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EX-10.3 - EXHIBIT 10.3 - PROCERA NETWORKS, INC.ex10_3.htm
EX-10.2 - EXHIBIT 10.2 - PROCERA NETWORKS, INC.ex10_2.htm
EX-10.1 - EXHIBIT 10.1 - PROCERA NETWORKS, INC.ex10_1.htm
EX-10.4 - EXHIBIT 10.4 - PROCERA NETWORKS, INC.ex10_4.htm
EX-31.2 - EXHIBIT 31.2 - PROCERA NETWORKS, INC.ex31_2.htm
EX-32.1 - EXHIBIT 32.1 - PROCERA NETWORKS, INC.ex32_1.htm
EX-31.1 - EXHIBIT 31.1 - PROCERA NETWORKS, INC.ex31_1.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-Q


(Mark one)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010

or

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from   to   .

Commission File Number: 000-49862
 

PROCERA NETWORKS, INC.
(Exact name of registrant as specified in its charter)


 
Nevada
 
33-0974674
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. employer identification number)

100-C Cooper Court, Los Gatos, California
 
95032
(Address of principal executive offices)
 
(Zip code)

(408) 890-7100
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ   No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  o
 
Accelerated filer  x
 
Non-accelerated filer  o
 
Smaller reporting company  o
 
 
 
 
(Do not check if a smaller reporting company)
 
 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o   No þ
 
As of November 5, 2010, the registrant had 112,082,724 shares of its common stock, par value $0.001, outstanding.
 


 
1

 

PROCERA NETWORKS, INC.

INDEX
 
 
 
 
 
 
Page
PART I. FINANCIAL INFORMATION
 
 
 
 
 
 
 
 
 
 
 
Item 1.
 
Consolidated Financial Statements
 
 
 
 
 
 
 
 
 
 
 
 
   
3
 
 
 
 
 
 
 
 
 
 
   
4
 
 
 
 
 
 
 
 
 
 
   
5
 
 
 
 
 
 
 
 
 
 
   
6
 
 
 
 
 
 
 
 
 
Item 2.
   
14
 
 
 
 
 
 
 
 
 
Item 3.
   
21
 
 
 
 
 
 
 
 
 
Item 4.
   
21
 
 
 
 
 
 
 
 
PART II. OTHER INFORMATION
 
 
 
 
 
 
 
 
 
 
 
Item 1.
   
22
 
 
 
 
 
 
 
 
 
Item 1A.
   
22
 
 
 
 
 
 
 
 
 
Item 2.
   
34
 
 
 
 
 
 
 
 
 
Item 3.
   
34
 
 
 
 
 
 
 
 
 
Item 4.
   
34
 
 
 
 
 
 
 
 
 
Item 5.
   
34
 
 
 
 
 
 
 
 
 
Item 6.
   
34
 
 
 
 
 
 
 
 
 
35
 

 
2


PART I. FINANCIAL INFORMATION

Item 1.
Consolidated Financial Statements

Procera Networks, Inc.
CONDENSED CONSOLIDATED BALANCE SHEETS

 
 
September 30,
2010
 
 
December 31,
2009
 
 
 
(Unaudited)
 
 
(Note 2)
 
ASSETS
 
 
 
 
 
 
Current Assets:
 
 
 
 
 
 
Cash and cash equivalents
 
$
8,286,808
 
 
$
3,191,896
 
Accounts receivable, less allowance of $312,618 and $281,140 at September 30, 2010 and December 31, 2009, respectively
 
 
6,769,185
 
 
 
8,908,620
 
Inventories, net
 
 
2,987,768
 
 
 
1,877,264
 
Prepaid expenses and other
 
 
682,833
 
 
 
692,007
 
Total current assets
 
 
18,726,594
 
 
 
14,669,787
 
 
 
 
 
 
 
 
 
 
Property and equipment, net
 
 
879,529
 
 
 
589,717
 
Goodwill
 
 
960,209
 
 
 
960,209
 
Other non-current assets
 
 
36,212
 
 
 
103,307
 
Total assets
 
$
20,602,544
 
 
$
16,323,020
 
 
 
 
 
 
 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
 
 
 
 
 
Current liabilities:
 
 
 
 
 
 
 
 
Line of credit
 
$
1,022,386
 
 
$
1,917,088
 
Accounts payable
 
 
1,123,890
 
 
 
1,003,225
 
Deferred revenue
 
 
3,401,622
 
 
 
2,103,060
 
Accrued liabilities
 
 
2,164,756
 
 
 
2,255,039
 
Notes payable
 
 
 
 
 
500,000
 
Total current liabilities
 
 
7,712,654
 
 
 
7,778,412
 
 
 
 
 
 
 
 
 
 
Non-current liabilities:
 
 
 
 
 
 
 
 
Deferred rent
 
 
 
 
 
29,371
 
Total liabilities
 
 
7,712,654
 
 
 
7,807,783
 
 
 
 
 
 
 
 
 
 
Commitments and contingencies (Note 11)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Stockholders’ equity:
 
 
 
 
 
 
 
 
Common stock, $0.001 par value; 130,000,000 shares authorized; 112,082,724 and 94,082,724 shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively
 
 
112,083
 
 
 
94,083
 
Additional paid-in capital
 
 
75,309,183
 
 
 
67,814,203
 
Accumulated other comprehensive loss
 
 
(330,743
)
 
 
(268,449
)
Accumulated deficit
 
 
(62,200,633
)
 
 
(59,124,600
)
Total stockholders’ equity
 
 
12,889,890
 
 
 
8,515,237
 
Total liabilities and stockholders’ equity
 
$
20,602,544
 
 
$
16,323,020
 

See accompanying notes to condensed consolidated financial statements.

 
3


Procera Networks, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

 
 
Three Months Ended
 
 
Nine Months Ended
 
 
 
September 30,
 
 
September 30,
 
2010
   
2009
2010
   
2009
Sales:
 
 
 
 
 
 
 
 
 
 
 
 
Product sales
 
$
3,491,821
 
 
$
3,787,205
 
 
$
9,588,376
 
 
$
8,509,093
 
Support sales
 
 
1,242,956
 
 
 
796,279
 
 
 
3,216,768
 
 
 
2,255,444
 
Total net sales
 
 
4,734,777
 
 
 
4,583,484
 
 
 
12,805,144
 
 
 
10,764,537
 
Cost of sales:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product cost of sales
 
 
1,891,090
 
 
 
2,969,853
 
 
 
5,266,405
 
 
 
6,909,181
 
Support cost of sales
 
 
131,884
 
 
 
125,699
 
 
 
392,809
 
 
 
330,188
 
Total cost of sales
 
 
2,022,974
 
 
 
3,095,552
 
 
 
5,659,214
 
 
 
7,239,369
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Gross profit
 
 
2,711,803
 
 
 
1,487,932
 
 
 
7,145,930
 
 
 
3,525,168
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
 
 
859,987
 
 
 
583,738
 
 
 
2,271,108
 
 
 
1,903,187
 
Sales and marketing
 
 
1,614,384
 
 
 
1,622,291
 
 
 
4,831,885
 
 
 
4,961,082
 
General and administrative
 
 
934,243
 
 
 
1,088,302
 
 
 
3,000,102
 
 
 
3,807,342
 
Total operating expenses
 
 
3,408,614
 
 
 
3,294,331
 
 
 
10,103,095
 
 
 
10,671,611
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loss from operations
 
 
(696,811
)
 
 
(1,806,399
)
 
 
(2,957,165
)
 
 
(7,146,443
)
Interest and other income (expense), net
 
 
(40,438
)
 
 
(64,518
)
 
 
(115,889
)
 
 
(1,806,702
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loss before income taxes
 
 
(737,249
)
 
 
(1,870,917
)
 
 
(3,073,054
)
 
 
(8,953,145
)
Income tax provision (benefit)
 
 
1,723
 
 
 
(275,870
)
 
 
2,979
 
 
 
(691,450
)
Net loss
 
$
(738,972
)
 
$
(1,595,047
)
 
$
(3,076,033
)
 
$
(8,261,695
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net loss per share - basic and diluted
 
$
(0.01
)
 
$
(0.02
)
 
$
(0.03
)
 
$
(0.09
)
Shares used in computing net loss per share-basic and diluted
 
 
112,082,724
 
 
 
94,082,724
 
 
 
107,928,878
 
 
 
88,516,837
 

See accompanying notes to condensed consolidated financial statements.

 
4


Procera Networks, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

 
 
Nine Months Ended
 
 
 
September 30,
 
 
 
2010
 
 
2009
 
Cash flows from operating activities:
 
 
 
 
 
 
Net loss
 
$
(3,076,033
)
 
$
(8,261,695
)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
 
 
 
 
 
 
 
 
Depreciation
 
 
384,773
 
 
 
361,417
 
Amortization of intangibles
 
 
 
 
 
2,478,573
 
Compensation related to stock-based awards
 
 
996,511
 
 
 
885,952
 
Interest expense related to conversion option embedded in convertible notes
 
 
 
 
 
1,664,756
 
Provision for bad debts
 
 
33,861
 
 
 
 
Provision for excess and obsolete inventory
 
 
120,886
 
 
 
82,755
 
Deferred income taxes
 
 
 
 
 
(695,239
)
    Loss on retirement of fixed assets
   
     
7,508
 
Changes in assets and liabilities:
 
 
 
 
 
 
 
 
Accounts receivable
 
 
2,405,102
 
 
 
(74,847
)
Inventories
 
 
(1,094,931
)
 
 
1,388,696
 
Prepaid expenses and other current assets
 
 
96,708
 
 
 
313,713
 
Accounts payable
 
 
103,972
 
 
 
(1,198,981
)
Accrued liabilities and deferred rent
 
 
(191,547
)
 
 
(431,601
)
Deferred revenue
 
 
1,185,434
 
 
 
519,195
 
Net cash provided by (used in) operating activities
 
 
964,736
 
 
 
(2,959,798
)
 
 
 
 
 
 
 
 
 
Cash flows from investing activities:
 
 
 
 
 
 
 
 
Purchase of property and equipment
 
 
(626,235
)
 
 
(66,789
)
Net cash used in investing activities
 
 
(626,235
)
 
 
(66,789
)
 
 
 
 
 
 
 
 
 
Cash flows from financing activities:
 
 
 
 
 
 
 
 
    Proceeds from issuance of common stock
 
 
6,471,203
 
 
 
3,538,227
 
Proceeds from exercise of stock options
 
 
 
 
 
134,800
 
Proceeds from issuance of notes payable
 
 
 
 
 
500,000
 
Proceeds from line of credit
   
1,022,386
     
 
Repayments on line of credit
 
 
(1,917,088
)
 
 
 
Payments on notes payable
 
 
(500,000
)
 
 
(550,000
)
Principal payments on capital leases
 
 
 
 
 
(1,682
)
    Other
   
45,266
     
 
Net cash provided by financing activities
 
 
5,121,767
 
 
 
3,621,345
 
 
 
 
 
 
 
 
 
 
Effect of exchange rates on cash and cash equivalents
 
 
(365,356
)
 
 
73,466
 
 
 
 
 
 
 
 
 
 
Net increase in cash and cash equivalents
 
 
5,094,912
 
 
 
668,224
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents, beginning of period
 
 
3,191,896
 
 
 
1,721,225
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents, end of period
 
$
8,286,808
 
 
$
2,389,449
 

See accompanying notes to condensed consolidated financial statements.

 
5


Procera Networks, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

1.
DESCRIPTION OF BUSINESS

Procera Networks, Inc. ("Procera" or the "Company") is a leading provider of bandwidth management and control products that deliver a broad set of capabilities, which include congestion management, operational intelligence and service creation capabilities, for broadband service providers worldwide. Procera’s products offer network administrators intelligent network traffic identification, control and service management.

The Company sells its products through its direct sales force, resellers, distributors and system integrators in the Americas, Asia Pacific and Europe. PacketLogic™, the Company’s principal product, is deployed at more than 600 broadband service providers, telephone companies, colleges and universities worldwide. The common stock of Procera began trading on the NYSE Amex Equities U.S. under the trading symbol “PKT” in 2007.

The Company was incorporated in 2002. In 2006, Procera acquired the stock of Netintact AB, a Swedish corporation and acquired the effective ownership of the stock of Netintact PTY, an Australian company. The Company has operations in California, Sweden and Australia.

2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

Procera has prepared the consolidated financial statements included herein pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) applicable to interim financial information.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations.  However, Procera believes that the disclosures are adequate to ensure the information presented is not misleading. The consolidated balance sheet at December 31, 2009 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by United States generally accepted accounting principles (“GAAP”) for complete financial statements. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in Procera’s Annual Report on Form 10-K for the year ended December 31, 2009, filed with the SEC on March 12, 2010.

Certain amounts from prior periods have been reclassified to conform to the current period presentation.  These reclassifications had no impact on stockholders' equity, previously reported net loss, or the net change in cash and cash equivalents.

The consolidated financial statements present the accounts of Procera and its wholly-owned subsidiaries, Netintact AB and Netintact PTY.  All significant inter-company balances and transactions have been eliminated.

Significant Accounting Policies

The accounting and reporting policies of the Company conform to GAAP and to the practices within the software and telecommunications industry.  There have been no significant changes in the Company's significant accounting policies during the nine months ended September 30, 2010 compared to our disclosures set forth in the Company's Annual Report on Form 10-K for the year ended December 31, 2009.

Use of Estimates. The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The Company believes its estimates of inventory reserves, allowance for bad debts, recoverability of long-lived assets, fair value of intangible assets and recognition and measurement of current and deferred income taxes to be the most sensitive estimates impacting financial position and results of operations in the near term.

Inventory Reserves. Each quarter, the Company evaluates its inventories for excess quantities and obsolescence. Inventories that are considered obsolete are written off. Remaining inventory balances are adjusted to approximate the lower of cost or market value. The valuation of inventories at the lower of cost or market requires the use of estimates as to the amounts of current inventories that will be sold. These estimates are dependent on management’s assessment of current and expected orders from the Company’s customers.

Accounting for Stock-Based Compensation. The Company accounts for stock-based compensation based on the fair value of all option grants or stock issuances made to employees or directors. These amounts are expensed over the respective vesting periods of each award using the straight-line attribution method. The Company calculates the fair value of each option using the Black-Scholes option pricing model.

 
6


Fair Value of Financial Instruments. Financial instruments include cash and cash equivalents, accounts receivable and payable, other current liabilities and debt. The carrying amounts reported in the balance sheets for cash and cash equivalents, accounts receivable and payable and other current liabilities approximate fair value due to the short-term nature of these items.

3.
RECENT ACCOUNTING PRONOUNCEMENTS

In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2009-13, “Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force” (“ASU 2009-13”). It updates the existing multiple-element revenue arrangements guidance currently included under Accounting Standards Codification (“ASC”) 605-25, which originated primarily from the guidance in EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables”. The revised guidance primarily provides two significant changes: 1) eliminates the need for objective and reliable evidence of the fair value for the undelivered element in order for a delivered item to be treated as a separate unit of accounting, and 2) eliminates the residual method to allocate the arrangement consideration. In addition, the guidance also expands the disclosure requirements for revenue recognition. ASU 2009-13 will be effective for the first annual reporting period beginning on or after June 15, 2010, with early adoption permitted provided that the revised guidance is retroactively applied to the beginning of the year of adoption. The Company is currently assessing the future impact of this new accounting update on its consolidated financial statements.

In October 2009, the FASB issued ASU 2009-14, “Certain Revenue Arrangements that Include Software Elements—a consensus of the FASB Emerging Issues Task Force” (“ASU 2009-14”).  ASU 2009-14 amends the scope of pre-existing software revenue guidance by removing from the guidance non-software components of tangible products and certain software components of tangible products. ASU 2009-14  will be effective for the first annual reporting period beginning on or after June 15, 2010, with early adoption permitted provided that the revised guidance is retroactively applied to the beginning of the year of adoption. The Company is currently assessing the future impact of this new accounting update on its consolidated financial statements.

In January 2010, the FASB issued ASU 2010-06 (“ASU 2010-06”), Fair Value Measurements and Disclosures (Topic 820) – Improving Disclosures about Fair Value Measurements. ASU 2010-06 requires an entity to disclose separately the amounts of significant transfers in and out of Level I and II fair value measurements, and describe the reasons for the transfers. It also requires additional disclosures regarding purchases, sales, issuances and settlements of Level III measurements. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for the additional disclosure of Level III measurements, which is effective for fiscal years beginning after December 15, 2010. The adoption of the provisions of ASU 2010-06 did not have a significant impact on the Company’s consolidated financial statements or related footnotes.

In April 2010, the FASB issued ASU 2010-17, which establishes authoritative guidance permitting use of the milestone method of revenue recognition for research or development arrangements that contain payment provisions or consideration contingent on the achievement of specified events. This guidance is effective for milestones achieved in fiscal years beginning on or after June 15, 2010 and allows for either prospective or retrospective application, with early adoption permitted. The Company is currently evaluating the impact that adoption of this guidance will have on its consolidated financial statements.

Other recent accounting pronouncements issued by the FASB, the American Institute of Certified Public Accountants, and the SEC did not or are not believed by management to have a material impact on the Company's consolidated financial statements.

 
7


4.
STOCK-BASED COMPENSATION

The Company has an equity incentive plan that provides for the grant of incentive stock options to eligible employees.  Stock-based employee compensation expense recognized pursuant to this plan on the Company’s condensed consolidated statements of operations for the three and nine-month periods ended September 30, 2010 and 2009 was as follows:

 
 
Three Months Ended
 
 
Nine Months Ended
 
 
 
September 30,
 
 
September 30,
 
2010
   
2009
2010
   
2009
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of goods sold
 
$
19,948
 
 
$
15,943
 
 
$
63,799
 
 
$
50,397
 
Research and development
 
 
2,715
 
 
 
8,585
 
 
 
11,234
 
 
 
25,869
 
Sales and marketing
 
 
82,276
 
 
 
57,694
 
 
 
223,977
 
 
 
217,291
 
General and administrative
 
 
251,685
 
 
 
193,622
 
 
 
697,501
 
 
 
592,395
 
Total stock-based compensation expense
 
$
356,624
 
 
$
275,844
 
 
$
996,511
 
 
$
885,952
 

No income tax benefits were recognized in the three and nine months ended September 30, 2010 and 2009 due to the Company’s continuing losses.  No stock-based compensation has been capitalized in inventory due to the immateriality of such amounts.

General Share-Based Award Information

The following table summarizes the Company’s stock option activity for the nine months ended September 30, 2010:

 
 
Number of Options
 
 
Weighted Average Exercise Price
 
 
Weighted Average Remaining Contractual Life
(in years)
 
Aggregate Intrinsic Value
 
 
 
 
 
 
 
 
 
 
 
 
 
Outstanding at December 31, 2009
 
 
9,080,724
 
 
$
0.99
 
 
 
 
 
 
Granted
 
 
1,277,035
 
 
$
0.48
 
 
 
 
 
 
Exercised
 
 
 
 
 
 
 
 
 
 
 
Cancelled/forfeited
 
 
(699,992
)
 
$
1.27
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Outstanding at September 30, 2010
 
 
9,657,767
 
 
$
0.91
 
 
 
6.84
 
 
$
127,120
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Vested and expected to vest at September 30, 2010
 
 
9,263,445
 
 
$
0.91
 
 
 
6.76
 
 
$
119,395
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exercisable at September 30, 2010
 
 
5,550,469
 
 
$
0.99
 
 
 
5.57
 
 
$
57,535
 

No options were exercised during the nine months ended September 30, 2010.  The total intrinsic value of options exercised during the nine months ended September 30, 2009, was $70,200.
 
As of September 30, 2010, total unrecognized compensation cost related to unvested stock options was $1,862,299, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average amortization period of 2.16 years.

The weighted average grant date fair value of options granted during the nine months ended September 30, 2010 and 2009 was $0.33 and $0.52, respectively.

Valuation Assumptions

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model while the expense is recognized over the requisite service period using the straight-line attribution approach.

 
8


The following assumptions were used in determining the fair value of stock-based awards granted during the three and nine months ended September 30, 2010 and 2009:

 
 
Three Months Ended
 
 
Nine Months Ended
 
 
 
September 30,
 
 
September 30,
 
 
 
2010
 
 
2009
 
 
2010
 
 
2009
 
Expected term (years)
 
 
4.30
 
 
 
4.61
 
 
 
4.55
 
 
 
4.27
 
Expected volatility
 
 
92.7
%
 
 
97.4
%
 
 
95.0
%
 
 
98.6
%
Risk-free interest rate
 
 
1.78
%
 
 
2.10
 
 
 
2.09
%
 
 
1.64
%
Expected dividend yield
 
 
0
%
 
 
0
%
 
 
0
%
 
 
0
%

The Company calculated the expected term of stock options granted using historical exercise data.  The Company used the exact number of days between the grant and the exercise dates to calculate a weighted average of the holding periods for all awards (i.e., the average interval between the grant and exercise or post-vesting cancellation dates) adjusted as appropriate. Expected volatilities were estimated using the historical share price performance over a period equivalent to the expected term of the option.  The risk-free interest rate for a period equivalent to the expected term of the option was extrapolated from the U.S. Treasury yield curve in effect at the time of the grant. The Company has never paid cash dividends and does not anticipate paying cash dividends in the foreseeable future.

5.
NET INCOME (LOSS) PER SHARE

The following table sets forth the computation of basic and diluted net income (loss) per share and potential shares of common stock that are not included in the computation of diluted net income (loss) per share because their effect is antidilutive:

 
 
Three Months Ended
 
 
Nine Months Ended
 
 
 
September 30,
 
 
September 30,
 
 
 
2010
 
 
2009
 
 
2010
 
 
2009
 
Numerator - basic and diluted
 
$
(738,972
)
 
$
(1,595,047
)
 
$
(3,076,033
)
 
$
(8,261,695
)
Denominator - basic and diluted:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding
 
 
112,082,724
 
 
 
94,082,724
 
 
 
107,928,878
 
 
 
88,516,837
 
Net loss per share - basic and diluted
 
$
(0.01
)
 
$
(0.02
)
 
$
(0.03
)
 
$
(0.09
)
Antidilutive securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Options issued and outstanding
 
 
9,657,767
 
 
 
7,650,531
 
 
 
9,657,767
 
 
 
7,650,531
 
Warrants
 
 
4,094,604
 
 
 
3,660,021
 
 
 
4,094,604
 
 
 
3,660,021
 
Total
 
 
13,752,371
 
 
 
11,310,552
 
 
 
13,752,371
 
 
 
11,310,552
 

6.
COMPREHENSIVE INCOME (LOSS)

The components of comprehensive income (loss) for the three and nine months ended September 30, 2010 and 2009 are as follows:

 
 
Three Months Ended
 
 
Nine Months Ended
 
 
 
September 30,
 
 
September 30,
 
 
 
2010
 
 
2009
 
 
2010
 
 
2009
 
Net loss
 
$
(738,972
)
 
$
(1,595,047
)
 
$
(3,076,033
)
 
$
(8,261,695
)
Foreign currency translation adjustments
 
 
28,725
 
 
 
(125,335
)
 
 
(62,295
)
 
 
147,021
 
Comprehensive loss
 
$
(710,247
)
 
$
(1,720,382
)
 
$
(3,138,328
)
 
$
(8,114,674
)

 
9


7.
INVENTORIES

Inventories are stated at the lower of cost, which approximates actual costs on a first in, first out basis, or market. Inventories at September 30, 2010 and December 31, 2009 consisted of the following:

 
 
September 30,
2010
 
 
December 31,
2009
 
Finished goods
 
$
2,890,506
 
 
$
1,824,052
 
Raw materials
 
 
97,262
 
 
 
53,212
 
Inventories, net
 
$
2,987,768
 
 
$
1,877,264
 

8.
ACCRUED LIABILITIES

Accrued liabilities at September 30, 2010 and December 31, 2009 consisted of the following:
 
 
 
September 30,
2010
 
 
December 31,
2009
 
Payroll and related
 
$
769,404
 
 
$
1,188,777
 
Audit and legal services
 
 
67,269
 
 
 
65,850
 
Sales and VAT taxes
 
 
46,572
 
 
 
72,839
 
Sales commissions
 
 
195,898
 
 
 
323,508
 
Warranty
 
 
446,440
 
 
 
333,662
 
Other
 
 
639,173
 
 
 
270,403
 
Total
 
$
2,164,756
 
 
$
2,255,039
 

Warranty Reserve

The Company warrants its products against material defects for a specific period of time, generally twelve months. The Company provides for the estimated future costs of warranty obligations in cost of sales when the related revenue is recognized. The accrued warranty costs represent the best estimate at the time of sale of the total costs that the Company expects to incur to repair or replace product parts which fail while still under warranty.  The amount of accrued estimated warranty costs are primarily based on current information on repair costs.  The Company periodically reviews the accrued balances and updates the historical warranty cost trends.

Changes in the warranty reserve during the nine months ended September 30, 2010 were as follows:

Warranty obligation at December 31, 2009
 
$
333,662
 
Provision for current period sales
 
 
160,830
 
Deductions for warranty claims
 
 
(48,052
)
Warranty obligation at September 30, 2010
 
$
446,440
 

9.
STOCKHOLDERS’ EQUITY

On March 4, 2010, the Company closed a registered placement of its common stock primarily to institutional investors. The offering price of the Company’s common stock was $0.40 per share. The Company sold 18 million shares of common stock at a gross sales price of $7.2 million, and received net proceeds of approximately $6.5 million after deducting the placement agent’s commission and legal and other offering costs. The placement agent also received a warrant to purchase 180,000 shares of the Company’s common stock at an exercise price of $0.40 per share which expires on March 4, 2013. The warrant had an estimated fair value of $44,547 calculated using the Black-Scholes option pricing model.

 
10


Warrants

A summary of warrant activity for the nine months ended September 30, 2010 is as follows:
 
 
 
Warrants
 
 
 
Number of Shares
 
 
Weighted Average Purchase Price
 
Outstanding December 31, 2009
 
 
4,160,021
 
 
$
0.95
 
Issued
 
 
180,000
 
 
 
0.40
 
Exercised
 
 
 
 
 
 
Cancelled/expired
 
 
(245,417
)
 
 
1.70
 
Outstanding September 30, 2010
 
 
4,094,604
 
 
$
0.84
 

The chart below shows the outstanding warrants as of September 30, 2010 by exercise price and the average contractual life before expiration.

Exercise Price
   
Number Outstanding
   
Weighted Average Remaining Contractual Life (Years)
   
Number Exercisable
 
$ 0.40       1,927,750       2.49       1,927,750  
  0.60       569,107       1.13       569,107  
  1.50       1,020,000       1.42       1,020,000  
  1.75       17,759       1.21       17,759  
  2.00       199,988       2.05       199,988  
                             
$ 0.84       4,094,604       1.66       4,094,604  

10.
INCOME TAXES

At September 30, 2010 and December 31, 2009, the Company had $236,794 of unrecognized tax benefits, none of which would affect the Company’s effective tax rate if recognized.

The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. As of September 30, 2010, the Company had no accrued interest or penalties related to uncertain tax positions. The tax years 2004-2009 remain open to examination by one or more of the major taxing jurisdictions to which the Company is subject. The Company does not anticipate that the total unrecognized tax benefits will significantly change due to the settlement of audits and the expiration of statutes of limitations prior to September 30, 2011.

In 2002, the Company established a valuation allowance for substantially all of its deferred tax assets. Since that time, the Company has continued to record a valuation allowance. A valuation allowance is required to be established or maintained when it is “more likely than not” that all or a portion of deferred tax assets will not be realized. The Company will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal.
 
 
11.
COMMITMENTS AND CONTINGENCIES

Legal

The Company is periodically involved in legal actions and claims that arise as a result of events that occur in the normal course of operations. The Company does not believe that any of its currently outstanding legal actions and claims will have, individually or in the aggregate, a material adverse effect on the Company's financial position or results of operations.

Operating Leases

The Company leases its operating and office facilities for various terms under long-term, non-cancelable operating lease agreements. The leases expire at various dates through 2013 and provide for renewal options ranging from month-to-month to 5 year terms. The Company expects that these leases will be renewed or replaced in the normal course of business by leases on other properties. The leases provide for increases in future minimum annual rental payments based on defined increases which are generally meant to correlate with the Consumer Price Index, subject to certain minimum increases. Also, the agreements generally
require the Company to pay executory costs (real estate taxes, insurance and maintenance and repairs).

 
11


The Company and its subsidiaries have entered into office lease agreements for its headquarters in Los Gatos, California; Netintact, AB offices in Varberg, Sweden; and Netintact PTY offices in Melbourne, Australia.

As of September 30, 2010, future minimum lease payments under operating leases are as follows:

Three months ending December 31, 2010
 
$
92,941
 
Years ending December 31,
 
 
 
 
2011
 
 
250,050
 
2012
 
 
142,675
 
2013
 
 
35,669
 
Total minimum lease payments
 
$
521,335
 

Secured Line of Credit

On December 10, 2009, the Company entered into a two-year loan and security agreement for a secured line of credit facility (“Secured Credit Facility”) for short-term working capital purposes with Silicon Valley Bank. The Secured Credit Facility provides borrowings of up to $2.0 million through December 10, 2011. Borrowings under the facility bear interest at the prime rate plus 1%, but not less than 5% per annum. If the Company’s cash balance falls below $2,000,000, outstanding borrowings will bear an additional interest charge of 0.6875% per month, or 8.25% per annum. Under the terms of the Secured Credit Facility, the Company will pay Silicon Valley Bank a $17,000 fee in each of the two years of the agreement and will pay a minimum monthly interest charge of $3,000 per month.  The Company also issued a warrant to Silicon Valley Bank for the purchase of 500,000 shares of the Company’s common stock with an exercise price of $0.40 per share and a fair value of $166,302, which is being amortized to interest expense over the two-year term of the Secured Credit Facility. The Secured Credit Facility is secured by substantially all of the Company’s assets. The terms of the Secured Credit Facility include financial covenants requiring minimum quarterly revenue and restrictions on the Company’s ability to incur certain additional indebtedness, pay dividends, create or permit liens on assets or engage in mergers, consolidations or dispositions.  At September 30, 2010, the Company had $1.0 million outstanding on its Secured Credit Facility.

Notes Payable

In April 2009, the Company received loan proceeds totaling $500,000 through a private placement of nonconvertible debt.  Such nonconvertible debt bore interest at 10% per annum, which interest was due and payable on a quarterly basis.   The nonconvertible debt was repaid in full by the Company during the quarter ended March 31, 2010.

12.
SEGMENT INFORMATION

The Company operates in one segment, using one measure of profitability to manage its business. Sales for geographic regions were based upon the customer’s location. The location of long-lived assets is based on the physical location of the Company’s regional offices. The following summarizes sales and long-lived assets by geographical region:

 
 
Three Months Ended
 
 
Nine Months Ended
 
 
 
September 30,
 
 
September 30,
 
 
 
2010
 
 
2009
 
 
2010
 
 
2009
 
Sales:
 
 
 
 
 
 
 
 
 
 
 
 
United States
 
$
2,935,724
 
 
$
3,827,743
 
 
$
7,467,013
 
 
$
5,360,995
 
Europe, Middle East and Asia
 
 
1,799,053
 
 
 
755,741
 
 
 
5,338,131
 
 
 
5,403,542
 
Total
 
$
4,734,777
 
 
$
4,583,484
 
 
$
12,805,144
 
 
$
10,764,537
 
 
   
September 30,
2010
   
December 31,
 2009
 
Long-lived assets                
United States
 
$
465,735
 
 
$
501,317
 
Europe
 
 
431,282
 
 
 
167,535
 
Australia
 
 
18,724
 
 
 
24,172
 
Total
 
$
915,741
 
 
$
693,024
 

Sales made to customers located outside the United States as a percentage of total net revenues were 38% and 42% for the three and nine months ended September 30, 2010, respectively, and 16% and 51% for the three and nine months ended September 30, 2009, respectively.

 
12


For the three months ended September 30, 2010, revenue from two customers represented 19% and 12% of net revenues, respectively, and for the nine months ended September 30, 2010, revenue from another customer (Cox Communications, Inc.) represented 15% of net revenues, with no other single customer representing more than 10% of net revenues. For the three and nine months ended September 30, 2009, revenue from one customer (Cox Communications, Inc.) represented 73% and 32% of net revenue, respectively, with no other single customer representing more than 10% of net revenue.

At September 30, 2010, accounts receivable from two customers represented 16% and 11%, respectively, of total accounts receivable, with no other single customer representing more than 10% of the accounts receivable balance. At December 31, 2009, accounts receivable from two customers represented 55% and 14%, respectively, of total accounts receivable with no other single customer representing more than 10% of the accounts receivable balance.  As of September 30, 2010 and December 31, 2009, approximately 48% and 27%, respectively, of the Company’s total accounts receivable were due from customers outside the United States.

 
13


Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is a discussion of our results of operations and current financial position. This discussion should be read in conjunction with our unaudited consolidated financial statements and related notes included elsewhere in this report and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2009.

As used in this quarterly report on Form 10-Q, references to the “Company,” “we,” “us,” “our” or similar terms include Procera Networks, Inc. and its consolidated subsidiaries.

Cautionary Note Regarding Forward-Looking Statements

Our disclosure and analysis in this quarterly report on Form 10-Q contain certain “forward-looking statements,” as such term is defined in Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These statements set forth anticipated results based on management’s plans and assumptions. From time to time, we also provide forward-looking statements in other materials we release to the public as well as oral forward-looking statements. Such statements give our current expectations or forecasts of future events; they do not relate strictly to historical or current facts. We have attempted to identify such statements by using words such as “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “will,” “could”, “initial” and similar expressions in connection with any discussion of future events or future operating or financial performance or strategies. Such forward-looking statements include, but are not limited to, statements regarding:

 
our services, including the development and deployment of products and services and strategies to expand our targeted customer base and broaden our sales channels;

 
the operation of our company with respect to the development of products and services;

 
our liquidity and financial resources, including anticipated capital expenditures, funding of capital expenditures and anticipated levels of indebtedness and the ability to raise capital through financing activities;

 
trends related to and management’s expectations regarding results of operations, required capital expenditures, revenues from existing and new products and sales channels, and cash flows, including but not limited to those statements set forth below in this Item 2; and

 
sales efforts, expenses, interest rates, foreign exchange rates, and the outcome of contingencies, such as legal proceedings.

We cannot guarantee that any forward-looking statement will be realized. Achievement of future results is subject to risks, uncertainties and potentially inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from past results and those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements.

We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. We also provide the following cautionary discussion of risks and uncertainties related to our businesses. These are factors that we believe, individually or in the aggregate, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties.

Our forward-looking statements are subject to a variety of factors that could cause actual results to differ significantly from current beliefs and expectations, identified under the caption "Risk Factors" and elsewhere in this quarterly report on Form 10-Q, as well as general risks and uncertainties such as those relating to general economic conditions and demand for our products and services.

Overview

We are a leading provider of evolved network traffic awareness, analysis and control solutions based on Deep Packet Inspection (DPI) technology for a broad range of broadband service providers worldwide. Our products offer network operators: network traffic identification, control and service management.

We have more than 600 customers who have installed over 1,300 of our systems in total. Our customers include cable multi-system operators, mobile service providers, telecommunications companies, universities and other entities.

Our products are marketed under the PacketLogic™ brand name. We have multiple products, performing at speeds from 2 megabits per second up to 80 gigabits per second, which are designed to address a broad market spectrum of customers.

 
14


Our PacketLogic family of products offers:

 
Accuracy.  Our proprietary DRDL software solution allows us to provide our customers with a high degree of application identification accuracy and the flexibility to regularly update the software to keep up with the rapid introduction of new Internet applications;

 
Scalability.  Our family of products is scalable from a few hundred megabits to 80 gigabits of traffic per second, up to 5 million subscribers and up to 48 million simultaneous data flows, which is critical to service providers as they upgrade to DOCSIS 3.0 (a high bandwidth broadband cable standard), FTTX (high bandwidth fiber to the home or neighborhood used by telecom broadband network providers) and LTE (enabling higher bandwidth mobile phone networks) technologies in the access network; and

 
Platform Flexibility.  Our products are deployable in many locations in a network and use non-proprietary hardware, and can rapidly leverage advances in computing technology which we believe to be a better solution than those which are dependent on specific network silicon processors or hardware platforms.

We face competition from suppliers of standalone DPI products including Allot Communications, Arbor Networks, Blue Coat Systems, Brocade Communications Systems, Cisco Systems, Ericsson, Huawei Technologies Company, Juniper Networks, and Sandvine Corporation. Some of our competitors also supply platform products with different degrees of DPI functionality, such as switch/routers, routers, session border controllers and VoIP switches.

Most of our competitors are larger and more established enterprises with substantially greater financial and other resources.  Some competitors may be willing to reduce prices and accept lower profit margins in order to compete with us.  As a result of such competition, we could lose market share and sales, or be forced to reduce our prices to meet competition.  However, we do not believe there is a dominant supplier in our market. Based on our belief in the superiority of our technology, we believe that we have an opportunity to capture meaningful market share and benefit from what we believe will be growth in the DPI market.

We were incorporated in 2002, and in October 2003, we merged with Zowcom, Inc., a publicly-traded Nevada corporation.  We acquired Netintact AB, a Swedish corporation, and Netintact PTY, an Australian company, in 2006.

Following the acquisitions of Netintact AB and Netintact PTY, our core products and business changed substantially to focus on DPI solutions. PacketLogic, the flagship product and technology of Netintact, now is the Company’s principal product offering. We sell our products through our direct sales force, resellers, distributors and systems integrators in the Americas, Asia Pacific and Europe.

Critical Accounting Estimates

Our discussion and analysis of our financial condition and results of operations are based upon financial statements which have been prepared in accordance with Generally Accepted Accounting Principles in the United States (“GAAP”).  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities.  On an ongoing basis, we evaluate these estimates.  We base our estimates on historical experience and on assumptions that are believed to be reasonable.  These estimates and assumptions provide a basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions, and these differences may be material.  Our significant accounting policies are summarized in Note 2 to our audited financial statements in our Annual Report on Form 10-K for the year ended December 31, 2009 filed with the SEC on March 12, 2010.

Management believes that there have been no significant changes during the nine months ended September 30, 2010 to the disclosures of our critical accounting policies and estimates set forth in Management’s Discussion and Analysis of Financial Condition and Results of Operations section of our Annual Report on Form 10-K for the year ended December 31, 2009, filed with the SEC on March 12, 2010. In accordance with SEC guidance, the Company believes the following critical accounting policies reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements:

 
·
Revenue Recognition;
 
·
Valuation of Goodwill, Intangible and Long-Lived Assets;
 
·
Allowance for Doubtful Account;
 
·
Stock-Based Compensation; and
 
·
Accounting for Income Taxes.

These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2009.

 
15


Recent Accounting Pronouncements

In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2009-13, “Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force” (ASU 2009-13). It updates the existing multiple-element revenue arrangements guidance currently included under Accounting Standards Codification (“ASC”) 605-25, which originated primarily from the guidance in EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables”. The revised guidance primarily provides two significant changes: 1) eliminates the need for objective and reliable evidence of the fair value for the undelivered element in order for a delivered item to be treated as a separate unit of accounting, and 2) eliminates the residual method to allocate the arrangement consideration. In addition, the guidance also expands the disclosure requirements for revenue recognition. ASU 2009-13 will be effective for the first annual reporting period beginning on or after June 15, 2010, with early adoption permitted provided that the revised guidance is retroactively applied to the beginning of the year of adoption. We are currently assessing the future impact of this new accounting update on our consolidated financial statements.

In October 2009, the FASB issued ASU 2009-14, “Certain Revenue Arrangements that Include Software Elements—a consensus of the FASB Emerging Issues Task Force” (“ASU 2009-14”).  ASU 2009-14 amends the scope of pre-existing software revenue guidance by removing from the guidance non-software components of tangible products and certain software components of tangible products. ASU 2009-14  will be effective for the first annual reporting period beginning on or after June 15, 2010, with early adoption permitted provided that the revised guidance is retroactively applied to the beginning of the year of adoption. We are currently assessing the future impact of this new accounting update on our consolidated financial statements.

In January 2010, the FASB issued ASU 2010-06 (“ASU 2010-06”), Fair Value Measurements and Disclosures (Topic 820) – Improving Disclosures about Fair Value Measurements. ASU 2010-06 requires an entity to disclose separately the amounts of significant transfers in and out of Level I and II fair value measurements, and describe the reasons for the transfers. It also requires additional disclosures regarding purchases, sales, issuances and settlements of Level III measurements. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for the additional disclosure of Level III measurements, which is effective for fiscal years beginning after December 15, 2010. The adoption of the provisions of ASU 2010-06 did not have a significant impact on our consolidated financial statements or related footnotes.

In April 2010, the FASB issued ASU 2010-17, which establishes authoritative guidance permitting use of the milestone method of revenue recognition for research or development arrangements that contain payment provisions or consideration contingent on the achievement of specified events. This guidance is effective for milestones achieved in fiscal years beginning on or after June 15, 2010 and allows for either prospective or retrospective application, with early adoption permitted. We are currently evaluating the impact that adoption of this guidance will have on our consolidated financial statements.

Results of Operations

Comparison of Three and Nine Months Ended September 30, 2010 and 2009

Revenue

 
 
Three Months Ended
 
 
 
 
 
Nine Months Ended
 
 
 
 
 
 
September 30,
 
 
 
 
 
September 30,
 
 
 
 
 
 
2010
 
 
2009
 
 
Change
 
 
2010
 
 
2009
 
 
Change
 
 
 
($ in thousands)
 
 
 
 
 
($ in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net product revenue
 
$
3,492
 
 
$
3,787
 
 
 
(8)
%
 
$
9,588
 
 
$
8,509
 
 
 
13
%
Net support revenue
 
 
1,243
 
 
 
796
 
 
 
56
%
 
 
3,217
 
 
 
2,255
 
 
 
43
%
Total revenue
 
$
4,735
 
 
$
4,583
 
 
 
3
%
 
$
12,805
 
 
$
10,765
 
 
 
19
%

Our revenue is derived from two sources: product revenue, which includes sales of our hardware appliances bundled with software licenses, and service revenue, which includes revenue from support and services.

Total revenue increased by 3% and 19% for the three and nine months ended September 30, 2010, compared with the same periods in 2009.  The increase for the three months ended September, 30, 2010 reflected increased support revenue, partially offset by a decrease in product revenue.  The increase for the nine months ended September 30, 2010 reflected increases in product and support revenue.

The decrease in product revenue of 8% for the three months ended September 30, 2010, compared with the same period of 2009, was the result of lower sales of our high-end PL10000 series product and smaller orders from new service provider customers in the third quarter of 2010 compared with the same period of the prior year, partially offset by an increase in sales of the PL8720 introduced in the second quarter of 2010.  The increase in product revenue of 19% for the nine months ended September 30, 2010, compared with the same period of 2009, was the result of increased sales of the PL8720 product that was introduced in the second quarter of 2010, partially offset by lower sales of our high-end PL10000 series product.

 
16


The increase in support revenue of 56% and 43% for the three and nine months ended September 30, 2010, compared with the same periods in 2009, reflected an increase in project related services delivered in the third quarter of 2010, compared with the same period of the prior year and the continued expansion of the installed base of our products for which we have sold ongoing support services.

Cost of Sales

Cost of sales includes: (i) direct labor and material costs for products sold, (ii) costs expected to be incurred for warranty, and (iii) adjustments to inventory values, including the write-down of slow moving or obsolete inventory.

The following table presents the breakdown of cost of sales by category:

 
 
Three Months Ended
 
 
 
 
 
Nine Months Ended
 
 
 
 
 
 
September 30,
 
 
 
 
 
September 30,
 
 
 
 
 
 
2010
 
 
2009
 
 
Decrease
 
 
2010
 
 
2009
 
 
Decrease
 
 
 
($ in thousands)
 
 
 
 
 
($ in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Materials and per-use licenses
 
$
1,515
 
 
$
2,347
 
 
 
 
 
$
4,334
 
 
$
4,077
 
 
 
 
Percent of net product revenue
 
 
43
%
 
 
62
%
 
 
(19)
%
 
 
45
%
 
 
48
%
 
 
(3)
%
Applied labor and overhead
 
 
225
 
 
 
223
 
 
 
 
 
 
 
629
 
 
 
1,124
 
 
 
 
 
Percent of net product revenue
 
 
6
%
 
 
6
%
 
 
%
 
 
7
%
 
 
13
%
 
 
(6)
%
Other indirect costs
 
 
151
 
 
 
146
 
 
 
 
 
 
 
303
 
 
 
691