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NETLIST INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Unaudited Condensed Consolidated Financial Statements and the related notes thereto contained in Part I, Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Report and in our other reports filed with the Securities and Exchange Commission, or SEC, including our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 and subsequent reports on Form 8-K, which discuss our business in greater detail. This report contains forward-looking statements regarding future events and our future performance. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those expected or projected. These risks and uncertainties include, but are not limited to risks associated with the launch and commercial success of our products, programs and technologies; the success of product partnerships;continuing development, qualification and volume production of EXPRESSvault™, NVvault™, HyperCloud™ and VLP Planar-X RDIMM; the timing and magnitude of the anticipated decrease in sales to our key customer; our ability to leverage our NVvault™ technology in a more diverse customer base; the rapidly-changing nature of technology; risks associated with intellectual property, including the costs and unpredictability of litigation over infringement of our intellectual property and the possibility of our patents being reexamined by the USPTO; volatility in the pricing of DRAM ICs and NAND; changes in and uncertainty of customer acceptance of, and demand for, our existing products and products under development, including uncertainty of and/or delays in product orders and product qualifications; delays in our and our customers' product releases and development; introductions of new products by competitors; changes in end-user demand for technology solutions; our ability to attract and retain skilled personnel; our reliance on suppliers of critical components and vendors in the supply chain; fluctuations in the market price of critical components; evolving industry standards; and the political and regulatory environment in the PRC. Other risks and uncertainties are described under the heading "Risk Factors" in Part II, Item IA of this Quarterly Report on Form 10-Q, and similar discussions in our other SEC filings. Except as required by law, we undertake no obligation to revise or update publicly any forward-looking statements for any reason. Overview We design, manufacture and sell high-performance, intelligent memory subsystems for datacenter server and high-performance computing and communications markets. Our memory subsystems consist of combinations of dynamic random access memory integrated circuits ("DRAM ICs" or "DRAM"), NAND flash memory ("NAND"), application-specific integrated circuits ("ASICs") and other components assembled on printed circuit boards ("PCBs"). We primarily market and sell our products to leading original equipment manufacturer ("OEM") customers. Our solutions are targeted at applications where memory plays a key role in meeting system performance requirements. We leverage a portfolio of proprietary technologies and design techniques, including efficient planar design, alternative packaging techniques and custom semiconductor logic, to deliver memory subsystems with high memory density, small form factor, high signal integrity, attractive thermal characteristics and low cost per bit. Unless the context otherwise requires, all references in this Report to "we," "us," "our," "the Company," or "Netlist" refer to Netlist, Inc. and its subsidiaries. 30 -------------------------------------------------------------------------------- Table of Contents Our Products HypercloudTM In November 2009, we introduced HyperCloud™ DDR3 memory technology. HyperCloud™ utilizes an ASIC chipset that incorporates Netlist patented rank multiplication technology that increases memory capacity and load reduction technology that increases memory bandwidth. We expect that these patented technologies will make possible improved levels of performance for memory intensive datacenter applications and workloads, including enterprise virtualization, cloud computing infrastructure, business intelligence real-time data analytics, and high performance computing. In February 2012 and May 2012, we achieved memory qualification of HyperCloud™ at IBM and HP, respectively. In November 2011, we introduced the world's first 32GB two-virtual rank RDIMM integrating HyperCloud™ with our proprietary Planar-X technology. The new memory modules enable up to 768GB of DRAM memory in next generation two-processor servers. Additionally, we announced collaborative agreements with each of Hewlett-Packard Company ("HP") and International Business Machines ("IBM"), pursuant to which these OEMs have agreed to cooperate with us in efforts to qualify HyperCloud™ memory products for use with their respective products. HP and IBM have agreed to engage with us in joint marketing and further product development efforts. We and each of the OEMs have committed financial and other resources toward the collaboration. However, the efforts undertaken under either of the collaborative agreements may not result in any new revenues for us. NVvaultTM In February 2010, we announced general availability of NVvaultTM battery-free, a non-volatile cache memory subsystem targeting RAID storage applications. NVvaultTM battery-free provides server and storage OEMs a solution for enhanced datacenter fault recovery. Unlike our traditional battery-powered fault tolerant cache product which relied solely on batteries to power the cache, NVvaultTM battery-free utilizes a combination of DRAM for high throughput performance and flash for extended data retention. The introduction of NVvaultTM battery-free, as well as the launch of the current version of the battery-powered module in connection with Dell introduction of the PERC 7 line of servers in December 2009, has resulted in RAID controller subsystem revenues of $10.8 million, or 77.5% of total revenues for the three months ended March 31, 2012. We expect a decline in NVvault™ sales to Dell through 2013 following Intel's launch of its Romley platform in the first quarter of 2012. This reduction in sales could have a significant impact on our revenues and gross profit as soon as the second quarter of 2012. In order to leverage our NVvault™ technology into a more diverse customer base, we continue to pursue additional qualifications of NVvault™ with other customers. We also introduced EXPRESSvault™in March 2011, and we are in the process of qualifying next generation DDR3NVvault™ with customers. While, nearly 100% of 2010 sales were made to Dell, as a result of our diversification efforts, approximately 5% or revenues for each of the three month periods ended March 31, 2012 and April 2, 2011 were to other customers. Specialty Memory Modules and Flash-Based Products The remainder of our revenues arose primarily from OEM sales of specialty memory modules and flash-based products, the majority of which were utilized in data center and industrial applications. When developing custom modules for an equipment product launch, we engage with our OEM 31 -------------------------------------------------------------------------------- Table of Contents customers from the earliest stages of new product definition, providing us unique insight into their full range of system architecture and performance requirements. This close collaboration has also allowed us to develop a significant level of systems expertise. We leverage a portfolio of proprietary technologies and design techniques, including efficient planar design, alternative packaging techniques and custom semiconductor logic, to deliver memory subsystems with high speed, capacity and signal integrity, small form factor, attractive thermal characteristics and low cost per bit. Revenues from our specialty modules and flash-based products are subject to fluctuation as a result of the life cycles of the products into which our modules are incorporated. Our ability to continue to produce revenues from specialty memory modules and flash-based products is dependent on our ability to qualify our products on new platforms as current platforms reach the end of their lifecycles, and on the state of the global economy. Consistent with the concentrated nature of the OEM customer base in our target markets, a small number of large customers have historically accounted for a significant portion of our net sales. One customer represented approximately 85% and 70% of our net sales for the three months ended March 31, 2012 and April 2, 2011, respectively. Key Business Metrics The following describes certain line items in our condensed consolidated statements of operations that are important to management's assessment of our financial performance: Net Sales. Net sales consist primarily of sales of our high performance memory subsystems, net of a provision for estimated returns under our right of return policies, which generally range up to 30 days. We generally do not have long-term sales agreements with our customers. Although OEM customers typically provide us with non-binding forecasts of future product demand over specific periods of time, they generally place orders with us approximately two weeks in advance of scheduled delivery. Selling prices are typically negotiated monthly, based on competitive market conditions and the current price of DRAM ICs and NAND. Purchase orders generally have no cancellation or rescheduling penalty provisions. We often ship our products to our customers' international manufacturing sites. All of our sales to date, however, are denominated in U.S. dollars. We also sell excess component inventory of DRAM ICs and NAND to distributors and other users of memory ICs. As compared to previous years, component inventory sales remain a relatively small percentage of net sales as a result of our efforts to diversify both our customer and product line bases. This diversification effort has also allowed us to use components in a wider range of memory subsystems. We expect that component inventory sales will continue to represent a minimal portion of our net sales in future periods. Cost of Sales. Our cost of sales includes the cost of materials, manufacturing costs, depreciation and amortization of equipment, inventory valuation provisions, stock-based compensation, and occupancy costs and other allocated fixed costs. The DRAM ICs and NAND incorporated into our products constitute a significant portion of our cost of sales, and thus our cost of sales will fluctuate based on the current price of DRAM ICs and NAND. We attempt to pass through such DRAM IC and NAND flash memory cost fluctuations to our customers by frequently renegotiating pricing prior to the placement of their purchase orders. However, the sales prices of our memory subsystems can also fluctuate due to competitive situations unrelated to the pricing of DRAM ICs and NAND, which affects gross margins. The gross margin on our sales of excess component DRAM IC and NAND inventory is much lower than the gross margin on our sales of our memory subsystems. As a result, fluctuations in DRAM IC and NAND inventory sales as a percentage of our overall sales could impact our overall gross margin. We assess the valuation of our inventories on a quarterly basis and record a provision to cost of sales as necessary to reduce inventories to the lower of cost or net realizable value. 32 -------------------------------------------------------------------------------- Table of Contents Research and Development. Research and development expense consists primarily of employee and independent contractor compensation and related costs, stock-based compensation, non-recurring engineering fees, computer-aided design software licenses, reference design development costs, patent filing and protection legal fees, depreciation or rental of evaluation equipment, and occupancy and other allocated overhead costs. Also included in research and development expense are the costs of material and overhead related to the production of engineering samples of new products under development or products used solely in the research and development process. Our customers typically do not separately compensate us for design and engineering work involved in developing application-specific products for them. All research and development costs are expensed as incurred. We anticipate that research and development expenditures will increase in future periods as we seek to expand new product opportunities, increase our activities related to new and emerging markets and continue to develop additional proprietary technologies. Selling, General and Administrative. Selling, general and administrative expenses consist primarily of employee salaries and related costs, stock-based compensation, independent sales representative commissions, professional services, promotional and other selling and marketing expenses, and occupancy and other allocated overhead costs. A significant portion of our selling effort is directed at building relationships with OEMs and other customers and working through the product approval and qualification process with them. Therefore, the cost of material and overhead related to products manufactured for qualification is included in selling expenses. As we continue to service existing and establish new customers, we anticipate that our sales and marketing expenses will increase. Critical Accounting Policies The preparation of our condensed consolidated financial statements in conformity with accounting principles generally accepted in the U.S. requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of net sales and expenses during the reporting period. By their nature, these estimates and assumptions are subject to an inherent degree of uncertainty. We base our estimates on our historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. We review our estimates on an on-going basis. Actual results may differ from these estimates, which may result in material adverse effects on our operating results and financial position. We believe the following critical accounting policies involve our more significant assumptions and estimates used in the preparation of our condensed consolidated financial statements: Revenue Recognition. We recognize revenues in accordance with the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 605. Accordingly, we recognize revenues when there is persuasive evidence that an arrangement exists, product delivery and acceptance have occurred, the sales price is fixed or determinable, and collectibility of the resulting receivable is reasonably assured. We generally use customer purchase orders and/or contracts as evidence of an arrangement. Delivery occurs when goods are shipped for customers with FOB Shipping Point terms and upon receipt for customers with FOB Destination terms, at which time title and risk of loss transfer to the customer. Shipping documents are used to verify delivery and customer acceptance. We assess whether the sales price is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund. Customers are generally allowed limited rights of return for up to 30 days, except for sales of excess component inventories, which contain no right-of-return privileges. 33 -------------------------------------------------------------------------------- Table of Contents Estimated returns are provided for at the time of sale based on historical experience or specific identification of an event necessitating a reserve. We offer a standard product warranty to our customers and have no other post-shipment obligations. We assess collectibility based on the creditworthiness of the customer as determined by credit checks and evaluations, as well as the customer's payment history. All amounts billed to customers related to shipping and handling are classified as net sales, while all costs incurred by us for shipping and handling are classified as cost of sales. Fair Value of Financial Instruments. Our financial instruments consist principally of cash and cash equivalents, investments in marketable securities, accounts receivable, accounts payable, accrued expenses and debt instruments. Other than for certain investments in auction rate securities, the fair value of our cash equivalents and investments in marketable securities is determined based on quoted prices in active markets for identical assets or Level 1 inputs. The fair value of our auction rate securities is determined based on Level 3 inputs. We recognize transfers between Levels 1 through 3 of the fair value hierarchy at the beginning of the reporting period. We believe that the carrying values of all other financial instruments approximate their current fair values due to their nature and respective durations. Allowance for Doubtful Accounts. We perform credit evaluations of our customers' financial condition and limit the amount of credit extended to our customers as deemed necessary, but generally require no collateral. We evaluate the collectibility of accounts receivable based on a combination of factors. In cases where we are aware of circumstances that may impair a specific customer's ability to meet its financial obligations subsequent to the original sale, we will record an allowance against amounts due, and thereby reduce the net recognized receivable to the amount that we reasonably believe will be collected. For all other customers, we record allowances for doubtful accounts based primarily on the length of time the receivables are past due based on the terms of the originating transaction, the current business environment and our historical experience. Uncollectible accounts are charged against the allowance for doubtful accounts when all cost effective commercial means of collection have been exhausted. Generally, our credit losses have been within our expectations and the provisions established. However, we cannot guarantee that we will continue to experience credit loss rates similar to those we have experienced in the past. Our accounts receivable are highly concentrated among a small number of customers, and a significant change in the liquidity or financial position of one of these customers could have a material adverse effect on the collectability of our accounts receivable, our liquidity and our future operating results. Inventories. We value our inventories at the lower of the actual cost to purchase or manufacture the inventory or the net realizable value of the inventory. Cost is determined on an average cost basis which approximates actual cost on a first-in, first-out basis and includes raw materials, labor and manufacturing overhead. At each balance sheet date, we evaluate ending inventory quantities on hand and record a provision for excess quantities and obsolescence. Among other factors, we consider historical demand and forecasted demand in relation to the inventory on hand, competitiveness of product offerings, market conditions and product life cycles when determining obsolescence and net realizable value. In addition, we consider changes in the market value of DRAM ICs and NAND in determining the net realizable value of our raw material inventory. Once established, any write downs are considered permanent adjustments to the cost basis of our excess or obsolete inventories. 34 -------------------------------------------------------------------------------- Table of Contents A significant decrease in demand for our products could result in an increase in the amount of excess inventory quantities on hand. In addition, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision required for excess and obsolete inventory. In the future, if our inventories are determined to be overvalued, we would be required to recognize additional expense in our cost of sales at the time of such determination. Likewise, if our inventories are determined to be undervalued, we may have over-reported our costs of sales in previous periods and would be required to recognize additional gross profit at the time such inventories are sold. In addition, should the market value of DRAM ICs or NAND decrease significantly, we may be required to lower our selling prices to reflect the lower current cost of our raw materials. If such price decreases reduce the net realizable value of our inventories to less than our cost, we would be required to recognize additional expense in our cost of sales in the same period. Although we make every reasonable effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand, technological developments or the market value of DRAM ICs or NAND could have a material effect on the value of our inventories and our reported operating results. Impairment of Long-Lived Assets. We evaluate the recoverability of the carrying value of long-lived assets held and used in our operations for impairment on at least an annual basis or whenever events or changes in circumstances indicate that their carrying value may not be recoverable. When such factors and circumstances exist, we compare the projected undiscounted future net cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amount. These projected future cash flows may vary significantly over time as a result of increased competition, changes in technology, fluctuations in demand, consolidation of our customers and reductions in average selling prices. If the carrying value is determined not to be recoverable from future operating cash flows, the asset is deemed impaired and an impairment loss is recognized to the extent the carrying value exceeds the estimated fair value of the asset. The fair value of the asset or asset group is based on market value when available, or when unavailable, on discounted expected cash flows. Warranty Reserve. We offer product warranties generally ranging from one to three years, depending on the product and negotiated terms of purchase agreements with our customers. Such warranties require us to repair or replace defective product returned to us during the warranty period at no cost to the customer. Warranties are not offered on sales of excess inventory. Our estimates for warranty-related costs are recorded at the time of sale based on historical and estimated future product return rates and expected repair or replacement costs. While such costs have historically been consistent between periods and within our expectations and the provisions established, unexpected changes in failure rates could have a material adverse impact on us, requiring additional warranty reserves, and adversely affecting our gross profit and gross margins. Stock-Based Compensation. We account for equity issuances to non-employees in accordance with ASC Topic 505. All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. The measurement date used to determine the fair value of the equity instrument issued is the earlier of the date on which the third-party performance is complete or the date on which it is probable that performance will occur. In accordance with ASC Topic 718, employee and director stock-based compensation expense recognized during the period is based on the value of the portion of stock-based payment awards that is ultimately expected to vest during the period. Given that stock-based compensation expense recognized in the condensed consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. ASC Topic 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Our estimated average forfeiture rates are based on historical forfeiture experience and estimated future forfeitures. 35 -------------------------------------------------------------------------------- Table of Contents The fair value of common stock option awards to employees and directors is calculated using the Black-Scholes option pricing model. The Black-Scholes model requires subjective assumptions regarding future stock price volatility and expected time to exercise, along with assumptions about the risk-free interest rate and expected dividends, all of which affect the estimated fair values of our common stock option awards. The expected term of options granted is calculated as the average of the weighted vesting period and the contractual expiration date of the option. This calculation is based on the safe harbor method permitted by the SEC in instances where the vesting and exercise terms of options granted meet certain conditions and where limited historical exercise data is available. The expected volatility is based on the historical volatility of our common stock. The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the expected term of the grant effective as of the date of the grant. The expected dividends assumption is based on our history and our expectations regarding dividend payouts. We evaluate the assumptions used to value our common stock option awards on a quarterly basis. If factors change and we employ different assumptions, stock- based compensation expense may differ significantly from what we have recorded in prior periods. Compensation expense for common stock option awards with graded vesting schedules is recognized on a straight-line basis over the requisite service period for the last separately vesting portion of the award, provided that the accumulated cost recognized as of any date at least equals the value of the vested portion of the award. We recognize the fair value of restricted stock awards issued to employees and outside directors as stock-based compensation expense on a straight-line basis over the vesting period for the last separately vesting portion of the awards. Fair value is determined as the difference between the closing price of our common stock on the grant date and the purchase price of the restricted stock award, if any, reduced by expected forfeitures. If there are any modifications or cancellations of the underlying vested or unvested stock-based awards, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense, or record additional expense for vested stock-based awards. Future stock-based compensation expense and unearned stock- based compensation may increase to the extent that we grant additional common stock options or other stock-based awards. Income Taxes. Deferred tax assets and liabilities are recognized to reflect the estimated future tax effects of future deductible or taxable amounts attributable to events that have been recognized on a cumulative basis in the condensed consolidated financial statements, calculated at enacted tax rates for expected periods of realization. We regularly review our deferred tax assets for recoverability and establish a valuation allowance, when determined necessary, based on historical taxable income, projected future taxable income, and the expected timing of the reversals of existing temporary differences. Because we have operated at a loss for an extended period of time, we did not recognize deferred tax assets related to losses incurred in 2012 or 2011. In the future, if we realize a deferred tax asset that currently carries a valuation allowance, we may record an income tax benefit or a reduction to income tax expense in the period of such realization. ASC Topic 740 prescribes a recognition threshold and measurement requirement for the financial statement recognition of a tax position that has been taken or is expected to be taken on a tax return and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under ASC Topic 740 we may only recognize or continue to recognize tax positions that meet a "more likely than not" threshold. 36 -------------------------------------------------------------------------------- Table of Contents The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws and regulations themselves are subject to change as a result of changes in fiscal policy, changes in legislation, the evolution of regulations and court rulings. Therefore, the actual liability for U.S. or foreign taxes may be materially different from our estimates, which could result in the need to record additional tax liabilities or potentially reverse previously recorded tax liabilities. Results of Operations The following table sets forth certain condensed consolidated statements of operations data as a percentage of net sales for the periods indicated: Three Months Ended March 31, April 2, 2012 2011 Net sales 100 % 100 % Cost of sales 61 68 Gross profit 39 32 Operating expenses: Research and development 27 31 Selling, general and administrative 19 24 Total operating expenses 46 55 Operating loss (7 ) (23 ) Other (expense) income: Interest expense, net (1 ) (1 ) Other income, net - - Total other expense, net (1 ) (1 ) Loss before provision for income taxes (8 ) (24 ) Provision for income taxes - - Net loss (8 )% (24 )% 37 -------------------------------------------------------------------------------- Table of Contents Three Months Ended March 31, 2012 Compared to Three Months Ended April 2, 2011 Net Sales, Cost of Sales and Gross Profit The following table presents net sales, cost of sales and gross profit for the three months ended March 31, 2012 and April 2, 2011 (in thousands, except percentages): Three Months Ended March 31, April 2, % 2012 2011 Change Change Net sales $ 13,967 $ 12,000 $ 1,967 16 % Cost of sales 8,531 8,196 335 4 % Gross profit $ 5,436 $ 3,804 $ 1,632 43 % Gross margin 39 % 32 % 7 % Net Sales. The increase in net sales for the three months ended March 31, 2012 as compared with the three months ended April 2, 2011 resulted primarily from increases of approximately (i) $3.2 million in sales of NVvault™ non-volatile cache systems used in RAID controller subsystems, including $1.6 million from NVvault™ battery-free, the flash-based cache system that became generally available in 2010, (ii) $0.4 million in sales of HyperCloud™ memory modules and (iii) $0.3 million in sales of VLP RDIMM products, resulting from existing and new customer qualifications, offset by a decrease of $1.9 million of specialty memory module sales primarily used in industrial applications as one customer slowed production as a result of its product nearing the end of its life. Gross Profit and Gross Margin. The overall improvements in gross profit are due to increased sales and manufacturing volume, as well as a shift in sales toward higher margin products. Gross profit for the three months ended March 31, 2012 as compared to the three months ended April 2, 2011 increased due to the 16% increase in net sales between the two periods, resulting in an improved ability to absorb fixed manufacturing costs. These volume-based improvements were augmented by decreased DRAM prices, which positively affected margins in some product categories. As noted previously, the expected decline in Dell NVvault™ sales could have a significant impact on our revenue and gross profit as early as the second quarter of 2012. Research and Development. The following table presents research and development expenses for the three months ended March 31, 2012 and April 2, 2011 (in thousands, except percentages): Three Months Ended March 31, April 2, % 2012 2011 Change Change Research and development $ 3,842 $ 3,684 $ 158 4 % The increase in research and development expense in the three months ended March 31, 2012 as compared to the three months ended April 2, 2011 resulted primarily from increases of (i) $0.3 million in internal engineering headcount costs, as the we invested in further development of our HyperCloud™ products and (ii) $0.3 million in material expenses related to product builds and testing, primarily related to our HyperCloud™ products, partially offset by decreases of (i) $0.3 million in non-recurring engineering charges for supply partners engaged in new product development activities (ii) $0.1 million in professional and outside services. 38 -------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative. The following table presents selling, general and administrative expenses for the three months ended March 31, 2012 and April 2, 2011 (in thousands, except percentages): Three Months Ended March 31, April 2, % 2012 2011 Change Change Selling, general and administrative $ 2,609 $ 2,917 $ (308 ) (11 )% Selling, general and administrative expense decreased by $0.3 million for the three months ended March 31, 2012 as compared to the three months ended April 2, 2011, as we improved operating efficiency. Other (Expense) Income. The following table presents other (expense) income for the three months ended March 31, 2012 and April 2, 2011 (in thousands, except percentages): Three Months Ended March 31, April 2, % 2012 2011 Change Change Interest expense, net $ (71 ) $ (25 ) $ (46 ) 184 % Other income, net 5 - 5 - % Total other expense, net $ (66 ) $ (25 ) $ (41 ) 164 % The increase in interest expense for the three months ended March 31, 2012 compared with the three months ended April 2, 2011 was the result of the term loan that originated in May 2011. Other income, net, for the three months ended March 31, 2012 was insignificant. 39 -------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes. The following table presents the provision for income taxes for the three months ended March 31, 2012 and April 2, 2011 (in thousands, except percentages): Three Months Ended March 31, April 2, % 2012 2011 Change Change Provision for income taxes $ - $ - $ - - % We did not record a benefit of income taxes for the three months ended March 31, 2012 and April 2, 2011, as tax benefits resulting from operating losses generated were fully reserved. Liquidity and Capital Resources We have historically financed our operations primarily through issuances of equity and debt securities and cash generated from operations. We have also funded our operations with a revolving line of credit and term loans under our bank credit facility, capitalized lease obligations and from the sale and leaseback of our former domestic manufacturing facility. Working Capital and Cash and Marketable Securities The following table presents working capital, cash and cash equivalents and investments in marketable securities (in thousands): March 31, December 31, 2012 2011 Working Capital $ 22,231 $ 17,775 Cash and cash equivalents(1) $ 13,874 $ 10,535 Long-term marketable securities 451 444 $ 14,325 $ 10,979 -------------------------------------------------------------------------------- (1) Included in working capital Our working capital increased in the three months ended March 31, 2012 primarily as a result of $3.6 million in funds raised through sales of our common stock through our sales agreement with Ascendiant, and the renegotiated payment structure of our term loans, which resulted in a $1.3 million reduction in the current portion of long-term debt. Both of these transactions are described under Capital Resources below. 40 -------------------------------------------------------------------------------- Table of Contents Cash Provided by and Used in the Three Months Ended March 31, 2012 and April 2, 2011 The following table summarizes our cash flows for the periods indicated (in thousands): Three Months Ended March 31, April 2, 2012 2011 Net cash provided by (used in): Operating activities $ 208 $ (3,295 ) Investing activities (317 ) 715 Financing activities 3,448 (269 ) Net increase (decrease) in cash and cash equivalents $ 3,339 $ (2,849 ) Operating Activities. Net cash provided by operating activities for the three months ended March 31, 2012 was primarily the result of cash provided by changes in operating assets and liabilities of approximately $0.2 million. Net losses of $1.1 million were offset by $1.1 million in non-cash operating expense, primarily comprised of depreciation and amortization and stock-based compensation, resulting in a neutral effect on our cash position. Net cash used in operating activities for the three months ended April 2, 2011 was primarily a result of (i) net loss of approximately $2.8 million and (ii) cash used by changes in operating assets and liabilities of approximately $1.4 million, partially offset by approximately $0.9 million in net non-cash operating expenses, primarily comprising depreciation and amortization and stock-based compensation. Accounts receivable decreased approximately $1.1 million during the three months ended March 31, 2012 primarily as a result of the decrease in our net sales during the period compared with the fourth quarter of 2011. We continue to be successful in collecting cash from sales to our customers substantially in accordance with our standard payment terms with those customers. Inventories increased approximately $1.6 million during the three months ended March 31, 2012 as we continued the qualification process and prepared for production of our HyperCloud™ and high-density VLP products. During the three months ended March 31, 2012 and April 2, 2011, we were able to partially fund the growth in our current assets through an increase in accounts payable of $1.1 million and $2.1 million, respectively, primarily from component vendors. Investing Activities. Net cash used in investing activities for the three months ended March 31, 2012 was the result of the acquisition of $0.3 million in property and equipment. Net cash provided by investing activities for the three months ended April 2, 2011 was primarily the result of sales of marketable securities of $0.8 million, offset by the acquisition of $0.1 million in property and equipment. Financing Activities. Net cash provided by financing activities for the three months ended March 31, 2012 was primarily the result of net proceeds of $3.6 million from the sale of 1,036,830 shares of our common stock through our sales agreement with Ascendiant, described below under the caption Capital Resources, and $0.5 million in proceeds from the exercise of equity awards under our stock option plan, offset by repayment of bank debt, capital leases and other notes payable of $0.6 million. Net cash used in financing activities for the three months ended April 2, 2011 was a result of repayment of bank debt, capital leases and other notes payable of $0.3 million. Capital Resources On October 31, 2009, we entered into a credit agreement with Silicon Valley Bank, which was amended on March 24, 2010, June 30, 2010, September 30, 2010, May 11, 2011, August 10, 2011 and May 14, 2012. Currently, the credit agreement provides for a line of credit pursuant to which we can borrow up to the lesser of (i) 80% of eligible accounts receivable, or (ii) $10.0 million. We have the option to increase credit availability to $15.0 million at any time through the maturity date of September 30, 2014, subject to the conditions of the credit agreement. 41 -------------------------------------------------------------------------------- Table of Contents Prior to the May 14, 2012 amendment the credit agreement contained an overall sublimit of $10.0 million to collateralize our contingent obligations under letters of credit and other finanicial services. Amounts outstanding under the overall sublimit reduce the amount available under the line. At March 31, 2012, letters of credit in the amount of $3.0 million were outstanding. The letters of credit expire on October 31, 2012. As a result of the May 14, 2012 amendment, letters of credit and other financial services are no longer subject to borrowing base sublimits, and do not reduce the amount available under the line of credit. Rather, the Company has an additional credit facility for up to $3.0 million in letters of credit through September 30, 2014. Interest on the line of credit is payable monthly at either (i) prime plus 1.25%, as long as we maintain $8.5 million in revolving credit availability plus unrestricted cash on deposit with the bank, or (ii) prime plus 2.25%. Additionally, the credit agreement requires payment of an unused line, as well as anniversary and early termination fees, as applicable. The following table presents details of outstanding borrowings and availability under our line of credit as adjusted for the May 14, 2012 amendment described above (in thousands): March 31, December 31, 2012 2011 Availability under the revolving line of credit $ 7,224 $ 7,797 Outstanding borrowings on the revolving line of credit - - Amounts reserved under credit sublimits - (2,022 ) Unutilized borrowing availability under the revolving line of credit $ 7,224 $ 5,775 We made no borrowings under the Silicon Valley Bank line of credit in the three months ended March 31, 2012. Outstanding borrowings under the line of credit did not exceed $0.5 million at any time during the year ended December 31, 2011. In connection with the September 30, 2010 amendment, Silicon Valley Bank extended a $1.5 million term loan under the credit agreement, bearing interest at a rate of prime plus 2.00%. We were required to make equal monthly principal payments over the 36 month term, which totaled $0.5 million annually. In May 2011, Silicon Valley Bank extended an additional $3.0 million term loan, bearing interest at a rate of prime plus 2.75%. We were required to make equal monthly principal payments over the 24 month term of the loan, totaling $1.5 million annually. As of March 31, 2012, $2.5 million was outstanding under the term loans. In May 2012, Silicon Valley Bank consolidated the term loans and extended additional credit, resulting in a combined term loan balance of $3.5 million. We will be required to make equal monthly principal payments over a 36 month period, beginning in December 2012, and monthly interest payments from the date of the funding through the final payoff of the loan. The consolidated loan bears interest at a rate of prime plus 2.50%. All obligations under the credit agreement are secured by a first priority lien on our tangible and intangible assets. The only restriction on the use of funds under the revolving line of credit is that we must be in compliance with the covenants of the credit agreement. The credit agreement includes affirmative and negative covenants, including financial covenants with respect to our liquidity and tangible net worth. As of March 31, 2012, we were in compliance with all financial covenants and expect to maintain compliance for the foreseeable future. However, we have in the past been in violation of one or more covenants of other credit agreements, and we could violate one or more covenants in the future. If we were to be in violation of covenants under our credit agreement, our lender 42 -------------------------------------------------------------------------------- Table of Contents could choose to accelerate payment on all outstanding loan balances and we could lose vendor credit should the letters of credit issued under the credit agreement become unavailable. If that were to occur, we may be unable to quickly obtain equivalent or suitable replacement financing. If we were not able to secure alternative sources of funding, such acceleration would have a material adverse impact on our financial condition. On November 21, 2011, we entered into a sales agreement with Ascendiant as sales agent. In accordance with the terms of the sales agreement, we may issue and sell shares of our common stock having an aggregate offering price of up to $10.0 million. Sales of shares of our common stock may be made in a series of transactions from time to time as we may direct Ascendiant in sales deemed to be an "at the market" offering as defined in Rule 415 under the Securities Act of 1933. Such sales are made pursuant to our effective $40 million shelf registration statement filed with the SEC in September 2011. Since November 2011, we have received net proceeds of approximately $5.5 million, including approximately $3.6 million raised through the sale of approximately 1,036,830 shares in the three months ended March 31, 2012. We may terminate the sales agreement with Ascendiant at any time. In the event of such termination, we would expect to make available any remaining unsold portion of the $10.0 million in aggregate offering price for other sources of financing that are permitted under the effective shelf registration statement. The sales agreement with Ascendiant does not preclude us from pursuing other sources of financing. We have in the past utilized equipment leasing arrangements to finance certain capital expenditures. Equipment leases continue to be a financing alternative that we expect to pursue in the future. We believe our existing cash balances, borrowing availability under our bank credit facility, proceeds available under the sales agreement with Ascendiant and the cash expected to be generated 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 levels of net sales, the timing and extent of expenditures to support research and development activities, the expansion of manufacturing capacity both domestically and internationally and the continued market acceptance of our products. We could be required, or may choose, to seek additional funding through public or private equity or debt financings. In addition, in connection with any future acquisitions, we may require additional funding which may be provided in the form of additional debt or equity financing or a combination thereof. These additional funds may not be available on terms acceptable to us, or at all. New Accounting Pronouncements In May 2011, the FASB issued Accounting Standards Update ("ASU") No. 2011-4, Fair Value Measurement ("ASU 11-4"). ASU 11-4 amends existing guidance to achieve convergence in measurement and disclosure between U.S. Generally Accepted Accounting Standards ("GAAP") and International Financial Reporting Standards ("IFRS"). ASU 11-4 is effective for fiscal year 2012. The adoption of ASU 11-4 did not impact the Company's results of operations or its financial position. In June 2011, the FASB issued ASU No. 2011-5, Comprehensive Income ("ASU 11-5"). ASU 11-5 amends existing guidance to increase the prominence of items reported in other comprehensive income and to facilitate convergence of U.S. GAAP and IFRS. ASU 11-5 is effective for fiscal year 2012. The adoption of ASU 11-5 did not impact the Company's results of operations or its financial position. 43 -------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not have any undisclosed borrowings or debt, and we have not entered into any synthetic leases. We are, therefore, not materially exposed to financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. |