 2013. General and administrative expenses attributable to Net Optics were approximately $598,000 for the three months ended September 30, 2014. General and administrative expenses included stock-based compensation expense of $762,000 and $1.7 million for the three months ended September 30, 2014 and 2013, respectively. Our general and administrative expenditures in the three months ended September 30, 2014 included charges of $1.8 million related to (i) internal investigations and related remediation efforts and (ii) the securities class action against the Company and certain of its current and former officers and directors as well as shareholder derivative actions. These costs consisted primarily of legal and accounting costs and expenses, recruiting and consulting expenses, severance and retention costs, and related expenses. Excluding the activities of Net Optics, stock-based compensation and other charges noted above, general and administrative expenses in the three months ended September 30, 2014 increased 12.8% to $11.6 million compared to $10.3 million in the three months ended September 30, 2013. This increase was primarily due to an increase in net compensation and related employee costs of approximately $555,000 and higher depreciation and amortization costs. The increase in compensation and other related costs was primarily due to an increase in general and admininstrative headcount. During the nine months ended September 30, 2014, general and administrative expenses increased 38.9% to $49.3 million from $35.5 million in the nine months ended September 30, 2013. General and administrative expenses attributable to Net Optics were approximately $2.6 million for the nine months ended September 30, 2014. General and administrative expenses included stock-based compensation expense of $1.8 million and $5.0 million for the nine months ended September 30, 2014 and 2013, respectively. 29 -------------------------------------------------------------------------------- Our general and administrative expenditures in the nine months ended September 30, 2014 included charges of $11.9 million related to (i) internal investigations and related remediation efforts, (ii) the restatement of our financial statements for the first quarter of 2013 and for the three and six months ended June 30, 2013, and (iii) the securities class action against the company and certain of its current and former officers and directors as well as shareholder derivative actions. These costs consisted primarily of legal and accounting costs and expenses, recruiting and consulting expenses, severance and retention costs, and related expenses. Our general and administrative expenditures in the nine months ended September 30, 2013 included $1.2 million of proceeds realized from the settlement of a legal matter, partially offset by $1.0 million in costs related to the April 2013 restatement of certain of our previously filed financial statements. Excluding the activities of Net Optics, stock-based compensation and other charges noted above, general and administrative expenses in the nine months ended September 30, 2014 increased 7.9% to $33.0 million compared to $30.6 million in the nine months ended September 30, 2013. This increase was primarily due to an increase in net compensation and related employee costs of $1.5 million and higher depreciation and amortization costs. The increase in compensation and other related costs was primarily due to an increase in general and administrative headcount. Amortization of Intangible Assets. During the three and nine months ended September 30, 2014, amortization of intangible assets increased to $10.9 million and $36.0 million, respectively, from $10.1 million and $30.3 million in the three and nine months ended September 30, 2013, respectively. This increase was primarily due to the incremental amortization of intangibles related to our 2013 acquisition of Net Optics. Acquisition and Other Related Expenses. During the three months ended September 30, 2014, acquisition and other related expenses decreased 12.2% to approximately $582,000 from $663,000 in the three months ended September 30, 2013. During the nine months ended September 30, 2014, acquisition and other related expenses increased 11.6% to $3.4 million from $3.0 million in the nine months ended September 30, 2013. Acquisition and other related costs for the three and nine months ended September 30, 2013 and 2014 primarily related to integration activities associated with the acquisitions of BreakingPoint Systems and Net Optics, respectively. Acquisition and other related costs primarily consisted of transaction and integration-related costs such as professional fees for legal, accounting and tax services, integration-related consulting fees, certain employee, facility and infrastructure costs, and other acquisition-related costs. Restructuring. Restructuring costs for the three months ended September 30, 2014 were $4.6 million compared to zero for the three months ended September 30, 2013. Restructuring costs incurred during the three months ended September 30, 2014 were primarily related to one-time expenses for employee termination benefits consisting of severance and other employee related costs and lease termination costs associated with the 2014 Corporate Restructuring. See Note 4 to the condensed consolidated financial statements included in this Form 10-Q. Restructuring costs for the nine months ended September 30, 2014 were $8.7 million compared to approximately $58,000 for the nine months ended September 30, 2013. Restructuring costs incurred during the nine months ended September 30, 2014 were primarily related to one-time expenses for employee termination benefits consisting of severance and other employee-related costs associated and lease termination costs associated with the 2014 Corporate Restructuring and the Net Optics Restructuring. See Note 4 to the condensed consolidated financial statements included in this Form 10-Q. Interest Income and Other, Net. Interest income and other, net was approximately $(99,000) and $530,000 for the three and nine months ended September 30, 2014, respectively, as compared to $2.0 million and $5.6 million for the three and nine months ended September 30, 2013, respectively. These decreases were primarily due to a $2.9 million realized gain recorded during the second quarter of 2013 on the sale of certain of our auction rate securities that were previously written-down and a $1.0 million realized gain recorded during the third quarter of 2013 for the sale of auction rate securities that were previously written-down and a decrease in foreign currency translation gains. Interest Expense. Interest expense, including the amortization of debt issuance costs, was $1.9 million and $5.8 million for the three and nine months ended September 30, 2014, respectively. Interest expense, including the amortization of debt issuance costs, was $1.9 million and $5.8 million for the three and nine months ended September 30, 2013, respectively. Interest expense relates to our convertible senior notes, as well as the amortization of deferred issuance costs and commitment fees related to our credit facility which we established in December 2012. For additional information, see Note 5 to the condensed consolidated financial statements included in this Form 10-Q. 30 -------------------------------------------------------------------------------- Income Tax. Income tax benefit was $3.0 million, or an effective rate of (29.3%), for the three months ended September 30, 2014 as compared to an income tax expense of $123,000, or an effective rate of 2.9%, for the three months ended September 30, 2013. Income tax benefit was $10.9 million, or an effective rate of (20.6%), for the nine months ended September 30, 2014 as compared to an income tax expense of approximately $705,000, or an effective rate of 4.5%, for the nine months ended September 30, 2013. The lower effective tax rate for the three and nine months ended September 30, 2014, when compared to the same periods in 2013, was primarily the result of the Company generating pre-tax losses in 2014 compared to pre-tax earnings in 2013. LIQUIDITY AND CAPITAL RESOURCES Our cash, cash equivalents and short-term investments increased to $113.6 million as of September 30, 2014 from $85.7 million as of December 31, 2013, which increase was primarily due to $24.2 million in net cash provided by our operating activities and $6.8 million of proceeds from exercises of share-based awards, partially offset by capital expenditures of $5.9 million. Of our total cash, cash equivalents and short-term investments, $28.8 million and $25.3 million were held outside of the United States in various foreign subsidiaries as of September 30, 2014 and December 31, 2013, respectively. Under current tax laws and regulations, if our cash, cash equivalents or investments associated with the subsidiaries' undistributed earnings were to be repatriated in the form of dividends or deemed distributions, we would be subject to additional U.S. income taxes and foreign withholding taxes. We consider these funds to be indefinitely reinvested in our foreign operations and do not intend to repatriate them, including for purposes of repaying the Company's Notes as discussed below. We had no exposure to European sovereign debt as of September 30, 2014. The following table sets forth our summary cash flows for the nine months ended September 30, 2014 and 2013 (in thousands): Nine Months Ended September 30, 2014 2013 Net cash provided by operating activities $ 24,243 $ 70,131 Net cash used in investing activities (22,193 ) (75,542 ) Net cash provided by financing activities 6,382 15,346 Cash Flows from Operating Activities Net cash provided by operating activities was $24.2 million during the nine months ended September 30, 2014 and $70.1 million during the nine months ended September 30, 2013. This decrease in cash flow generated from operations was primarily driven by a net loss of $41.9 million for the nine months ended September 30, 2014 compared to net income of $14.9 million for the nine months ended September 30, 2013. The decrease in cash flow from operations was partially offset by a $3.4 million increase related to net working capital changes during the nine months ended September 30, 2014 as compared to the nine months ended September 30, 2013. The working capital changes were due to the timing of payments of accrued liabilities and an increase in deferred revenues during the nine months ended September 30, 2014 as compared to the nine months ended September 30, 2013 due to a higher volume of technical support, warranty and software maintenance contracts. Cash Flows from Investing Activities Net cash used in investing activities was $22.2 million during the nine months ended September 30, 2014 and $75.5 million during the nine months ended September 30, 2013. The decrease in net cash used in investing activities was primarily a result of lower net purchases of available for sale securities and lower purchases of property and equipment during the nine months ended September 30, 2014 as compared to the nine months ended September 30, 2013. 31 -------------------------------------------------------------------------------- Cash Flows from Financing Activities Net cash provided by financing activities was $6.4 million during the nine months ended September 30, 2014 compared to $15.3 million during the nine months ended September 30, 2013. This decrease in cash provided by financing activities was primarily due to a $7.1 million decrease in proceeds from the exercise of share-based awards, during the nine months ended September 30, 2014 as compared to the nine months ended September 30, 2013, and $1.5 million of excess tax benefits from the nine months ended September 30, 2013. We believe that our existing balances of cash and cash equivalents, investments, and cash flows expected to be generated from our operations will be sufficient to satisfy our operating requirements for at least the next 12 months. We expect, however, to require financing to repay or refinance all or a portion of our Notes, which mature in December 2015, in full. There can be no assurance that any such financing will be available on favorable terms or at all, or that our available cash, future cash flow from operations and any available financing will be sufficient to enable us to repay or refinance the Notes in their entirety at maturity. Our Credit Facility, under which we currently are unable to borrow or obtain letters of credit (see discussion below), will mature on December 21, 2016, but may mature on September 14, 2015 if we do not have available liquidity (domestic cash and investments, plus availability under the Credit Facility) of $25 million in excess of the amount required to repay in full our 3.00% Convertible Senior Notes due December 15, 2015 in the aggregate principal amount of $200 million (the "Notes") beginning on June 15, 2015. If we satisfy this requirement between June 15, 2015 and September 14, 2015, but fail to do so after September 14, 2015 and prior to December 15, 2015, the maturity date is the date on which the requirement is no longer satisfied. We entered into amendments with the lenders under the Credit Facility Agreement to extend the delivery dates for our financial statements for the quarters ended September 30, 2013, December 31, 2013 and March 31, 2014 and of our audited financial statements for the fiscal year ended December 31, 2013. We subsequently completed all such deliveries in compliance with the extended delivery dates. Under an amendment to the Credit Facility Agreement dated June 27, 2014, the date for delivery of our financial statements for the quarter ended June 30, 2014 was extended to August 29, 2014. We did not, however, deliver the required financial statements on or before that date. On August 29, 2014, the administrative agent provided us with notice that we were in default under the Credit Facility Agreement because we had not timely provided the administrative agent with our financial statements for the quarter ended June 30, 2014 and a related compliance certificate and because we were in default under the Indenture dated as of December 21, 2010 governing our Notes (the "Indenture") for failing to timely file our 2014 Second Quarter Form 10-Q with the trustee. The administrative agent's notice expressly reserved the rights of the administrative agent and the lenders to exercise their respective rights, powers, privileges and remedies in connection with such event or events of default. Due to the occurrence of such event or events of defaults, the Company is blocked from borrowing and obtaining letters of credit under the Credit Facility provided under the Credit Facility Agreement. The administrative agent also has the right (with the consent of a majority of the lenders based on total credit exposure) or obligation (at the request of such a majority of the lenders) to terminate the Credit Facility Agreement, accelerate any amounts due thereunder and exercise all other available remedies. We do not have a contractual right to cure these defaults, and the defaults may be waived only with the consent of a majority of the lenders based on total credit exposure. We have not requested such a waiver. As of the date of the filing of this Form 10-Q, no amounts are outstanding under the Credit Facility Agreement. See Note 5 to the condensed consolidated financial statements included herein. To the extent that any breach of the Indenture resulting from our delayed filings with the SEC other than the delayed filings of our 2014 First Quarter Form 10-Q and the 2014 Second Quarter Form 10-Q (i.e., the delayed filings of our Quarterly Report on Form 10-Q for the quarter ended September 30, 2013 ("2013 Third Quarter Form 10-Q"), the 2013 Form 10-K and a Current Report on Form 8-K/A relating to our acquisition of Net Optics on December 5, 2013 (the "Form 8-K/A") may have constituted events of default under the Credit Facility Agreement (which requires us to comply with the Indenture), we obtained waivers from the lenders. Those waivers remain in effect, and the required filings have been made. On May 15, 2014, we entered into an amendment and waiver agreement with the lenders that included a waiver from the lenders of any breach of the Credit Facility Agreement arising out of our failure to timely file with the trustee the 2014 First Quarter Form 10-Q. This waiver was only effective as long as (i) no event of default occurred under the Indenture due to our failure to complete any necessary remedial action in respect of the delayed filing within 60 days of receipt of notice from either the trustee under the Indenture or the holders of 25% of the aggregate principal amount of our Notes demanding such remedial action (such a notice was received by the Company from the trustee on July 16, 2014) and (ii) no delisting of our common stock from the Nasdaq Global Select Market occurred. This waiver expired on September 14, 2014 (i.e., 60 days following our receipt on July 16, 2014 of notice from the trustee), and we did not file the 2014 First Quarter Form 10-Q with the SEC and the trustee until September 15, 2014. As with the defaults described above, we do not have a contractual right to cure any default that resulted from the expiration of the waiver prior to such filing of the 2014 First Quarter Form 10-Q, and the default may be waived only with the consent of a majority of the lenders based on total credit exposure. We have not requested such a waiver. 32 -------------------------------------------------------------------------------- We may seek additional sources of capital as necessary or appropriate to fund acquisitions or to otherwise finance our growth or operations; there can be no assurance that such funds, if needed, will be available on favorable terms, if at all. Our access to the capital markets to raise funds, through the sale of equity or debt securities, is subject to various factors, including the conditions in U.S. capital markets and the timely filing of our periodic reports with the SEC. Our failure to timely file our 2013 Third Quarter Form 10-Q, our 2013 Form 10-K, our Form 8-K/A, our 2014 First Quarter Form 10-Q and our 2014 Second Quarter Form 10-Q with the SEC currently limits our ability to access the capital markets using short-form registration under the Securities Act of 1933, as Amended. Our Notes were issued under an Indenture that includes various default provisions, which, under certain circumstances, could result in the acceleration of our repayment obligations under the Notes and/or an increase for up to 180 days in the overall interest rate charged on the Notes. Under the Indenture, if we do not cure a default within 60 days after our receipt of such a notice and unless we obtain a waiver from the holders of more than 50% in aggregate principal amount of the Notes, an "event of default" would occur under the Indenture. Upon an event of default, we could, and would intend to, elect that for the first 180 days thereafter (or such lesser amount of time during which the event of default continues), the sole remedy would be the payment to the holders of the Notes of additional interest at an annual rate equal to 0.50%. If we elect to pay additional interest and the event of default is not cured within 180 days, or if we do not make such an election when an event of default first occurs, the trustee or the holders of at least 25% in aggregate principal amount of the Notes may declare the principal amount of the Notes to be due and payable immediately. In a notice dated July 16, 2014, the trustee under the Indenture provided us with notice that we were in default under the Indenture of our obligation to timely file our 2014 First Quarter Form 10-Q with the trustee and directed us to cure such default. In accordance with the terms of the Indenture, we had 60 days to cure such default. Such cure period expired on September 14, 2014, at which time the default became an event of default and gave the trustee and the holders of the Notes the right to exercise various remedies, including acceleration of the Notes. In accordance with the terms of the Indenture, by delivery of notice to the trustee, the paying agent and the holders of the Notes, we elected to pay additional interest at a rate equal to 0.50% as the sole remedy available to the holders of the Notes for the up to 180-day period commencing on September 14, 2014. Our filing of our 2014 First Quarter Form 10-Q with the SEC on September 15, 2014 cured the default and subsequent event of default that was the subject of the trustee's notice dated July 16, 2014, at which point we were no longer required to pay the additional interest on the Notes. On September 3, 2014, the trustee provided us with notice that we were in default under the Indenture because we had not timely filed our 2014 Second Quarter Form 10-Q with the trustee. Our filing of the 2014 Second Quarter Form 10-Q with the SEC on September 15, 2014 cured the default that was the subject of the trustee's notice dated September 3, 2014. The Indenture also provides that if our common stock ceases to be listed on the Nasdaq Global Select Market, then any holder of the Notes could require us to repurchase the holder's Notes in accordance with the terms of the Indenture. On May 2, 2014, the Listing Qualifications Department of The NASDAQ Stock Market LLC ("Nasdaq") notified us that due to our delay in filing with the SEC our 2013 Third Quarter Form 10-Q and 2013 Form 10-K, our common stock would be delisted unless we timely requested a hearing before a Nasdaq Hearings Panel (the "Panel"). On May 15, 2014, Nasdaq advised us that the delayed filing of the 2014 First Quarter Form 10-Q served as an additional basis for the delisting determination. On August 19, 2014, Nasdaq advised us that our delayed filing of our 2014 Second Quarter Form 10-Q served as a further basis for the delisting determination. Upon receiving the May 2, 2014 notice from Nasdaq, we timely requested a hearing before a Panel, and the hearing was held on June 12, 2014. At the hearing, we presented a plan to regain compliance with the listing rule and requested an extension of time in which to do so Thereafter, on June 23, 2014, we filed with the SEC certain delinquent reports that included our 2013 Third Quarter Form 10-Q and 2013 Form 10-K. 33 -------------------------------------------------------------------------------- On July 9, 2014, we received a letter from Nasdaq indicating that the Panel had determined to continue the listing of our common stock subject to the condition that, on or before September 12, 2014, we became current in our periodic filings with the SEC. We would also be required to demonstrate at such time that we are in compliance with all other requirements for continued listing on the Nasdaq Global Select Market. The Panel indicated that in the event we were unable to satisfy such conditions, our common stock would be delisted. On September 5, 2014, following our request that the Panel extend the September 12, 2014 date, we were notified that the Panel had extended our date to become current in our periodic filings with the SEC to November 13, 2014. On September 16, 2014, prior to the November 13, 2014 date specified by the Panel and following the filing of our 2014 First Quarter Form 10-Q and 2014 Second Quarter Form 10-Q with the SEC on September 15, 2014, Nasdaq confirmed to us that we have become current with respect to our periodic filing obligations with the SEC. Any acceleration of our repayment obligations or requirement that we pay additional interest under the Notes, or any requirement that we offer to repurchase the Notes, could materially and adversely impact our liquidity. Safe Harbor Under the Private Securities Litigation Reform Act of 1995 Statements that are not historical facts in this Management's Discussion and Analysis of Financial Condition and Results of Operations and other sections of this Form 10-Q may be deemed to be forward-looking statements within the meaning of the Exchange Act, and are subject to the safe harbor created by that Section. Words such as "may," "will," "should," "could," "would," "expect," "plan," "anticipate," "believe," "estimate," "project," "predict," "potential," and variations of these words and similar expressions are intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and are subject to risks and uncertainties. These risks, uncertainties and other factors may cause our future results, performances or achievements to be materially different from those expressed or implied by our forward-looking statements and include, among other things: the risk that that anticipated benefits and synergies of our 2012 acquisitions of Anue and BreakingPoint and our 2013 acquisition of Net Optics, will not be realized, and risks relating to recent and future changes in management, changes in the global economy, competition, consistency of orders from significant customers, our success in leveraging our intellectual property portfolio, expertise, and market opportunities, our expectations regarding the transition into Software Defined Networks (SDN), Network Functions Virtualization (NFV), and virtualized networks, our success in developing, producing and introducing new products, our success in developing new sales channels and customers, market acceptance of our products, war, terrorism, political unrest, natural disasters and other circumstances that could, among other consequences, reduce the demand for our products, disrupt our supply chain and/or impact the delivery of our products, material weaknesses in our internal controls, the 2013 and 2014 restatements of certain of our prior period financial statements, the securities class action and shareholder derivative action currently pending against us and certain of our current and former officers and directors, our default under the Credit Facility Agreement and any future default under the Indenture governing our Notes. The factors that may cause future results to differ materially from our current expectations also include, without limitation, the risks identified in our 2013 Form 10-K, in Part II, Item 1A, "Risk Factors," in this Form 10-Q and in our other filings with the SEC. |