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VITESSE SEMICONDUCTOR CORP - 10-K - 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 the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled "Risk Factors" included in Part I, Item 1A. of this Annual Report on Form 10-K. Overview We are a leading supplier of high-performance ICs that are used primarily by manufacturers of networking systems for Carrier and Enterprise networking applications. We design, develop and market a diverse portfolio of high-performance, low-power and cost-competitive networking and connectivity IC solutions. For more than 30 years, we have been a leader in the adoption of new technologies in Carrier and Enterprise networking. Both bandwidth demands and complexity, driven by the introduction of new content-rich services, the convergence of voice, video and data, and enhanced 4G/LTE mobile networks, have risen dramatically in Carrier and Enterprise networks . Media-rich devices, such as smartphones and game consoles, require increased bandwidth. New Enterprise deployment options, such as Cloud-based services and social media and telepresence, also spur demand. More recently, there is a trend for increased Ethernet deployment within networks used in Industrial and Military networking, automotive transport, and future Smart Grid applications, collectively referred to as IoT. As a result, Carrier, Enterprise, and increasingly, IoT networks are transitioning to all-IP and packet-based Ethernet networks that can scale in terms of services, bandwidth and capability, while lowering power consumption and acquisition and operations costs. These networks are based on technology that is significantly more sophisticated, service-aware, secure and reliable than traditional Enterprise-grade Ethernet LAN technology. Such networks are built on new technology that is often referred to as "Carrier Ethernet" in Carrier networks and "Converged Enhanced Ethernet" in Enterprise networks. Realization of Our Transition Strategy Several years ago, we embarked on the strategic mission of re-inventing Vitesse to take advantage of the dramatic ongoing transformation of our target networking markets. Our objective is to be the leading supplier of high-performance ICs for the global communications infrastructure markets. In an effort to diversify ourselves and provide new opportunities for growth, we re-positioned our R&D teams and invested heavily to enter new markets, develop new products, and penetrate new customers. To continue to grow our new product revenue, we must win market share in high-growth communications market segments. As with any high technology company, growth opportunities begin with new products. Over the past four years, we introduced many new "platform" products and technologies that will serve as the basis for future product development. From that effort, we began sampling the first of our "new product" portfolio in 2010. Since then, revenue from these new products has grown to over 27% of total revenues, or $28.6 million for fiscal 2013. Our new products have captured design wins at over 200 customers, including market leaders such as Alcatel-Lucent, Cisco, Ericsson, Hewlett Packard, Huawei, Juniper, Samsung, and ZTE. In 2013, we introduced the third-generation of both our switch engine and PHY products. These new products allowed us to significantly increase our served markets in both Carrier and Enterprise networking. We have become the clear choice for meeting our customers' needs for service delivery, synchronization, security, and signal integrity. We believe we have effectively and efficiently targeted these high-growth infrastructure markets with substantial R&D investments over the last five years. To optimize our R&D efficiency, we chose to serve large, growing, independent markets which rely increasingly on Ethernet technology: Carrier and Enterprise networks. As we are now three years into the deployment of these new products, we can see that our target markets and products were well chosen. Increasingly, we also now see opportunities for our products and technology within the IoT, where Ethernet-based networks are emerging. There is 35 -------------------------------------------------------------------------------- Table of Contents tremendous synergy and cost savings in terms of R&D effort to provide Ethernet switch and PHY products into this emerging adjacent market. In bringing our new products to market, our customer engagements and number of design opportunities identified by our sales team have consistently increased since 2010. Early customer adoption of our new products has exceeded our goals. In 2013, design wins for our new products increased by approximately 40% from 2012. While many of these wins represented additional business at our most important customers, what we call "same-store-sales," many others are wins at new customers, and reflect our growing market share. Because our products our highly complex, it takes our customers 12 to 36 months to go from sample availability to first customer shipment, as customers do the necessary development work to complete and qualify their systems in the network. Since it typically takes an additional 12 to 24 months to ramp into full production, we believe design wins represent a good leading indicator of future revenues. We augment our product revenues by leveraging our substantial intellectual property portfolio to generate revenues. Our primary focus for intellectual property licensing has been our Gigabit Ethernet CuPHY and switch cores and eFEC technology. We license to non-competing third parties in adjacent or similar markets. Our accounting policy generally uses the "sell-through" model for sales to our distributors. The "sell-through" model recognizes revenue only upon shipment of the merchandise from our distributor to the final customer. As such, we may have variability in our revenue from quarter-to-quarter as customers have substantial flexibility to reschedule backlog with of our distribution partners as part of the terms and conditions of sale. Our distributor sales were 52.7% , 51.6% and 44.6% of product revenue in 2013, 2012 and 2011, respectively. In the normal course of business, we regularly assess our product portfolio to ensure it aligns with our strategy. At such time, we may determine to phase-out products, or EOL. When we EOL a product, we typically provide up to six months notice for our customers to make a last-time-buy of product and six additional months to take receipt of that product. The EOL announcement can result in near-term increases in our revenues as customers typically respond to these announcements by making last-time-buys to ensure that they have adequate stock on hand to support their production forecast. During the last three years, we accelerated our comprehensive efforts to increase our product gross margins and operating margins, which together have substantially increased our operating leverage. Our efforts in operations include reduction in materials costs and cycle times, improved product yields, implementation of programs such as lean manufacturing, and an enhanced customer-centric focus. As a fabless semiconductor company, we outsource the majority of our manufacturing. Our successful management of our supply chain has provided us with competitive materials pricing and effective lead times for the materials we purchase. We have sizable advantages due to lower fixed costs, reduced cycle times, and lower inventory resulting from our outsourcing of almost all of our wafer fabrication and assembly. During periods of strong demand, we could experience longer lead times, difficulties in obtaining capacity, and/or difficulty in meeting commitments for our required deliveries during periods of strong demand. Average margins vary widely within the markets we serve, with the Carrier networking market having the highest average margins and the Enterprise networking market having the lowest average margins. We endeavor to increase margins by providing products that have significant added value relative to our competition. In addition, we have strengthened our cash balances by reducing our inventory every fiscal year since September 30, 2010, resulting in a reduction of $16.6 million over the past three fiscal years. We have also focused on streamlining our R&D and SG&A organizations reducing expenses almost 25.0% over the past three fiscal years. We leverage top-level consultants to help us achieve short-term design goals while ensuring we maintain our in-house engineering talent to drive our overall corporate objectives. Critical Accounting Policies and Estimates Our accounting policies are more fully described in Note 1 of the consolidated financial statements. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We base our estimates on historical experience and on various other assumptions that we believe are reasonable in the circumstances. We regularly discuss with our audit committee the basis of our estimates. These estimates could change under different assumptions or conditions. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require management's most difficult, subjective and complex judgments. 36 -------------------------------------------------------------------------------- Table of Contents Revenue Recognition Product Revenues We recognize product revenue when the following fundamental criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred; (iii) the price to the customer is fixed or determinable; and (iv) collection of the sales price is reasonably assured. Delivery occurs when goods are shipped and title and risk of loss transfer to the customer, in accordance with the terms specified in the arrangement with the customer. Revenue recognition is deferred where the earnings process is incomplete. A substantial portion of our product sales is made through distributors under agreements allowing for pricing credits and/or right of return. Our past history with these pricing credits and/or right of return provisions prevents us from being able to reasonably estimate the final price of our inventory to be sold and the amount of inventory that could be returned pursuant to these agreements. As a result, the fixed and determinable revenue recognition criterion has not been met at the time we deliver products allowing for pricing credits or right of returns. Accordingly, product revenue from sales made through these distributors is not recognized until the distributors ship the product to their customers. From time-to-time, we may ship goods to our distributors with no pricing credits and/or no or limited right of return. Under these circumstances, at the time of shipment, product prices are fixed or determinable and the amount of future returns and pricing allowances to be granted in the future can be reasonably estimated and are accrued. Accordingly, revenues are recorded net of these estimated amounts. Intellectual Property Revenues We derive intellectual property revenues from the sale and licensing of our intellectual property, maintenance and support fees and royalty revenue following the sale by our licensees of products incorporating the licensed technology. We recognize revenue from the sale and licensing of our intellectual property when there is persuasive evidence of an arrangement, fees are fixed or determinable, delivery has occurred, and collectability is reasonably assured. The timing of delivery is dependent on, and varies with, the terms of each contract. Other than maintenance and support, there is no continuing obligation under these arrangements after delivery of the intellectual property. Deferred revenue is created when we bill a customer in accordance with a contract prior to having met the requirements for revenue recognition. Certain of our agreements may contain maintenance and support obligations. Under such agreements we provide unspecified bug fixes and technical support. No other upgrades, products, or post-contract support are provided. These arrangements may be renewable annually by the customer. Support revenue is recognized ratably over the period during which the obligation exists, typically 12 months or less. We recognize royalty revenue in the period in which the licensee reports shipment of products incorporating our intellectual property components. Royalties are calculated on a per unit basis, as specified in our agreement with the licensee. We allocate revenue to all deliverables based on their relative selling prices. In such circumstances, we use a hierarchy to determine the selling price to be used for allocating revenues to deliverables: (i) vendor-specific objective evidence of fair value ("VSOE"); (ii) third-party evidence of selling price ("TPE"); and (iii) best estimate of the selling price ("ESP"). VSOE generally exists only when we sell the deliverable separately and revenue is the price actually charged by us for that deliverable. Generally, we are not able to determine TPE because our licensing arrangements differ from that of our peers. We have concluded that no VSOE or TPE exists because it is rare that either we or our competitors sell the deliverables on a stand-alone basis. ESPs reflect our best estimate of what the selling prices of the elements would be if they were sold regularly on a stand-alone basis. While changes in the allocation of the estimated sales price between the units of accounting will not affect the amount of total revenue recognized for a particular sales arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could affect our results of operations. In determining ESPs, we apply significant judgment as we weigh a variety of factors, based on the facts and circumstances of the arrangement. The facts and circumstances we may consider include, but are not limited to, prices charged for similar offerings, if any, our historical pricing practices as well as the nature and complexity of different technologies being licensed, geographies and the number of uses allowed for a given license. 37 -------------------------------------------------------------------------------- Table of Contents Inventory Valuation Inventories are stated at lower of cost or market and consist of materials, labor, and overhead. Inventory costs are determined using standard costs which approximate actual costs under the first-in, first-out method. Costs include the costs of purchased finished products, sorted wafers, and outsourced assembly and test, as well as internal overhead. We evaluate inventories for excess quantities and obsolescence. Our evaluation considers market and economic conditions; technology changes, new product introductions, and changes in strategic business direction; and requires estimates that may include elements that are uncertain. In order to state the inventory at lower of cost or market, we maintain reserves against individual stocking units. Inventory write-downs, once established, are not reversed until the related inventories have been sold or scrapped. If future demand or market conditions are less favorable than our projections, a write-down of inventory may be required, and would be reflected in cost of goods sold in the period the revision is made. Fair Value We use different valuation methodologies that use Level 3 inputs to value our Term A and Term B Loans, 2014 Debentures and related compound embedded derivative. The valuation methodologies we use and our assessment of the significance of a particular input to the fair value measurement may produce a fair value that may not be indicative of net realizable value or future fair values. Although we believe our valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date. Stock Based Compensation We account for stock based compensation under ASC Topic 718, Compensation-Stock Compensation, which requires us to record related compensation costs. Calculating the fair value of stock-based compensation awards requires the input of highly subjective assumptions, including the expected life of the awards and expected volatility of our stock price. Expected volatility is a statistical measure of the amount by which a stock price is expected to fluctuate during a period. Our estimates of expected volatilities are based on weighted historical implied volatility. The expected forfeiture rate applied in calculating stock-based compensation cost is estimated using historical data and is updated annually. The assumptions used in calculating the fair value of stock-based awards involve estimates that require management judgment. If factors change and we use different assumptions, our stock-based compensation expense could change significantly in the future. In addition, if our actual forfeiture rate is different from our estimate, our stock-based compensation expense could change significantly in the future. Income Taxes We account for income taxes in accordance with ASC Topic 740, Income Taxes, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, we must make estimates and judgments in determining the provision for taxes for financial statement purposes. These estimates and judgments occur in the calculation of tax credits, benefits, and deductions, and in the calculation of certain tax assets and liabilities that arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes, as well as the interest and penalties related to uncertain tax positions. Significant changes in these estimates may result in an increase or decrease to our tax provision in a subsequent period. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We must assess the likelihood that we will be able to recover our deferred tax assets. Our valuation allowance against the deferred tax assets is based on our assessments of historical losses and projected operating results in future periods on a "more likely than not" basis. If and when we generate future taxable income in our tax jurisdictions against which these tax assets may be applied, some portion or all of the valuation allowance would be reversed and an increase in net income would consequently be reported in future years. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We recognize liabilities for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. If we determine that a tax position will more likely than not be sustained on audit, the second step requires us to estimate and measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. It is inherently difficult and subjective to estimate such amounts, as we have to determine the probability of various possible outcomes. We re-evaluate these uncertain tax 38 -------------------------------------------------------------------------------- Table of Contents positions on a quarterly basis. This evaluation is based on factors such as changes in facts or circumstances, changes in tax law, new audit activity, and effectively settled issues. Determining whether an uncertain tax position is effectively settled requires judgment. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision in the period in which a change in judgment occurs. Litigation We are party to various claims and lawsuits arising in the normal course of business. We closely monitor these claims and lawsuits and frequently consult with our legal counsel to determine whether they may, when resolved have a material adverse affect on our financial position or results or operations and accrue and/or disclose loss contingencies as appropriate. Impact of Recent Accounting Pronouncements For information with respect to recent accounting pronouncements and the impact of these pronouncements see "The Company and Its Significant Accounting Policies" footnote in the accompanying notes to the audited consolidated financial statements. 39 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth certain consolidated statements of operations data for the periods indicated. The percentages in the table are based on net revenues. September 30, 2013 2012 2011 $ % $ % $ % (in thousands, except for percentages) Net revenues: Product revenues $ 101,334 97.6 % $ 109,920 92.0 % $ 132,742 94.2 % Intellectual property revenues 2,439 2.4 % 9,563 8.0 % 8,225 5.8 % Net revenues 103,773 100.0 % 119,483 100.0 % 140,967 100.0 % Costs and expenses: Cost of product revenues 46,763 45.1 % 46,407 38.8 % 53,674 38.1 % Engineering, research and development 41,927 40.4 % 42,713 35.7 % 52,990 37.6 % Selling, general and administrative 30,210 29.1 % 29,822 25.0 % 41,233 29.3 % Restructuring and impairment - - % (1,424 ) (1.2 )% 3,656 2.6 % Amortization of intangible assets 347 0.3 % 330 0.3 % 348 0.2 % Costs and expenses 119,247 114.9 % 117,848 98.6 % 151,901 107.8 % (Loss) income from operations (15,474 ) (14.9 )% 1,635 1.4 % (10,934 ) (7.8 )% Other expense (income): Interest expense, net 7,916 7.6 % 7,778 6.5 % 8,456 6.0 % Gain on compound embedded derivative (803 ) (0.8 )% (4,897 ) (4.1 )% (7,680 ) (5.4 )% Loss on extinguishment of debt - - % - - % 3,874 2.7 % Other expense (income), net 39 - % 40 - % (153 ) (0.1 )% Other expense, net 7,152 6.8 % 2,921 2.4 % 4,497 3.2 % Loss before income tax benefit (22,626 ) (21.8 )% (1,286 ) (1.1 )% (15,431 ) (10.9 )% Income tax benefit (548 ) (0.5 )% (174 ) (0.1 )% (619 ) (0.4 )% Net loss $ (22,078 ) (21.3 )% $ (1,112 ) (1.0 )% $ (14,812 ) (10.5 )% 40-------------------------------------------------------------------------------- Table of Contents Fiscal Years Ended September 30, 2013 and 2012 Product Revenues We sell our products into the following markets: (i) Carrier networking; (ii) Enterprise networking; and (iii) Non-core. The Carrier networking market includes core, metro, edge, and access equipment used for transport, switching, routing, mobile access, and backhaul in service provider networks. The Enterprise networking market covers Ethernet switching and routing equipment used within LANs in SME/SMB networks and Cloud Access services. The Non-core market is comprised of products that have not received additional investment over the last five fiscal years and, as a result, have generally been in decline. The demand for our products is affected by various factors, including our development and introduction of new products, availability and pricing of competing products, capacity constraints at our suppliers, EOL product decisions, and general economic conditions. Therefore, our revenues for the fiscal years ended 2013 and 2012 may not necessarily be indicative of future revenues. Product revenue by market is as follows: September 30, 2013 2012 % of Product % of Product % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Carrier networking $ 56,306 55.6 % $ 47,630 43.4 % $ 8,676 18.2 % Enterprise networking 43,419 42.8 % 53,899 49.0 % (10,480 ) (19.4 )% Non-core 1,609 1.6 % 8,391 7.6 % (6,782 ) (80.8 )% Product revenues $ 101,334 100.0 % $ 109,920 100.0 % $ (8,586 ) (7.8 )% The increase in Carrier networking revenues is attributable to an almost doubling in sales of our new Ethernet switch products, more than tripling in sales of our new Connectivity products, and increased sales for our SONET/SDH framer products going through EOL. The increases were partially offset by declines in sales from other SONET/SDH products. The decrease in Enterprise networking revenues is driven by a decrease in sales of our switch fabrics products that had gone through EOL in the prior fiscal year and declines in our mature crosspoint products, partially offset by a more than doubling in sales of our new switch products. The decrease in Non-core revenues is largely attributable to a decrease of our legacy Fiber Channel PHYs and network processors, some of which had gone through EOL in the prior fiscal year. In fiscal year 2012, a number of older products went through EOL. Revenue from these EOL products was $15.9 million in fiscal year 2013 as compared to $24.9 million in fiscal year 2012, and we expect these EOL revenues will continue to decline. We also classify our product revenues based on our three product lines: (i) Connectivity; (ii) Ethernet switching; and (iii) Transport processing. 41 -------------------------------------------------------------------------------- Table of Contents Product revenue by product line is as follows: September 30, 2013 2012 % of Product % of Product % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Connectivity $ 42,885 42.3 % $ 52,933 48.1 % $ (10,048 ) (19.0 )% Ethernet switching 38,675 38.2 % 32,607 29.7 % 6,068 18.6 % Transport processing 19,774 19.5 % 24,380 22.2 % (4,606 ) (18.9 )% Product revenues $ 101,334 100.0 % $ 109,920 100.0 % $ (8,586 ) (7.8 )% Although revenues for our new Connectivity products increased, Connectivity revenues overall decreased due to the broad-based decline in the networking equipment market, which negatively impacted the demand for our more mature SONET/SDH PHY-based products. In addition, there was a strong decline in our legacy non-core products, particularly Fibre Channel PHYs products. The increase in Ethernet switching revenues is largely attributable to a doubling in our new switches selling into both the Carrier and Enterprise networking markets. The increase was partially offset by declines in sales of our mature products. The decrease in Transport processing revenues for fiscal year 2013 compared to fiscal year 2012 is largely attributable to lower sales of switch fabrics, NPUs and optical transport network products that had gone through EOL in the prior fiscal year. These increases were offset by increased revenues for SONET framers, going through EOL in the current fiscal year. Intellectual Property Revenue September 30, 2013 2012 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Intellectual property revenues $ 2,439 2.4 % $ 9,563 8.0 % $ (7,124 ) (74.5 )% Intellectual property revenue includes licenses, royalties, and the sale of patents. For the fiscal year ended September 30, 2012, intellectual property revenue also included the settlement of all future royalties under an existing agreement. Intellectual property revenues decreased in fiscal year 2013 as compared to the prior fiscal year due to a decrease in deliverables of intellectual property. The timing and amounts of intellectual property revenues fluctuate. Expenses associated with intellectual property revenue are included in selling, general and administrative ("SG&A") expenses. Net revenue from customers that were equal to or greater than 10% of total net revenues is as follows: September 30, 2013 2012 Nu Horizons Electronics ** * 13.5 % WPG Holdings** 17.7 % 10.7 % ____________________________________________ * Less than 10% of total net revenues for period indicated. ** Distributors 42-------------------------------------------------------------------------------- Table of Contents Net revenue by geographic area is as follows: September 30, 2013 2012 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) United States $ 28,454 27.4 % $ 41,559 34.8 % $ (13,105 ) (31.5 )% Asia Pacific 61,454 59.2 % 62,260 52.1 % (806 ) (1.3 )% EMEA* 13,865 13.4 % 15,664 13.1 % (1,799 ) (11.5 )% Total net revenues $ 103,773 100.0 % $ 119,483 100.0 % $ (15,710 ) (13.1 )% _________________________________________________ * Europe, Middle East and Africa Revenue by geographic area is based upon the country of billing. The geographic location of distributors and third-party manufacturing service providers may be different from the geographic location of the ultimate end users. We believe a substantial portion of the products billed to OEMs and third-party manufacturing service providers in the Asia Pacific region are ultimately shipped to end-markets in the United States and Europe. Cost of Product Revenue September 30, 2013 2012 % of Product % of Product % ti Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Cost of product revenues $ 46,763 46.1 % $ 46,407 42.2 % $ 356 0.8 % We use third-parties for wafer fabrication and assembly services. Cost of product revenues consists predominantly of: (i) purchased finished wafers; (ii) assembly services; (iii) test services; and (iv) labor and overhead costs associated with product procurement, planning and quality assurance. Our cost of product revenues is affected by various factors, including product mix, volume, and provisions for excess and obsolete inventories, material costs, manufacturing efficiencies, and the position of our products within their life-cycles. Our cost of product revenues as a percent of net product revenues is affected by these factors, as well as customer mix, volume, pricing, and competitive pricing programs. Although the overall cost of product revenues did not change, the cost as a percentage of revenues increased in fiscal year 2013 as compared to fiscal year 2012 due to a mix of products that had an overall higher cost. Engineering, Research and Development September 30, 2013 2012 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Engineering, research and development $ 41,927 40.4 % $ 42,713 35.7 % $ (786 ) (1.8 )% R&D expenses consist primarily of compensation expenses for employees and contractors engaged in research, design and development activities. R&D also includes costs of mask tooling, which we fully expense in the period, and electronic design 43 -------------------------------------------------------------------------------- Table of Contents automation ("EDA") tools, software licensing contracts, subcontracting and fabrication costs, depreciation and amortization, and overhead including facilities expenses. The level of R&D expense will vary from period-to-period, depending on timing of development projects and the purchase of masks aligned to those projects. The level of R&D expense as a percentage of net revenues will vary, depending, in part, on the level of net revenues. Our R&D efforts are critical to maintaining a high level of new product introductions and are critical to our plans for future growth. The decrease in R&D expense for fiscal year 2013 compared to fiscal year 2012 is largely attributable to lower overhead testing expenses of $1.5 million and other expenses of $0.7 million, partially offset by higher employee compensation and contractor expenses of $1.4 million for providing new product development and design services. Selling, General and Administrative September 30, 2013 2012 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Selling, general and administrative $ 30,210 29.1 % $ 29,822 25.0 % $ 388 1.3 % SG&A expense consists primarily of compensation expense, legal and other professional fees, facilities expenses, outside labor, and communication expense, and is comparable to the prior fiscal year. In fiscal year 2013, our SG&A compensation expense decreased by $1.6 million. Due to the relocation of our main Camarillo facility to an adjacent facility, we incurred $0.9 million in asset retirement expenses as well as increased rent of $0.7 million. In fiscal year 2012, we collected $1.9 million of accounts receivable that was written off as uncollectible in fiscal year 2011. Fiscal year 2012 also included a $1.3 million write-down of an intangible asset. Restructuring and Impairment Charges September 30, 2013 2012 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages)Restructuring and impairment $ - - % $ (1,424 ) (1.2 )% $ 1,424 (100.0 )% During fiscal year 2011 we consolidated design activities and consolidated our Camarillo operations into a single facility, exiting an adjacent leased facility. In the fourth quarter of fiscal year 2012, we determined that it was unlikely we would be able to sublease the exited property for the remaining lease term through December 2015. Therefore, we decided that we would reoccupy the exited facility upon expiration of our main Camarillo facility lease in January 2014, instead of locating to a new facility as originally planned. Accordingly, we reversed the remaining lease termination reserve of $1.4 million. Interest Expense, Net September 30, 2013 2012 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages)Interest expense, net $ 7,916 7.6 % $ 7,778 6.5 % $ 138 1.8 % 44-------------------------------------------------------------------------------- Table of Contents Net interest expense is comprised of cash interest expense, amortization of debt discount, premium, and debt issuance costs, net of interest income. Net interest expense for the fiscal year 2013 is comparable to the prior fiscal year. Gain on Compound Embedded Derivative September 30, 2013 2012 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Gain on compound embedded derivative $ (803 ) (0.8 )% $ (4,897 ) (4.1 )% $ 4,094 (83.6 )% The gain on our compound embedded derivative related to our 2014 Debentures is primarily generated by the decrease in the price of our underlying common stock during those periods. The compound embedded derivative included in our 2014 Debentures required bifurcation and accounting at fair value because the economic and contractual characteristics of the compound embedded derivative met the criteria for bifurcation and separate accounting due to the conversion price not being indexed to our own stock. The compound embedded derivative is comprised of the conversion option and a make-whole payment for foregone interest if the holder converts the debenture early. The make-whole payment for foregone interest expired October 30, 2012, and upon its expiration, the compound embedded derivative no longer met the criteria for bifurcation as all components of the conversion feature were indexed to our own stock. A final valuation was completed on October 30, 2012, resulting in gain of $0.8 million due to the change in fair value. Income Tax Benefit September 30, 2013 2012 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages)Income tax benefit $ (548 ) (0.5 )% $ (174 ) (0.1 )% $ (374 ) 214.9 % Our effective tax rate was 2.4% for the fiscal year ended September 30, 2013 compared to 13.6% for the comparable period in the prior fiscal year. Our income tax benefit is primarily impacted by foreign taxes, a refund of withholding taxes on foreign income that would have been creditable against United States income taxes, and certain nondeductible interest and share based expenses. The income tax benefit is also impacted by the release of a portion of the valuation allowances related to certain foreign jurisdictions' deferred tax assets as such balances were more likely than not realizable within the applicable carryforward period based on our analysis of the available positive and negative evidence. 45 -------------------------------------------------------------------------------- Table of Contents Fiscal Years Ended September 30, 2012 and 2011 Product Revenues Product revenue by market is as follows: September 30, 2012 2011 % of Product % of Product % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Carrier networking $ 47,630 43.4 % $ 61,685 46.5 % $ (14,055 ) (22.8 )% Enterprise networking 53,899 49.0 % 64,754 48.8 % (10,855 ) (16.8 )% Non-core 8,391 7.6 % 6,303 4.7 % 2,088 33.1 % Product revenues $ 109,920 100.0 % $ 132,742 100.0 % $ (22,822 ) (17.2 )% The decrease in Carrier networking revenues is largely attributable to a broad-based weakness in our end customer markets for Carrier networking, particularly a decline in our SONET/SDH products, including framers, EoS mappers, and FTTH products. The declines were partially offset by increases in transport products going through EOL and in our newer technologies and products, particularly in Ethernet Cu PHYs. The decrease in Enterprise networking revenues is driven by declines in 1 Gigabit Ethernet switch and PHY products selling into low-end SME/SMB applications due to overall weak market conditions, primarily in the United States and Asia. The decrease was partially offset by an increase in Enterprise processing due to revenues from switch fabrics going through EOL and an increase in new products. The increase in Non-core revenues is largely attributable to increased sales of our mature network processors and Fibre Channel products as some of these products moved into EOL. Revenue from EOL products totaled $24.9 million and $6.3 million in the fiscal year ended September 30, 2012 and 2011, respectively. Product phase-outs are part of our normal course of business, and we will continue this practice in the future. We expect revenues from EOL products to decline in fiscal year 2013. However, we cannot predict the degree and/or timing of the impact of product phase-out on future revenues. From time-to-time, upon customer request or due to a change in our product strategy, we may decide to resume producing a part we previously phased-out. We also classify our product revenues based on our three product lines: (i) Connectivity; (ii) Ethernet switching; and (iii) Transport processing. Product revenue by product line is as follows: September 30, 2012 2011 % of Product % of Product % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Connectivity $ 52,933 48.1 % $ 67,734 51.0 % $ (14,801 ) (21.9 )% Ethernet switching 32,607 29.7 % 37,940 28.6 % (5,333 ) (14.1 )% Transport processing 24,380 22.2 % 27,068 20.4 % (2,688 ) (9.9 )% Product revenues $ 109,920 100.0 % $ 132,742 100.0 % $ (22,822 ) (17.2 )% The decrease in Connectivity revenues is largely attributable to the broad-based decline in the networking equipment market, which negatively impacted the demand for our more mature products, particularly SONET/SDH-based products. The decrease in Ethernet switching revenues is largely attributable to declines in our Gigabit Ethernet Cu PHYs selling primarily into the Enterprise market, and Ethernet MAC products selling into both the Carrier and Enterprise markets. The decrease was partially offset by sales of our new Cu PHY products to the Carrier market. 46 -------------------------------------------------------------------------------- Table of Contents The decrease in Transport processing revenues for fiscal year 2012 compared to fiscal year 2011 is largely attributable to the broad-based market decline for our mature SONET/SDH framers and mappers, offset by increased sales of switch fabric products to customers increasing inventories of these products as they approach EOL. Intellectual Property Revenue September 30, 2012 2011 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages)Intellectual property revenues $ 9,563 8.0 % $ 8,225 5.8 % $ 1,338 16.3 % Intellectual property includes licenses, royalties, and patents, and for the year ended September 30, 2012 also included the settlement of all future royalties under an existing agreement. Net revenue from customers that were equal to or greater than 10% of total net revenues is as follows: September 30, 2012 2011 Nu Horizons Electronics ** 13.5 % 20.6 % WPG Holdings** 10.7 % * Huawei * 10.3 % ________________________________________________ * Less than 10% of total net revenues for period indicated. ** Distributor Net revenue by geographic area is as follows: September 30, 2012 2011 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages)United States $ 41,559 34.8 % $ 51,698 36.7 % $ (10,139 ) (19.6 )% Asia Pacific 62,260 52.1 % 63,923 45.3 % (1,663 ) (2.6 )% EMEA* 15,664 13.1 % 25,346 18.0 % (9,682 ) (38.2 )% Total net revenues $ 119,483 100.0 % $ 140,967 100.0 % $ (21,484 ) (15.2 )% _________________________________________________ *Europe, Middle East and Africa Cost of Product Revenues September 30, 2012 2011 % of Product % of Product % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Cost of product revenues $ 46,407 42.2 % $ 53,674 40.4 % $ (7,267 ) (13.5 )% The overall decrease in cost of product revenues is largely attributable to lower product revenues, slightly offset by a mix of products that had an overall higher cost. Our cost of product revenues is affected by various factors, including product mix, volume, and provisions for excess and obsolete inventories, material costs, manufacturing efficiencies, and the position of our 47 -------------------------------------------------------------------------------- Table of Contents products within their life-cycles. Our cost of product revenues as a percent of net product revenues is affected by these factors, as well as customer mix, volume, pricing, and competitive pricing programs. Engineering, Research and Development September 30, 2012 2011 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Engineering, research and development $ 42,713 35.7 % $ 52,990 37.6 % $ (10,277 ) (19.4 )% The decrease in R&D expense for fiscal year 2012 compared to fiscal year 2011 is largely attributable to lower compensation and facility expense of $4.9 million resulting from our consolidation of multiple locations and shift in activities to lower-cost areas, lower mask and test wafer expense of $1.9 million, and lower EDA tools expense of $2.0 million. Selling, General and Administrative September 30, 2012 2011 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Selling, general and administrative $ 29,822 25.0 % $ 41,233 29.3 % $ (11,411 ) (27.7 )% The decrease in SG&A expense for fiscal year 2012 compared to fiscal year 2011 is largely attributable to lower compensation related expenses of $3.6 million, a $4.1 million change in bad debt expense due to successful collection of $1.9 million of the $2.2 million of bad debts reserved in the fourth quarter of fiscal year 2011, $1.4 million in lower legal and accounting fees, and lower facility and depreciation expenses of $1.2 million due to our consolidation of facilities. Partially offsetting the reductions was a $1.3 million intangible asset write-down expense in fiscal year 2012 . Restructuring and Impairment Charges September 30, 2012 2011 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Restructuring and impairment $ (1,424 ) (1.2 )% $ 3,656 2.6 % $ (5,080 ) (138.9 )% During fiscal year 2011 we consolidated design activities and consolidated our Camarillo operations into a single facility, exiting an adjacent leased facility. In connection with these activities we incurred approximately $3.7 million of restructuring charges. In the fourth quarter of fiscal year 2012, we determined that it was unlikely we would be able to sublease the exited property for the remaining lease term through December 2015. Therefore, we decided that we would reoccupy the exited facility upon expiration of our main Camarillo facility lease in January 2014, instead of locating to a new facility as originally planned. Accordingly, we reversed the remaining lease termination reserve of $1.4 million. Interest Expense, Net September 30, 2012 2011 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages)Interest expense, net $ 7,778 6.5 % $ 8,456 6.0 % $ (678 ) (8.0 )% 48-------------------------------------------------------------------------------- Table of Contents The decrease in net interest expense for fiscal year 2012 compared to fiscal year 2011 was primarily due to an $8.0 million pay-down on the Senior Term Loan in January 2011, the restructuring of the Senior Term Loan on February 4, 2011, and the $1.5 million principal payment on the Term A Loan in July 2011. Gain on Compound Embedded Derivative September 30, 2012 2011 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Gain on compound embedded derivative $ (4,897 ) (4.1 )% $ (7,680 ) (5.4 )% $ 2,783 (36.2 )% The gain on our compound embedded derivative related to our 2014 Debentures is primarily generated by the decrease in the price of our underlying common stock during those periods. Loss on Extinguishment of Debt September 30, 2012 2011 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Loss on extinguishment of debt $ - - % $ 3,874 2.7 % $ (3,874 ) (100.0 )% A loss on extinguishment of debt for fiscal year 2011 was a result of the extinguishment of the Senior Term Loan at fair value, in which we recognized a $3.9 million loss for the difference between the aggregate fair values of Term A and B Loans plus additional amounts and fees paid to the noteholders compared to the net carrying value of the Senior Term Loan. Income Tax Benefit September 30, 2012 2011 % of Net % of Net % Amount Revenues Amount Revenues Change Change (in thousands, except percentages) Income tax benefit $ (174 ) (0.1 )% $ (619 ) (0.4 )% $ 445 (71.9 )% Our effective tax benefit for fiscal year 2012 was 13.6% . Our income tax benefit is primarily impacted by foreign taxes, withholding taxes on foreign income that are creditable against United States income taxes, the removal of unrecognized tax benefits, and certain nondeductible interest and share based expenses. The income tax benefit is also impacted by the release of a portion of the valuation allowances related to certain foreign jurisdictions' deferred tax assets as such balances were more likely than not realizable within the applicable carryforward period based on our analysis of the available positive and negative evidence. Our effective tax benefit for fiscal year 2011 was 4.0% . Financial Condition and Liquidity Cash Flow Analysis 49 -------------------------------------------------------------------------------- Table of Contents Cash increased to $68.9 million at September 30, 2013, from $23.9 million at September 30, 2012 and from $17.3 million at September 30, 2011. Our cash flows from operating, investing and financing activities are summarized as follows: September 30, 2013 2012 2011 (in thousands)Net cash (used in) provided by operating activities $ (9,119 ) $ 7,072 $ (7,211 ) Net cash used in investing activities (1,492 ) (1,602 ) (3,457 ) Net cash provided by (used in) financing activities 55,583 1,103 (10,141 ) Net increase (decrease) in cash 44,972 6,573 (20,809 ) Cash at beginning of period 23,891 17,318 38,127 Cash at end of period $ 68,863 $ 23,891 $ 17,318 Net Cash (Used In) Provided By Operating Activities During the fiscal year ended September 30, 2013, cash used in operating activities totaled $9.1 million. Cash increased $1.9 million from operating with lower inventory levels and prepaid and other assets, partially offset by $0.4 million from higher receivables. Cash also increased by $3.1 million due to increased accounts payable and deferred revenue due to higher purchases from distributors, which was offset by $0.2 million from lower accrued liabilities. Inventory decreased $1.4 million from $12.1 million at September 30, 2012 to $10.7 million at September 30, 2013 due to ongoing efforts to ensure purchases align with production and efforts to manage excess inventory. Accounts payable, accrued liabilities and other liabilities increased by $1.6 million from $18.5 million at September 30, 2012 to $20.1 million at September 30, 2013 due to the timing of payments to our vendors and other service providers. During the fiscal year ended September 30, 2012, cash provided by operating activities totaled $7.1 million. Excluding changes in working capital, cash generated by operations totaled $2.2 million. Cash increased $8.8 million from operating with lower inventory levels and $0.9 million from operating with lower accounts receivable, prepaid and other assets. These increases were partially offset by $1.9 million cash used to pay down accounts payable, accrued expenses and other liabilities, and $3.0 million related to a decrease in deferred revenue due to lower purchases from distributors. Inventory decreased $8.8 million from $20.9 million at September 30, 2011 to $12.1 million at September 30, 2012 due to ongoing efforts to ensure purchases align with production and concerted efforts to manage excess inventory. Accounts payable, accrued liabilities and other liabilities decreased by $3.1 million from $21.6 million at September 30, 2011 to $18.5 million at September 30, 2012 due to the timing of payments to our vendors and other service providers and non-cash restructuring gain. During the fiscal year ended September 30, 2011, cash used in operating activities totaled $7.2 million. Excluding changes in working capital, cash used to fund our losses totaled $6.0 million. We also used $9.6 million to pay down our accounts payable and accrued liabilities and $3.0 million related to a decrease in deferred revenue due to lower purchases from distributors. These uses were partially offset by the generation of cash from the collection of accounts receivable of $4.0 million and operating with lower inventory levels of $6.4 million. Accounts receivable decreased $4.0 million from $15.8 million at September 30, 2010 to $9.6 million at September 30, 2011. The decrease in accounts receivable was primarily due to lower sales during the year ended September 30, 2011 compared to the same period in the prior fiscal year, as well as a $2.2 million reserve for potential bad debt. Inventory decreased $6.4 million from $27.3 million at September 30, 2010 to $20.9 million at September 30, 2011. Due to positive changes in the availability of materials, we decreased purchasing in fiscal year 2011. Accounts payable and accrued expenses decreased by $9.8 million from $29.5 million at September 30, 2010 to $19.7 million at September 30, 2011 due to a reduction in purchases from our suppliers as industry-wide material shortages eased, as well as the timing of payments to our vendors and other service providers, and a payment of $3.0 million in settlement of litigation with the SEC in the second quarter of fiscal year 2011. Net Cash Used In Investing Activities 50 -------------------------------------------------------------------------------- Table of Contents Investing activities used $1.6 million for capital expenditures and payments under licensing agreements, partially offset by $0.2 million of proceeds from the sale of fixed assets in fiscal year 2013. In 2012 and 2011 investing activities used $1.7 million and $3.5 million, respectively, for capital expenditures and payments under licensing agreements. Net Cash Used In Financing Activities Financing activities provided $55.6 million in cash in fiscal year 2013, primarily due to the sale of common stock. Proceeds from the sale of common stock totaled $54.5 million and were offset by $0.6 million in cash used for the repurchase of restricted stock units for payroll taxes paid on behalf of employees. Financing activities provided $1.1 million in cash in fiscal year 2012, primarily for the repurchase and retirement of restricted stock units for payroll taxes. Financing activities used $10.1 million in cash in fiscal year 2011, primarily for a principal payment of $8.0 million on the Senior Term loan, $1.5 million payment of our Term A Loan, and $0.6 million for the repurchase of restricted stock units for payroll taxes paid on behalf of employees. Capital Resources, including Long-Term Debt, Contingent Liabilities and Operating Leases Prospective Capital Needs Our principal sources of liquidity are our existing cash, cash generated from product sales, and cash generated from the sales or licensing of our intellectual property. Our cash totaled $68.9 million at September 30, 2013. Our working capital at September 30, 2013 was $69.4 million. In order to achieve sustained profitability and positive cash flows from operations, we may need to further reduce operating expenses and/or increase revenue. We have completed a series of cost reduction actions that have improved our operating expense structure. We will continue to perform additional actions, as necessary. Our ability to maintain, or increase, current revenue levels to sustain profitability will depend, in part, on demand for our products. We believe that our existing cash, along with cash expected to be generated from product sales and the sale or licensing of our intellectual property, and the careful management of working capital requirements, will be sufficient to fund our operations and R&D efforts, anticipated capital expenditures, working capital, and other financing requirements for the next 12 months. In order to increase our working capital, we may seek to obtain additional debt or equity financing. However, we cannot assure you that such financing will be available to us on favorable terms, or at all, particularly in light of recent economic conditions in the capital markets. Our long-term debt is comprised of our Term A and B Loans and 2014 Debentures. On November 5, 2013 we amended the credit agreement for the Term A and B Loans (the "Amendment"). The Amendment extends the maturity dates of each of outstanding Term A and Term B Loans from February 4, 2014 and October 30, 2014, respectively, to August 31, 2016 and also provides that the Term A and B Loans will each bear interest in cash at 9.0% per annum payable quarterly in arrears. The Amendment also provides us with a right to optionally prepay the Term A and B Loans in whole or in part subject to a prepayment fee and the right, so long as no event of default exists under the credit agreement for the Term A and Term B Loans, to purchase, repay, redeem or defease any or all of the 2014 Debentures. On November 5, 2013, we repurchased $13.7 million principal amount of our 2014 Debentures, leaving $32.8 million principal amount of 2014 Debentures outstanding. We will continue to consider opportunistically repurchasing additional debentures ahead of their maturity. We have a Form S-3 universal shelf registration statement on file with the SEC. The universal shelf registration statement on Form S-3 permits Vitesse to sell, in one or more public offerings, shares of our common stock, shares of preferred stock or debt securities, or any combination of such securities, for proceeds in an aggregate amount of up to $75.0 million. As of September 30, 2013, we raised a total of $58.8 million in gross proceeds from the sale of 29,371,280 shares of our common stock, leaving approximately $16.2 million available pursuant to the Form S-3. The Form S-3 will expire in accordance with applicable SEC rules on December 27, 2014. However, we expect to file an amendment to the Form S-3 (or to file another Form S-3) in the first quarter of fiscal 2014 that will permit Vitesse to sell, in one or more public offerings, shares of our common stock, shares of preferred stock or debt securities, or any combination of such securities, for proceeds in an aggregate amount of up to $75.0 million. 51 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations Our significant contractual obligations as of September 30, 2013 are as follows: Payment Obligations by Fiscal Year 2014 2015 2016 2017 2018 Thereafter Total (in thousands) Convertible subordinated debt (1) $ - $ 46,493 $ - $ - $ - $ - $ 46,493 Term A Loan (2) - - 7,857 - - - 7,857 Term B Loan (3) - - 9,342 - - - 9,342 Loan interest (4) 4,904 3,092 1,771 - - 9,767 Operating leases (5) 2,068 1,128 199 - - - 3,395 Software licenses (6) 8,147 6,689 2,800 2,800 2,800 - 23,236 Inventory and other purchase obligations (7) 10,652 798 60 60 - - 11,570 Total $ 25,771 $ 58,200 $ 22,029 $ 2,860 $ 2,800 $ - $ 111,660 ________________________________________________ (1) 2014 Debentures represents amounts due for our 8.0% convertible debentures due October 2014. (2) Term A Loan represents amounts due for our 10.5% fixed rate senior notes due August 31, 2016, which bear interest at 9.0% effective November 6, 2013. (3) Term B Loan represents amounts due for our 8.0% fixed rate senior notes due August 31, 2016, which bear interest at 9.0% effective November 6, 2013. (4) Interest payable for 2014 Debentures through 2015 and Term A and Term B Loans through 2016. (5) We lease facilities under non-cancellable operating lease agreements that expire at various dates through 2016. (6) Software license commitments represent non-cancellable licenses of technology from third-parties used in the development of our products. (7) Inventory and other purchase obligations represent non-cancellable purchase commitments. For purposes of the table above, inventory and other purchase obligations are defined as agreements that are enforceable and legally binding and that specify all significant terms. Our purchase orders are based on our current manufacturing needs and are typically fulfilled by our vendors within a relatively short time. Other purchase commitments may be for longer periods and are dictated by contractual terms. Off-Balance Sheet Arrangements At September 30, 2013, we had no material off-balance sheet arrangements, other than operating leases. |