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A10 NETWORKS, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q. The following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words "believe," "may," "will," "potentially," "estimate," "continue," "anticipate," "intend," "could," "would," "project," "plan" "expect," and similar expressions that convey uncertainty of future events or outcomes are intended to identify forward-looking statements. These forward-looking statements include, but are not limited to, statements concerning the following: • our ability to maintain an adequate rate of revenue growth; • our business plan and our ability to effectively manage our growth; • costs associated with defending intellectual property infringement and other claims; • our ability to attract and retain end-customers; • our ability to further penetrate our existing customer base; • our ability to displace existing products in established markets; • our ability to expand our leadership position in next-generation application delivery and server load balancing solutions; • our ability to timely and effectively scale and adapt our existing technology; • our ability to innovate new products and bring them to market in a timely manner; • our ability to expand internationally; • the effects of increased competition in our market and our ability to compete effectively; • the effects of seasonal trends on our results of operations; • our expectations concerning relationships with third parties; • the attraction and retention of qualified employees and key personnel; • our ability to maintain, protect, and enhance our brand and intellectual property; and • future acquisitions of or investments in complementary companies, products, services or technologies. These forward-looking statements are subject to a number of risks, uncertainties, and assumptions, including those described in "Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment, and new risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties, and assumptions, the forward-looking events and circumstances discussed in this Quarterly Report on Form 10-Q may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. You should not rely upon forward-looking statements as predictions of future events. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee that the future results, levels of activity, performance or events and circumstances reflected in the forward-looking statements will be achieved or occur. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. We undertake no obligation to update publicly any forward-looking statements for any reason after the date of this Quarterly Report on Form 10-Q to conform these statements to actual results or to changes in our expectations, except as required by law. Overview We are a leading provider of application networking technologies. Our solutions enable service providers, enterprises, Web giants and government organizations to accelerate, secure and optimize the performance of their data center applications and networks. Our products are built on our Advanced Core Operating System (" ACOS") platform of advanced network technologies, which is designed to enable our products to deliver substantially greater performance and security relative to prior generation application networking products. Our software based ACOS architecture also provides the flexibility that enables us to expand our business to offer additional products to solve a growing array of networking and security challenges arising from increased Internet cloud and mobile computing. 16 -------------------------------------------------------------------------------- We currently offer three software based advanced application networking solutions. These are Application Delivery Controllers ("ADCs") to optimize data center performance, Carrier Grade Network Address Translation ("CGN") to provide address and protocol translation services for service provider networks, and a Distributed Denial of Service Threat Protection System ("TPS") for network-wide security protection. We deliver these solutions both on optimized hardware appliances and as virtual appliances across our Thunder Series and AX Series product families. We derive revenue from sales of products and related support services. Products revenue are generated primarily by sales of hardware appliances with perpetual licenses to our embedded software solutions. We generate services revenue primarily from sales of maintenance and support. Our end-customers predominantly purchase maintenance and support in conjunction with purchases of our products. We sell our products globally to service providers and enterprises that depend on data center applications and networks to generate revenue and manage operations efficiently. Our end-customers operate in a variety of industries, including telecommunications, technology, industrial, retail, financial and education. Since inception, our customer base has grown rapidly. As of September 30, 2014, we had sold products to more than 3,600 customers across 68 countries, including three of the top four United States wireless carriers, seven of the top ten United States cable service providers, and the top three wireless carriers in Japan, in addition to other global enterprises, Web giants and governmental organizations. We sell substantially all of our solutions through our high-touch sales organization as well as distribution channel partners, including distributors, value added resellers and system integrators, and fulfill nearly all orders globally through such partners. We believe this sales approach allows us to obtain the benefits of channel distribution, such as expanding our market coverage, while still maintaining face-to-face relationships with our end-customers. We outsource the manufacturing of our hardware products to original design manufacturers. We perform quality assurance and testing at our San Jose, California facilities, as well as at our manufacturers' locations. We warehouse and deliver the majority of our products out of our San Jose warehouse. We also outsource warehousing and delivery to a third-party logistics provider in some regions. During the nine months ended September 30, 2014, 48% of our total revenue was generated from the United States, 27% from Japan, and 25% from other geographical regions. During the year ended December 31, 2013, 48% of our total revenue was generated from the United States, 28% from Japan and 24% from other geographical regions. As a result of the nature of our target market and the current stage of our development, a substantial portion of our revenue comes from a limited number of large end-customers, including service providers, in any period. During the nine months ended September 30, 2014 and years ended December 31, 2013 and 2012, purchases from our ten largest end-customers accounted for approximately 41%, 43% and 49% of our total revenue. The composition of the group of these ten largest end-customers changes from period to period, but often includes service providers, who accounted for approximately 45%, 47% and 53% of our total revenue during the nine months ended September 30, 2014 and years ended December 31, 2013 and 2012. Sales to these large end-customers have typically been characterized by large but irregular purchases with long sales cycles. The timing of these purchases and the delivery of the purchased products is difficult to predict. As a consequence, any acceleration or delay in anticipated product purchases by or deliveries to our largest end-customers could materially impact our revenue and operating results in any quarterly period and cause our quarterly revenue and operating results to fluctuate from quarter to quarter and also be difficult to predict. We believe our revenue during the nine months ended September 30, 2013 was affected by the issuance of injunctions related to our now settled litigation with Brocade Communications Systems, Inc. Although such injunctions did not prevent us from selling our redesigned products, certain customers informed us that they would not purchase any of our products until we settled the dispute. Total revenue for the nine months ended September 30, 2014 was $134.3 million, a 35% increase from the same period in the prior year. During the three months ended September 30, 2014, revenue from the United States and Canada, collectively referred to herein as the North America region ("North America"), was below our expectation primarily driven by longer than expected close or sales cycles for certain large deals and lower service provider spending as compared to the same period in 2013. Further, we anticipate a possible slowdown in spending from North America service providers, which may lead to continued near term fluctuation in our products revenue and total revenue. We intend to continue to invest for long-term growth. We have invested and expect to continue to invest heavily in our product development efforts to deliver new products and additional features in our current products to address customer needs. In addition, we expect to continue to expand our global sales and marketing organizations, expand our distribution channel partner programs and increase awareness of our solutions on a global basis. Additionally we will be investing in general and administration resources to meet the requirements to operate as a public company. Our investments in growth in these areas may affect short-term profitability. 17 -------------------------------------------------------------------------------- Key Components of Our Results of Operations and Financial Condition Revenue Our products revenue consists of revenue from sales of our hardware appliances upon which our software is installed. Such software includes our ACOS software platform plus one of our ADC, CGN or TPS solutions. Purchase of a hardware appliance includes a perpetual license to the included software. We recognize products revenue at the time of shipment, provided that all other revenue recognition criteria have been met. As a percentage of revenue, our products revenue may vary from quarter to quarter based on, among other things, the timing of orders and delivery of products, cyclicality and seasonality, changes in currency exchange rates and the impact of significant transactions with unique terms and conditions. During the three months ended September 30, 2014, our revenue from North America was below our expectation primarily driven by longer than expected close or sales cycles for certain large deals and lower service provider spending as compared to the same period in 2013. We anticipate a possible slowdown in spending from North America service providers, which may lead to continued near term fluctuation in our products revenue and total revenue. We generate services revenue from sales of post contract support, or PCS, which is bundled with sales of products and professional services. We offer tiered PCS services under renewable, fee-based PCS contracts, primarily including technical support, hardware repair and replacement parts, and software upgrades on a when-and-if-released basis. We recognize services revenue ratably over the term of the PCS contract, which is typically one year, but can be up to five years. We expect our services revenue to increase in absolute dollars as we expand our installed base. Cost of Revenue Cost of products revenue is primarily comprised of cost of third-party manufacturing services and cost of component inventory for the hardware component of our products. Cost of products revenue also includes warehouse personnel costs, shipping costs, inventory write-downs, certain allocated facilities and information technology infrastructure costs, and expenses associated with logistics and quality control. Cost of services revenue is primarily comprised of personnel costs for our technical support, training and professional service teams. Cost of services revenue also includes the costs of inventory used to provide hardware replacements to end-customers under PCS contracts and certain allocated facilities and information technology infrastructure costs. Gross Margin Gross margin may vary and be unpredictable from quarter to quarter due to a variety of factors. These may include the mix of revenue from each of our regions, the mix of our products sold within a period, discounts provided to customers, discounts on early sales of new products to gain market penetration, inventory write-downs and international currency exchange rates. As to currency, our sales are generally denominated in U.S. dollars, however, in Japan they are denominated in the Japanese yen. Changes in the exchange rates between the U.S. dollar and Japanese yen will therefore affect our revenue and gross margin. For example, in the third quarter of 2014, gross margin was adversely impacted by an increase in our inventory reserve primarily due to obsolete inventory on hand and unfavorable exchange rate fluctuations between the U.S. dollar and the Japanese yen. Any of the factors noted above can generate either a positive or negative impact on gross margin as compared to another period. Although our third quarter ending September 30, 2014 gross margin was lower than anticipated, we expect our gross margin to be consistent with our historical average. Operating Expenses Our operating expenses consist of sales and marketing, research and development, general and administrative and litigation. The largest component of our operating expenses is personnel costs which consist of wages, benefits, bonuses, and, with respect to sales and marketing expenses, sales commissions. Personnel costs also include stock-based compensation and travel expenses. We expect personnel costs to continue to increase in absolute dollars as we hire new employees to continue to grow our business. 18 -------------------------------------------------------------------------------- Sales and Marketing Sales and marketing expenses are our largest functional category of total operating expense. These expenses primarily consist of personnel costs related to our employees engaged in sales and marketing activities. Sales and marketing expenses also include the cost of marketing programs, trade shows, consulting services, promotional materials, demonstration equipment, depreciation and certain allocated facilities and information technology infrastructure costs. We expect our sales and marketing expenses to continue to increase in absolute dollars as we increase the size of our sales and marketing organization and expand into new countries. Research and Development Research and development efforts are focused on new product development and on developing additional functionality for our existing products. These expenses consist of personnel costs, and to a lesser extent, prototype materials, depreciation and certain allocated facilities and information technology infrastructure costs. We expense research and development costs as incurred. We expect our research and development expenses to increase in absolute dollars as we continue to develop new products and enhance our existing products. General and Administrative General and administrative expenses consist primarily of personnel costs, professional fees and facility costs. General and administrative personnel costs include executive, finance, human resources, information technology, facility and legal (excluding litigation) related expenses. Professional fees consist primarily of fees for outside accounting, tax, legal, recruiting and other administrative services. We expect our general and administrative expenses to increase in absolute dollars due to the additional legal, accounting, insurance, investor relations and other costs that we will incur as a public company, as well as other costs associated with growing our business. Litigation Expense (Benefit) Litigation expense (benefit) is comprised of legal expenses incurred related to litigation and, if applicable, charges for litigation reserves. Legal expenses consist of professional fees incurred in defending ourselves against litigation matters and are expensed as incurred when professional services are provided. The litigation reserve, if any, consists of accruals we make related to estimated losses in pending legal proceedings. Litigation reserves, if any, are adjusted as we change our estimates or make payments in damages or settlements. Other Income (Expense), Net Interest Expense Interest expense consists primarily of interest expense on our debt obligations. At September 30, 2014, we have no outstanding balances on our credit facility. We expect to continue to incur commitment fees associated with the undrawn balance of our credit facility. At such time we choose to draw down on the credit facility we would reduce the commitment fees accrued and increase the interest on outstanding balances. Interest Income and Other Income (Expense), Net Interest income consists primarily of interest income earned on our cash and cash equivalents balances. Other income (expense) consists primarily of foreign currency exchange gains and losses and, through February 2013, fair value adjustments related to then-outstanding warrants to purchase our convertible preferred stock. Foreign currency exchange gains and losses relate to transactions and asset and liability balances denominated in currencies other than the U.S. dollar. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in foreign currency exchange rates. Provision for Income Taxes Provision for income taxes currently consists of taxes from state and foreign jurisdictions. For federal and state tax purposes, we maintain a valuation allowance against all of our net deferred tax assets. We will continue to maintain a full valuation allowance against our net federal and state deferred tax assets until there is sufficient evidence to support recoverability of our deferred tax assets. As a result, the provision for income taxes primarily relates to foreign and state taxes. 19 -------------------------------------------------------------------------------- Results of Operations The following tables provide a summary of our Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2014 and 2013 as derived from our condensed consolidated financial statements included in Part I Financial Information in this Quarterly Report on Form 10-Q (in thousands, except for percentages). Three Months Ended September 30, 2014 2013 Increase (Decrease) Percent of Percent of Amount Total Revenue Amount Total Revenue Amount Percent Revenue: Products $ 31,601 72.8 % $ 32,263 81.0 % $ (662 ) (2.1 )% Services 11,827 27.2 7,563 19.0 4,264 56.4 Total revenue 43,428 100.0 39,826 100.0 3,602 9.0 Cost of revenue: Products 8,818 20.3 6,669 16.7 2,149 32.2 Services 2,935 6.8 2,065 5.2 870 42.1 Total cost of revenue 11,753 27.1 8,734 21.9 3,019 34.6 Gross profit 31,675 72.9 31,092 78.1 583 1.9 Operating expenses: Sales and marketing 24,651 56.8 18,276 45.9 6,375 34.9 Research and development 12,342 28.4 8,517 21.4 3,825 44.9 General and administrative 5,141 11.8 3,686 9.3 1,455 39.5 Litigation expense (benefit) 910 2.1 1,683 4.2 (773 ) (45.9 ) Total operating expenses 43,044 99.1 32,162 80.8 10,882 33.8 Loss from operations (11,369 ) (26.2 ) (1,070 ) (2.7 ) (10,299 ) (962.5 ) Other income (expense), net: Interest expense (192 ) (0.4 ) (1,399 ) (3.5 ) 1,207 86.3 Interest income and other income (expense), net (510 ) (1.2 ) (73 ) (0.2 ) (437 ) (598.6 ) Total other income (expense), net (702 ) (1.6 ) (1,472 ) (3.7 ) 770 52.3 Loss before provision for income taxes (12,071 ) (27.8 ) (2,542 ) (6.4 ) (9,529 ) (374.9 ) Provision for income taxes 233 0.5 207 0.5 26 12.6 Net loss $ (12,304 ) (28.3 )% $ (2,749 ) (6.9 )% $ (9,555 ) (347.6 )% 20-------------------------------------------------------------------------------- Nine Months Ended September 30, 2014 2013 Increase (Decrease) Percent of Percent of Amount Total Revenue Amount Total Revenue Amount Percent Revenue: Products $ 102,140 76.1 % $ 78,596 79.0 % $ 23,544 30.0 % Services 32,165 23.9 20,942 21.0 11,223 53.6 Total revenue 134,305 100.0 99,538 100.0 34,767 34.9 Cost of revenue: Products 23,655 17.6 16,469 16.6 7,186 43.6 Services 8,491 6.3 5,783 5.8 2,708 46.8 Total cost of revenue 32,146 23.9 22,252 22.4 9,894 44.5 Gross profit 102,159 76.1 77,286 77.6 24,873 32.2 Operating expenses: Sales and marketing 70,189 52.3 49,588 49.8 20,601 41.5 Research and development 35,416 26.4 24,625 24.7 10,791 43.8 General and administrative 16,035 11.9 11,213 11.3 4,822 43.0 Litigation expense (benefit) (3,103 ) (2.3 ) 9,887 9.9 (12,990 ) (131.4 ) Total operating expenses 118,537 88.3 95,313 95.7 23,224 24.4 Loss from operations (16,378 ) (12.2 ) (18,027 ) (18.1 ) 1,649 9.1 Other income (expense), net: Interest expense (904 ) (0.7 ) (1,445 ) (1.5 ) 541 37.4 Interest income and other income (expense), net (673 ) (0.5 ) (1,437 ) (1.4 ) 764 53.2 Total other income (expense), net (1,577 ) (1.2 ) (2,882 ) (2.9 ) 1,305 45.3 Loss before provision for income taxes (17,955 ) (13.4 ) (20,909 ) (21.0 ) 2,954 14.1 Provision for income taxes 747 0.5 586 0.6 161 27.5 Net loss $ (18,702 ) (13.9 )% $ (21,495 ) (21.6 )% $ 2,793 13.0 % Comparison of the Three and Nine Months Ended September 30, 2014 and 2013 Revenue A summary of our total revenue for the three and nine months ended September 30, 2014 and 2013 is as follows (in thousands, except for percentages): Three Months Ended September 30, Increase (Decrease) 2014 2013 Amount Percent Revenue: Products $ 31,601 $ 32,263 $ (662 ) (2.1 )% Services 11,827 7,563 4,264 56.4 Total revenue $ 43,428 $ 39,826 $ 3,602 9.0 % 21-------------------------------------------------------------------------------- Nine Months Ended September 30, Increase (Decrease) 2014 2013 Amount Percent Revenue: Products $ 102,140 $ 78,596 $ 23,544 30.0 % Services 32,165 20,942 11,223 53.6 Total revenue $ 134,305 $ 99,538 $ 34,767 34.9 % Total revenue increased $3.6 million in the three months ended September 30, 2014 compared to the three months ended September 30, 2013 which consisted of a $4.3 million increase in services revenue partially offset by $0.7 million decrease in products revenue. We had lower than expected products revenue from our North America market during the three months ended September 30, 2014 primarily due to longer than expected close or sales cycles for certain large deals and lower North America service provider spending. Total revenue from North America service providers decreased by 62% in the three months ended September 30, 2014 as compared to the same period in 2013. Total revenue increased $34.8 million in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013 which consisted of a $23.5 million increase in products revenue and an $11.2 million increase in services revenue. These increases were primarily a result of the positive effects of the now settled Brocade litigation and acceptance of our new Thunder series of products introduced in the third quarter of 2013. Products revenue decreased $0.7 million during the three months ended September 30, 2014 compared to the three months ended September 30, 2013 as a result of the factors discussed above. Products revenue from North America service providers decreased 78% in the three months ended September 30, 2014 compared to the same period in 2013. The decrease in North America products revenue was offset by increases in revenue from international regions including EMEA and Asia Pacific, excluding Japan, primarily attributable to our efforts in expanding our international sales presence. Products revenue increased $23.5 million nine months ended September 30, 2014 primarily driven by a rise in sales of our products largely attributable to greater adoption of our solutions to new and existing customers which we believe resulted from the absence of the negative effect of the injunction issued in January 2013 related to the now settled Brocade litigation. The injunction did not prevent us from shipping our redesigned products in January 2013, but at that time, some customers informed us they would not purchase our products until after settlement of the litigation, which occurred in May 2013. In addition, there has been a rapid adoption of our Thunder Series products introduced in the third quarter of 2013 which accounted for the majority of products revenue in the three and nine months ended September 30, 2014. Our Thunder Series of products include our ADC, CGN and TPS product lines. Services revenue increased $4.3 million and $11.2 million in the three and nine months ended September 30, 2014 compared to the same periods in 2013 primarily attributable to the increase in PCS sales in connection with our increasing installed customer base as well as increases in our professional services revenue. Over 95% of our end-customers purchase one of our maintenance service products when purchasing our hardware products. During the three and nine months ended September 30, 2014, services revenue recognized from our installed base with existing contracts prior to the start of these reporting periods grew by 57% and 54% as compared to revenue generated during the same reporting periods in 2013. During the three months ended September 30, 2014, 47%, or $20.4 million of total revenue was generated from the United States. Total revenue from the U.S. decreased by 23% in the three months ended September 30, 2014 compared to the three months ended September 30, 2013 primarily as a result of longer than expected close or sales cycles for certain large deals and lower North America service provider revenue partially offset by an increase in services revenue that resulted from our increasing installed customer base. Total revenue from Japan increased 41%, or $2.9 million, in the three months ended September 30, 2014 compared to the three months ended September 30, 2013 primarily due to increased revenue from service providers by 58% partially offset by unfavorable fluctuations in the U.S dollar exchange rate against the Japanese yen. We continue to see growth in our Asia Pacific, excluding Japan and EMEA regions with revenue increasing by 113% to $6.3 million and 196% to $4.9 million during the three months ended September 30, 2014 as compared to the same period in the prior year. These increases are primarily a result of our efforts to expand our sales presence into these markets. During the nine months ended September 30, 2014, 48%, or $64.9 million of total revenue was generated from the United States and 27%, or $35.7 million of total revenue was generated from Japan. Total U.S. revenue grew by 37%, or $17.4 million, in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013, as the negative 22 -------------------------------------------------------------------------------- effects of the now settled Brocade litigation during the prior period have subsided. Total revenue from Japan increased by 15% to $35.7 million for the nine months ended September 30, 2014 compared to the same period in the prior year. We continue to see growth in our EMEA and Asia Pacific, excluding Japan regions with total revenue increasing by 97% to $13.0 million and 66% to $15.0 million during the nine months ended September 30, 2014 as compared to the same period in the prior year primarily due to our efforts to expand our presence in regions outside the United States. We anticipate a possible slowdown in spending from North America service providers, which may lead to continued near term fluctuation in our products revenue and total revenue. We expect services revenue to increase sequentially into the foreseeable future as we increase our installed base. Cost of Revenue, Gross Profit and Gross Margin Cost of revenue A summary of our cost of revenue for the three and nine months ended September 30, 2014 and 2013 is as follows (in thousands, except for percentages): Three Months Ended September 30, Increase (Decrease) 2014 2013 Amount Percent Cost of revenue: Products $ 8,818 $ 6,669 $ 2,149 32.2 % Services 2,935 2,065 870 42.1 Total cost of revenue $ 11,753 $ 8,734 $ 3,019 34.6 % Nine Months Ended September 30, Increase (Decrease) 2014 2013 Amount Percent Cost of revenue: Products $ 23,655 $ 16,469 $ 7,186 43.6 % Services 8,491 5,783 2,708 46.8 Total cost of revenue $ 32,146 $ 22,252 $ 9,894 44.5 % Gross Margin A summary of gross profit and gross margin for the three and nine months ended September 30, 2014 and 2013 is as follows (in thousands, except for gross margins): Three Months Ended September 30, 2014 2013 Increase (Decrease) Amount Gross Margin Amount Gross Margin Amount Gross Margin Gross profit: Products $ 22,783 72.1 % $ 25,594 79.3 % $ (2,811 ) (7.2 )% Services 8,892 75.2 5,498 72.7 3,394 2.5Total gross profit $ 31,675 72.9 % $ 31,092 78.1 % $ 583 (5.2 )% 23-------------------------------------------------------------------------------- Nine Months Ended September 30, 2014 2013 Increase (Decrease) Amount Gross Margin Amount Gross Margin Amount Gross Margin Gross profit: Products $ 78,485 76.8 % $ 62,127 79.0 % $ 16,358 (2.2 )% Services 23,674 73.6 15,159 72.4 8,515 1.2 Total gross profit $ 102,159 76.1 % $ 77,286 77.6 % $ 24,873 (1.5 )% Products gross margin decreased 7.2 percentage points and 2.2 percentage points in the three and nine months ended September 30, 2014 compared to the same periods in 2013 primarily due to an unfavorable shift in our geographical sales mix and a devaluation of the Japanese yen to the U.S. Dollar. During the three and nine months ended September 30, 2013 higher sales volumes were from geographic regions with generally higher gross margins compared to the same periods in 2014. In addition, during the three months ended September 30, 2014 our inventory reserve increased compared to the same period in 2013 as a result of our end-customers adopting our new Thunder Series. Services gross margin increased 2.5 percentage points and 1.2 percentage points in the three and nine months ended September 30, 2014 compared to the same period in 2013, as a result of growth in services revenue and partially offset by the impact of increases in cost of services. Our services revenue recognized from our installed base with existing contracts prior to the start of these reporting periods grew by 57% and 54% as compared to revenue generated during the same reporting periods in 2013. The increase in cost of services was primarily as a result of our investment to expand our service and support group in anticipation of future growth in our installed base. We increased our average support, training and professional services headcount by 59% during the nine months ended September 30, 2014 compared to the same period in 2013. Operating Expenses A summary of our operating expenses for the three and nine months ended September 30, 2014 and 2013 is as follows (in thousands, except for percentages): Three Months Ended September 30, Increase (Decrease) 2014 2013 Amount Percent Operating expenses: Sales and marketing $ 24,651 $ 18,276 $ 6,375 34.9 % Research and development 12,342 8,517 3,825 44.9 General and administrative 5,141 3,686 1,455 39.5 Litigation expense (benefit) 910 1,683 (773 ) (45.9 ) Total operating expenses $ 43,044 $ 32,162 $ 10,882 33.8 % Nine Months Ended September 30, Increase (Decrease) 2014 2013 Amount Percent Operating expenses: Sales and marketing $ 70,189 $ 49,588 $ 20,601 41.5 % Research and development 35,416 24,625 10,791 43.8 General and administrative 16,035 11,213 4,822 43.0 Litigation expense (benefit) (3,103 ) 9,887 (12,990 ) (131.4 ) Total operating expenses $ 118,537 $ 95,313 $ 23,224 24.4 % Sales and Marketing Sales and marketing expenses increased $6.4 million in the three months ended September 30, 2014 compared to the three months ended September 30, 2013 primarily attributable to $3.5 million increase in personnel and related costs, which 24 -------------------------------------------------------------------------------- includes a $1.1 million increase in stock-based compensation, as a result of a 24% increase in average sales and marketing headcount during the three months ended September 30, 2014 compared to the same period in 2013. The increase was also attributable to a $0.9 million increase in marketing and promotion costs associated with advertising and trade shows and $0.8 million increase in professional fees as we increased our sales and marketing efforts to grow our revenue and expand our international sales presence. Depreciation expense allocated to sales and marketing departments also increased by $0.5 million as a result of higher headcount and increased depreciation expense on our evaluation equipment. Sales and marketing expenses increased $20.6 million in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013 primarily attributable to $13.9 million increase in personnel and related costs, which includes a $2.5 million increase in stock-based compensation. The increase in personnel related costs was a result of higher sales and marketing headcount as we experienced a 27% increase in average headcount during the nine months ended September 30, 2014 compared to the same period in 2013. The increase was also attributable to a $2.3 million increase in marketing and promotion costs associated with advertising and trade shows, and $1.7 million increase in professional fees, as we increased our sales and marketing efforts to grow our revenue and expand our international sales presence. Depreciation expense allocated to sales and marketing departments also increased by $1.4 million as a result of higher headcount and increased depreciation expense on our evaluation equipment. Research and Development Research and development expenses increased $3.8 million in the three months ended September 30, 2014 compared to the three months ended September 30, 2013 primarily attributable to a $3.3 million increase in personnel and related costs, which includes a $0.8 million increase in stock-based compensation. The increases in personnel costs primarily resulted from a 27% increase in average research and development headcount for the three months ended September 30, 2014 compared to the same period in 2013, as we continued our efforts to develop new products and additional functionality for our existing products. The increases in research and development expenses also reflected a $0.4 million increase in depreciation and allocated facilities and information technology infrastructure costs in the three months ended September 30, 2014 compared to the same period in 2013. Research and development expenses increased $10.8 million in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013 primarily attributed to an $8.8 million increase in personnel and related costs, which includes a $1.6 million increase in stock-based compensation. The increase in personnel related costs was a result of higher research and development headcount as we experienced a 26% increase in average headcount during the nine months ended September 30, 2014 compared to the same period in 2013. The increases in research and development expenses also reflected a $1.0 million increase in professional services fees largely attributable to certification fees on our new products and a $1.0 million increase in depreciation and allocated facilities and information technology infrastructure costs in the nine months ended September 30, 2014 compared to the same period in 2013. General and Administrative General and administrative expenses increased $1.5 million in the three months ended September 30, 2014 compared to the three months ended September 30, 2013 primarily attributable to a $1.0 million increase in personnel related costs which includes a $0.3 million increase in stock-based compensation. The increase in personnel related costs was a result of an increase in our average general and administrative headcount of 29% for the three months ended September 30, 2014 compared to the same period in 2013. In addition, professional services costs increased by $1.1 million in the three months ended September 30, 2014 compared to the same periods in 2013 primarily related to increased general legal and consultant fees in connection with scaling our organization to support increased business activity and the costs associated with being a public company. These increases were partially offset by a $0.7 million decrease in other expenses primarily due to a decrease in bad debt expense. General and administrative expenses increased $4.8 million from the nine months ended September 30, 2013 to the nine months ended September 30, 2014 primarily attributed to a $2.5 million increase in personnel related costs which includes a $0.8 million increase in stock-based compensation. The increase in personnel related costs was a result of higher general and administrative headcount as we experienced a 27% increase in average headcount during the nine months ended September 30, 2014 compared to the same period in 2013. In addition, professional services costs increased by $1.7 million in the nine months ended September 30, 2014 compared to the same periods in 2013 primarily related to increased general legal and consultant fees in connection with scaling our organization to support increased business activity and costs associated with being a public company. 25-------------------------------------------------------------------------------- Litigation Expense (Benefit) Litigation expense decreased $0.8 million for the three months ended September 30, 2014 compared to the three months ended September 30, 2013 primarily attributable to reduction in litigation costs following the settlement of the litigation with Radware in August 2014. We recognized $3.1 million of litigation benefit and $9.9 million of litigation expense in the nine months ended September 30, 2014 and 2013. The litigation benefit for the nine months ended September 30, 2014 comprised of a benefit of $7.0 million from a settlement agreement with one of our legal services providers which resulted in the reduction of a previously accrued contractual liability partially offset by other litigation expense of $3.9 million. The $9.9 million litigation expense for the nine months ended September 30, 2013 primarily consisted of $7.3 million costs associated with the Brocade litigation which was settled in May 2013 and additional costs related to litigation with Radware and Parallel Networks. Interest Expense Interest expense decreased by $1.2 million in the three months ended September 30, 2014 compared to the three months ended September 30, 2013, primarily due to $1.1 million in interest expense on an unsecured convertible promissory note we issued to Brocade in July 2013 in accordance with the terms of the settlement of the Brocade litigation recorded in the three months ended September 30, 2013. We repaid the note in full in September 2013. Interest expense decreased $0.5 million in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013 due to $1.1 million in interest expense on an unsecured convertible promissory note we issued to Brocade in July 2013 recorded in the nine months ended September 30, 2013 partially offset by a $0.3 million contingent payment due upon completion of the initial public offering to a lender and $0.5 million of interest expense related to our revolving credit facility. Interest Income and Other Income (Expense), Net Interest income and other income (expense), net, was $0.5 million expense in the three months ended September 30, 2014 primarily comprised of foreign exchange losses resulting from declining Japanese yen exchange rates against the U.S dollar during the three months ended September 30, 2014. Interest income and other income (expense), net, was $0.7 million expense in the nine months ended September 30, 2014 primarily comprised of foreign exchange losses resulting from declining Japanese yen and the Euro exchange rates against the U.S dollar during the nine months ended September 30, 2014. Provision for Income Taxes We recorded an income tax provision of $0.2 million and $0.7 million for the three and nine months ended September 30, 2014 which is primarily the result of taxes in foreign jurisdictions. We recorded an income tax provision of $0.2 million and $0.6 million for the three and nine months ended September 30, 2013 which is primarily the result of taxes in foreign jurisdictions. We maintain a valuation allowance on federal and state deferred tax assets as we do not believe it is more likely than not that said deferred tax assets will be realized. We will continue to maintain a full valuation allowance on our deferred tax assets until there is sufficient evidence to support the reversal of all or some portion of this allowance. 26 -------------------------------------------------------------------------------- Liquidity and Capital Resources Prior to our initial public offering in March 2014, we had financed our operations primarily through private placements of our convertible preferred stock, debt financings and cash flows derived from the sale of our products and PCS contracts. In March 2014, we completed our initial public offering, whereby we sold 12,500,000 common shares at $15.00 per share (3,500,000 of which were offered by selling stockholders) and received net cash proceeds of $121.0 million after underwriting discounts and commissions and offering expenses during the nine months ended September 30, 2014. As of September 30, 2014, cash and cash equivalents were $107.1 million, including $2.6 million held outside the United States in our foreign subsidiaries. We currently do not have any plans to repatriate our earnings from our foreign operations. As of September 30, 2014, we had working capital of $107.7 million, an accumulated deficit of $165.8 million and total stockholders' equity of $105.7 million. We plan to continue to invest for long-term growth and anticipate our investment will continue to increase in absolute dollars. We believe that our existing cash and cash equivalents and our cash inflow from operations will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, the expansion of sales and marketing activities, the timing and extent of spending to support development efforts, the introduction of new and enhanced product and service offerings and the continuing market acceptance of our products. In the event that additional financing is required from outside sources, we may not be able to raise such financing on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition would be adversely affected. As we invest in the growth of our business, we expect to incur an additional $2.7 million in capital expenditures in the remainder of 2014 due to recurring investments in computer hardware and software. In addition, as described in the section "Legal Proceedings" we are currently involved in ongoing litigation. Any adverse settlements or judgments in any litigation could have a material adverse impact on our results of operations, cash balances and cash flows in the period in which such events occur. Credit Agreement In September 2013, we entered into a credit agreement with Royal Bank of Canada, acting as administrative agent and lender, and JPMorgan Chase Bank, N.A. and Bank of America, N.A. as lenders. The credit agreement provides a three year $35.0 million revolving credit facility, which includes a maximum $10.0 million letter of credit facility. As of December 31, 2013, we had outstanding borrowings under the revolving credit facility of $20.0 million, which was paid in March 2014. The revolving credit facility matures on September 30, 2016. Our obligations under the credit agreement are secured by a security interest on substantially all of our assets, including our intellectual property. The credit agreement contains customary non-financial covenants, and also requires us to comply with financial covenants. One financial covenant requires us to maintain a total leverage ratio, which is defined as total consolidated debt divided by adjusted EBITDA (defined as earnings before interest expense, tax expense, depreciation, amortization and stock-based compensation, adjusted for certain other non-cash or non-recurring income or expenses such as specified litigation settlement payments and litigation expenses) for the trailing four quarters. In addition, we must maintain a minimum amount of liquidity based on our unrestricted cash and availability under the revolving credit facility. The covenant requires us to maintain a minimum liquidity of $25.0 million provided that at least $10.0 million of such liquidity comprised of unrestricted cash and cash equivalents. The credit agreement includes customary events of default which, if triggered, could result in the acceleration of our obligations under the revolving credit facility, the termination of any obligation by the lenders to extend further credit and the right of the lenders to exercise their remedies as a secured creditor and foreclose upon the collateral securing our obligation under the credit agreement; however, we also have the ability, in certain instances, to cure non-compliance with the financial covenants through qualified equity contributions by certain holders of our equity. Currently, the agreement for our revolving credit facility contains restrictions on our ability to pay dividends. As of September 30, 2014, we had no outstanding balance on our credit facility and were in compliance with our covenants. 27-------------------------------------------------------------------------------- |