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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 June 27, 2014
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 001-34115
SONUS NETWORKS, INC.
(Exact name of Registrant as specified in its charter)
DELAWARE
 
04-3387074
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer Identification No.)

4 Technology Park Drive, Westford, Massachusetts 01886
(Address of principal executive offices) (Zip code)

(978) 614-8100
(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 x    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 x    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
 (Do not check if a smaller
reporting company)
 
Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No x

As of July 24, 2014, there were 246,795,393 shares of the registrant's common stock, $0.001 par value, outstanding.
 



SONUS NETWORKS, INC.
FORM 10-Q
QUARTER ENDED JUNE 27, 2014
TABLE OF CONTENTS

Item
 
Page
 
PART I FINANCIAL INFORMATION
 
 
 
Condensed Consolidated Balance Sheets as of June 27, 2014 and December 31, 2013 (unaudited)
 
Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 27, 2014 and June 28, 2013 (unaudited)
 
Condensed Consolidated Statements of Comprehensive Loss for the Three and Six Months Ended June 27, 2014 and June 28, 2013 (unaudited)
 
Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 27, 2014 and June 28, 2013 (unaudited)
 
PART II OTHER INFORMATION
 
 
 



Cautionary Note Regarding Forward-Looking Statements
This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of the U.S. Private Securities Litigation Reform Act of 1995, which are subject to a number of risks and uncertainties. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations and financial position, business strategy, plans and objectives of management for future operations and plans for future product development and manufacturing are forward-looking statements. Without limiting the foregoing, the words "anticipates", "believes", "could", "estimates", "expects", "intends", "may", "plans", "seeks" and other similar language, whether in the negative or affirmative, are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. Forward-looking statements are based on our current expectations and assumptions regarding our business, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. We therefore caution you against relying on any of these forward-looking statements.
Important factors that could cause actual results to differ materially from those in these forward-looking statements are discussed in Part I, Items 2 and 3, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Quantitative and Qualitative Disclosures About Market Risk," respectively, and Part II, Item 1A, "Risk Factors," of this Quarterly Report on Form 10-Q. Also, any forward-looking statement made by us in this Quarterly Report on Form 10-Q speaks only as of the date on which this Quarterly Report on Form 10-Q was first filed. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise.


3


PART I FINANCIAL INFORMATION


Item 1. Financial Statements
SONUS NETWORKS, INC.
Condensed Consolidated Balance Sheets
(in thousands, except share and per share data)
(unaudited)


 
June 27,
2014
 
December 31,
2013
Assets
Current assets:
 
 
 
Cash and cash equivalents
$
61,295

 
$
72,423

Marketable securities
56,118

 
138,882

Accounts receivable, net of allowance for doubtful accounts of $180 at June 27, 2014 and $157 at December 31, 2013
60,035

 
64,463

Inventory
23,509

 
21,793

Deferred income taxes
1,173

 
656

Other current assets
14,800

 
15,073

Total current assets
216,930

 
313,290

Property and equipment, net
20,629

 
19,102

Intangible assets, net
24,984

 
10,091

Goodwill
39,207

 
32,379

Investments
32,119

 
34,364

Deferred income taxes
1,210

 
2,121

Other assets
4,022

 
6,137

 
$
339,101

 
$
417,484

Liabilities and Stockholders' Equity
Current liabilities:
 
 
 
Accounts payable
$
10,397

 
$
11,164

Accrued expenses
28,857

 
34,026

Current portion of deferred revenue
40,638

 
41,169

Convertible subordinated note
2,380

 
2,380

Current portion of long-term liabilities
775

 
672

Total current liabilities
83,047

 
89,411

Deferred revenue
10,206

 
10,528

Deferred income taxes
1,352

 
922

Other long-term liabilities
3,994

 
4,371

Total liabilities
98,599

 
105,232

Commitments and contingencies (Note 16)

 

Stockholders' equity:
 
 
 
Preferred stock, $0.01 par value per share; 5,000,000 shares authorized, none issued and outstanding

 

Common stock, $0.001 par value per share; 600,000,000 shares authorized; 246,254,792 shares issued and outstanding at June 27, 2014; 266,226,845 shares issued and outstanding at December 31, 2013
246

 
266

Additional paid-in capital
1,218,173

 
1,280,442

Accumulated deficit
(983,942
)
 
(974,492
)
Accumulated other comprehensive income
6,025

 
6,036

Total stockholders' equity
240,502

 
312,252

 
$
339,101

 
$
417,484


See notes to the unaudited condensed consolidated financial statements.

4


SONUS NETWORKS, INC.
Condensed Consolidated Statements of Operations
(in thousands, except per share data)
(unaudited)


 
Three months ended
 
Six months ended
 
June 27,
2014
 
June 28,
2013
 
June 27,
2014
 
June 28,
2013
Revenue:
 
 
 
 
 
 
 
Product
$
45,845

 
$
42,939

 
$
90,985

 
$
80,735

Service
29,725

 
26,254

 
55,327

 
51,746

Total revenue
75,570

 
69,193

 
146,312

 
132,481

Cost of revenue:
 
 
 
 
 
 
 
Product
16,811

 
13,534

 
30,474

 
27,429

Service
11,471

 
11,651

 
22,127

 
23,242

Total cost of revenue
28,282

 
25,185

 
52,601

 
50,671

Gross profit
47,288

 
44,008

 
93,711

 
81,810

Operating expenses:
 
 
 
 
 
 
 
Research and development
20,921

 
18,019

 
39,893

 
35,520

Sales and marketing
18,782

 
19,191

 
38,363

 
40,305

General and administrative
11,995

 
9,733

 
23,181

 
20,443

Acquisition-related

 

 
1,306

 

Restructuring
391

 
1,698

 
1,560

 
3,647

Total operating expenses
52,089

 
48,641

 
104,303

 
99,915

Loss from operations
(4,801
)
 
(4,633
)
 
(10,592
)
 
(18,105
)
Interest income, net
50

 
90

 
85

 
228

Other income (expense), net
(10
)
 
3

 
2,325

 
3

Loss before income taxes
(4,761
)
 
(4,540
)
 
(8,182
)
 
(17,874
)
Income tax provision
(736
)
 
(330
)
 
(1,268
)
 
(744
)
Net loss
$
(5,497
)
 
$
(4,870
)
 
$
(9,450
)
 
$
(18,618
)
Loss per share
 
 
 
 
 
 
 
Basic
$
(0.02
)
 
$
(0.02
)
 
$
(0.04
)
 
$
(0.07
)
Diluted
$
(0.02
)
 
$
(0.02
)
 
$
(0.04
)
 
$
(0.07
)
Shares used to compute loss per share:
 
 
 
 
 
 
 
Basic
247,120

 
282,389

 
257,026

 
281,973

Diluted
247,120

 
282,389

 
257,026

 
281,973


See notes to the unaudited condensed consolidated financial statements.


5


SONUS NETWORKS, INC.
Condensed Consolidated Statements of Comprehensive Loss
(in thousands)
(unaudited)


 
Three months ended
 
Six months ended
 
June 27,
2014
 
June 28,
2013
 
June 27,
2014
 
June 28,
2013
Net loss
$
(5,497
)
 
$
(4,870
)
 
$
(9,450
)
 
$
(18,618
)
Other comprehensive loss, net of tax:
 
 
 
 
 
 
 
Foreign currency translation adjustments
(33
)
 
(129
)
 
61

 
(455
)
Unrealized loss on available-for sale marketable securities, net of tax
(62
)
 
(189
)
 
(72
)
 
(272
)
Other comprehensive loss, net of tax
(95
)
 
(318
)
 
(11
)
 
(727
)
Comprehensive loss, net of tax
$
(5,592
)
 
$
(5,188
)
 
$
(9,461
)
 
$
(19,345
)

See notes to the unaudited condensed consolidated financial statements.


6


SONUS NETWORKS, INC.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)


 
Six months ended
 
June 27,
2014
 
June 28,
2013
Cash flows from operating activities:
 
 
 
Net loss
$
(9,450
)
 
$
(18,618
)
Adjustments to reconcile net loss to cash flows provided by operating activities:
 
 
 
Depreciation and amortization of property and equipment
5,899

 
6,743

Amortization of intangible assets
2,207

 
2,373

Impairment of intangible assets

 
600

Stock-based compensation
12,712

 
8,764

Loss on disposal of property and equipment
61

 
21

Deferred income taxes
519

 
367

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
8,254

 
28,733

Inventory
4,386

 
1,958

Other operating assets
2,698

 
2,402

Accounts payable
(620
)
 
(5,291
)
Accrued expenses and other long-term liabilities
(4,635
)
 
(1,932
)
Deferred revenue
(1,777
)
 
2,809

Net cash provided by operating activities
20,254

 
28,929

Cash flows from investing activities:
 
 
 
Purchases of property and equipment
(6,271
)
 
(3,032
)
Business acquisition, net of cash acquired
(34,010
)
 

Divestiture of business
2,000

 

Purchases of marketable securities
(47,880
)
 
(180,306
)
Maturities/sales of marketable securities
134,127

 
147,944

Net cash provided by (used in) investing activities
47,966

 
(35,394
)
Cash flows from financing activities:
 
 
 
Proceeds from sale of common stock in connection with employee stock purchase plan
1,197

 
865

Proceeds from exercise of stock options
4,541

 
1,337

Payment of tax withholding obligations related to net share settlements of restricted stock awards
(1,571
)
 
(418
)
Repurchase of common stock
(83,518
)
 

Principal payments of capital lease obligations
(44
)
 
(62
)
Net cash (used in) provided by financing activities
(79,395
)
 
1,722

Effect of exchange rate changes on cash and cash equivalents
47

 
(583
)
Net decrease in cash and cash equivalents
(11,128
)
 
(5,326
)
Cash and cash equivalents, beginning of year
72,423

 
88,004

Cash and cash equivalents, end of period
$
61,295

 
$
82,678

Supplemental disclosure of cash flow information:
 
 
 
Interest paid
$
44

 
$
48

Income taxes paid
$
1,052

 
$
806

Income tax refunds received
$
28

 
$
110

Supplemental disclosure of non-cash investing activities:
 
 
 
Capital expenditures incurred, but not yet paid
$
147

 
$
450

Business acquisition purchase consideration - assumed equity awards
$
1,671

 
$


See notes to the unaudited condensed consolidated financial statements.

7


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements
(unaudited)

(1) BASIS OF PRESENTATION

Business

Sonus Networks, Inc. (“Sonus” or the “Company”) was incorporated in 1997 and is a leading provider of networked solutions for communications service providers (e.g., telecommunications, wireless and cable service providers) and enterprises to help them advance, protect and unify their voice and data communication networks, reduce expenses and position themselves to provide new services to their customers. Sonus helps many of the world's leading communications service providers and enterprises implement the next generation of Session Initiation Protocol ("SIP")-based solutions, including Voice over IP ("VoIP") and Unified Communications ("UC") through secure, reliable and scalable Internet Protocol ("IP") networks. We also provide tightly integrated signaling and advanced routing capabilities and applications that span the mission-critical demands of both existing and next-generation 4G/LTE and IP Multimedia Subsystems ("IMS") telecommunications networks. Sonus products include session border controllers ("SBCs"), diameter signaling controllers ("DSCs"), policy/routing servers, media and signaling gateways and network analytics tools. Sonus solutions address the need for communications service providers and enterprises to seamlessly link and leverage multivendor, multiprotocol communications systems and applications across a single network infrastructure. Previously, companies were required to implement separate networks for their voice and data applications. In a rapidly changing ecosystem of IP-enabled devices such as smartphones and tablets, companies want an infrastructure that enables the integration of voice and data capability into a single application on one integrated network. Sonus solutions help the Company's customers realize the intended value and benefits of UC both in public and private clouds by enabling disparate vendor communications environments, commonplace in most enterprises today, to work seamlessly together. Likewise, Sonus solutions facilitate the deployment and adoption of cloud-based communications.

The Company utilizes both direct and indirect sales channels to reach its target customers. Customers and prospective customers in the service provider space are traditional and emerging communications service providers, including long distance carriers, local exchange carriers, Internet service providers, wireless operators, cable operators, international telephone companies and carriers that provide services to other carriers. Enterprise customers and target enterprise customers include financial institutions, retailers, state and local governments, and other multinational corporations. The Company collaborates with its customers to identify and develop new, advanced services and applications that can help to reduce costs, improve productivity and generate new revenue.

Basis of Presentation

In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring items, necessary for their fair presentation with accounting principles generally accepted in the United States of America ("GAAP") and with the rules and regulations of the U.S. Securities and Exchange Commission ("SEC").

Interim results are not necessarily indicative of results for a full year or any future interim period. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2013 ("Annual Report") filed with the SEC effective February 28, 2014.

On February 19, 2014 (the "PT Acquisition Date"), the Company completed the acquisition of Performance Technologies, Incorporated ("PT"). The financial results of PT are included in the Company's condensed consolidated financial statements for the three months ended June 27, 2014 and in the Company's condensed consolidated financial statements for the six months ended June 27, 2014 for the period subsequent to the PT Acquisition Date.

Significant Accounting Policies

The Company's significant accounting policies are disclosed in Note 2 to the Consolidated Financial Statements included in the Annual Report. There were no material changes to the significant accounting policies during the three or six months ended June 27, 2014.


8


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

Principles of Consolidation

The condensed consolidated financial statements include the accounts of Sonus and its wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated in consolidation.

Use of Estimates and Judgments

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Significant estimates and judgments relied upon in preparing these consolidated financial statements include accounting for business combinations, revenue recognition for multiple element arrangements, inventory valuations, assumptions used to determine the fair value of stock-based compensation, intangible assets and goodwill valuations, including impairments, legal contingencies and recoverability of Sonus' net deferred tax assets and the related valuation allowances. Sonus regularly assesses these estimates and records changes in estimates in the period in which they become known. Sonus bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results could differ from those estimates.

Fair Value of Financial Instruments

The carrying amounts of the Company's financial instruments, which include cash equivalents, marketable securities, investments, accounts receivable, accounts payable, convertible subordinated debt and other long-term liabilities, approximate their fair values.

Operating Segments

The Company operates in a single segment. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker in making decisions regarding resource allocation and assessing performance. To date, the chief operating decision maker has made such decisions and assessed performance at the company level, as one segment. The Company's chief operating decision maker is its President and Chief Executive Officer.

Recent Accounting Pronouncements

On June 19, 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-12, Compensation - Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (a consensus of the FASB Emerging Issues Task Force) (“ASU 2014-12”). ASU 2014-12 clarifies that entities should treat performance targets that can be met after the requisite service period of a share-based payment award as performance conditions that affect vesting. Therefore, an entity would not record compensation expense (measured as of the grant date without taking into account the effect of the performance target) related to an award for which transfer to the employee is contingent upon the entity’s satisfaction of a performance target until it becomes probable that the performance target will be met. ASU 2014-12 does not contain any new disclosure requirements. ASU 2014-12 is effective for the Company on January 1, 2015. The Company does not expect the adoption of ASU 2014-12 to have a material impact on its condensed consolidated financial statements.

On May 28, 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”) its final standard on revenue from contracts with customers. ASU 2014-09 outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle of the revenue model is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In applying the revenue model to contracts within its scope, an entity identifies the contract(s) with a customer, identifies the performance obligations in the contract, determines the transaction price, allocates the transaction price to the performance obligations in the contract and recognizes revenue when (or as) the entity satisfies a performance obligation. ASU 2014-09 applies to all contracts with customers that are within the scope of

9


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

other topics in the FASB Accounting Standards Codification ("ASC"). Certain of ASU 2014-09’s provisions also apply to transfers of nonfinancial assets, including in-substance nonfinancial assets that are not an output of an entity’s ordinary activities (i.e., property plant and equipment; real estate; or intangible assets). Existing accounting guidance applicable to these transfers has been amended or superseded. ASU 2014-09 also requires significantly expanded disclosures about revenue recognition. ASU 2014-09 is effective for the Company on January 1, 2017. The Company is currently assessing the potential impact of the adoption of ASU 2014-09 on its condensed consolidated financial statements.

On April 10, 2014, the FASB issued ASU 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity (“ASU 2014-08”), which amends the definition of discontinued operations in ASC 205-20 and requires entities to provide additional disclosures about discontinued operations as well as disposal transactions that do not meet the discontinued operations criteria. The new guidance eliminates the previous criteria that the operations and cash flows of the component that have been (or will be) eliminated from the ongoing operations of the entity as a result of the disposal transaction. The new guidance also eliminates the previous criteria that the entity will not have any significant continuing involvement in the operations of the component after the disposal transaction. Instead, ASU 2014-08 requires discontinued operations treatment for disposals of a component or group of components that represents a strategic shift that has or will have a major impact on an entity’s operations or financial results. ASU 2014-08 requires entities to reclassify assets and liabilities of a discontinued operation for all comparative periods presented in the statement of financial position. In addition, ASU 2014-08 requires that an entity disclose in its statement of cash flows, for all periods presented, either: (1) operating and investing cash flows or (2) depreciation and amortization, capital expenditures and significant operating and investing non-cash items related to the discontinued operation. ASU 2014-08 is effective prospectively for all disposals (except disposals classified as held for sale before the adoption date) or components initially classified as held for sale in periods beginning on or after December 15, 2014. The Company does not expect the adoption of ASU 2014-08 to have a material impact on its condensed consolidated financial statements.

On July 18, 2013, the FASB issued ASU 2013-11, Presentation of a Liability for an Unrecognized Tax Benefit When a Net Operating Loss Carryforward or Tax Credit Carryforward Exists ("ASU 2013-11"), which provides guidance on financial statement presentation of an unrecognized tax benefit when a net operating loss ("NOL") carryforward, a similar tax loss or a tax credit carryforward exists. The FASB's objective in issuing ASU 2013-11 was to eliminate diversity in practice resulting from a lack of guidance on this topic in current GAAP. ASU 2013-11 requires that an entity present an unrecognized tax benefit, or a portion of an unrecognized tax benefit, in the financial statements as a reduction to a deferred tax asset for an NOL carryforward, a similar tax loss or a tax credit unless certain conditions exist. ASU 2013-11 was effective for the Company beginning January 1, 2014. The adoption of ASU 2013-11 did not have an impact on the Company's condensed consolidated financial statements, as the Company already applied the methodology prescribed by ASU 2013-11.

On March 4, 2013, the FASB issued ASU 2013-05, Foreign Currency Matters (Topic 830) - Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity ("ASU 2013-05"), which indicates that the entire amount of a cumulative translation adjustment ("CTA") related to an entity's investment in a foreign entity should be released when there has been either: (a) a sale of a subsidiary or group of net assets within a foreign entity and the sale represents the substantially complete liquidation of the investment in a foreign entity; (b) the loss of a controlling financial interest in an investment in a foreign entity (i.e., the foreign entity is deconsolidated); or (c) the step acquisition of a foreign entity (i.e., when the accounting for an entity has changed from applying the equity method for an investment in a foreign entity to consolidating the foreign entity). ASU 2013-05 does not change the requirement to release a pro rata portion of the CTA of the foreign entity into earnings for a partial sale of an equity method investment in a foreign entity. ASU 2013-05 was effective for the Company beginning January 1, 2014. The adoption of ASU 2013-05 did not have a material impact on the Company's condensed consolidated financial statements.


(2) ACQUISITION OF PT

On February 19, 2014 (the "PT Acquisition Date"), the Company acquired all of the outstanding common stock of PT for cash consideration of $34.0 million, or $3.75 per share of PT common stock. This acquisition has enabled Sonus to expand its solutions portfolio with signaling technology and acquire expertise to enable mobile service providers to offer new real-time multimedia services through their mobile infrastructure. Delivering these services across the LTE next-generation mobile

10


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

networks will require adoption of the next-generation signaling technology known in the industry as Diameter Signal. The acquisition of PT has allowed Sonus to diversify its product portfolio with an integrated, virtualized Diameter and SIP-based solution and deliver strategic value to service providers seeking to offer new multimedia services through mobile, cloud-based, real-time communications.

The transaction has been accounted for as a business combination and the financial results of PT have been included in the Company's condensed consolidated financial statements for the period subsequent to its acquisition.

As of June 27, 2014, the valuation of acquired assets, identifiable intangible assets, uncertain tax liabilities and certain accrued liabilities remains preliminary. The Company is in the process of finalizing its valuation, which it plans to complete in the third quarter of fiscal 2014. Based on new information gathered about facts and circumstances that existed as of the PT Acquisition Date related to the valuation of certain acquired assets and assumed liabilities, the Company updated its preliminary valuations of assets acquired and liabilities assumed as of June 27, 2014. The Company recorded adjustments which resulted in an increase to goodwill of $0.5 million, a decrease to other current assets of $0.3 million and an increase to other long-term liabilities of $0.2 million. Based on the updated purchase price allocation, the Company recorded $8.7 million of goodwill, primarily due to expected synergies between the combined companies and expanded market opportunities. The goodwill is not deductible for tax purposes.

A summary of the allocation of the purchase consideration for PT is as follows (in thousands):
Fair value of consideration transferred:
 
  Cash, net of cash acquired
$
34,010

  Unpaid purchase consideration
1,012

  Fair value of equity awards assumed
1,671

    Fair value of total consideration
$
36,693

Fair value of assets acquired and liabilities assumed:
 
  Marketable securities
$
2,315

  Other current assets
9,393

  Property and equipment
2,251

  Intangible assets
17,100

  Goodwill
8,725

  Current liabilities
(2,762
)
  Other long-term liabilities
(329
)
 
$
36,693


The valuation of the acquired intangible assets is inherently subjective and relies on significant unobservable inputs. The Company used an income approach to preliminarily value the acquired customer relationships and developed technology intangible assets. The valuation for each of these intangible assets was based on estimated projections of expected cash flows to be generated by the assets, discounted to the present value at discount rates commensurate with perceived risk. The valuation assumptions take into consideration the Company's estimates of contract renewal, technology attrition and revenue growth projections. The Company is amortizing the identifiable intangible assets in relation to the expected cash flows from the individual intangible assets over their respective useful lives (see Note 6).

The Company has not provided pro forma information as the results of PT are not material to the Company's financial results.
 
Acquisition-Related Expenses

Acquisition-related expenses include those expenses related to the acquisition that would otherwise not have been incurred by the Company. These expenses include professional and services fees, such as legal, audit, consulting, paying agent and other fees, and expenses related to cash payments to certain former PT executives under their respective PT change of control agreements.


11


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

The components of acquisition-related costs included in the Company's results of operations for the six months ended June 27, 2014 are as follows (in thousands):
 
 
Six months ended
 
 
June 27, 2014
Professional and services fees
 
$
1,057

Change of control agreements
 
249

 
 
$
1,306



The Company did not record any acquisition-related expenses in either the three months ended June 27, 2014 or the three or six months ended June 28, 2013.

Sale of Multi-Protocol Server Business

On June 20, 2014 (the "MPS Sale Date"), the Company sold its PT Multi-Protocol Server ("MPS") business for $2.0 million to an affiliate of Sunhillo Corporation, comprised of $0.2 million of inventory, $0.1 million of fixed assets, $0.2 million of deferred revenue and $1.9 million of PT goodwill allocable to the MPS business. The Company had acquired the MPS business in connection with the acquisition of PT. The Company incurred $0.4 million of transaction costs which are included as a component of General and administrative expenses. The results of operations of the MPS business are excluded from the Company's consolidated results for the period subsequent to the MPS Sale Date.


(3) EARNINGS (LOSS) PER SHARE
Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of shares outstanding during the period. For periods in which the Company reports net income, diluted net income per share is determined by using the weighted average number of common and dilutive common equivalent shares outstanding during the period unless the effect is antidilutive.

The calculations of shares used to compute basic and diluted loss per share are as follows (in thousands):
 
Three months ended
 
Six months ended
 
June 27,
2014
 
June 28,
2013
 
June 27,
2014
 
June 28,
2013
Weighted average shares outstanding—basic
247,120

 
282,389

 
257,026

 
281,973

Potential dilutive common shares

 

 

 

Weighted average shares outstanding—diluted
247,120

 
282,389

 
257,026

 
281,973



Options to purchase the Company's common stock, unvested shares of restricted stock, unvested performance-based stock awards for which the performance conditions have been satisfied and shares in connection with future purchases under the Company's Amended and Restated 2000 Employee Stock Purchase Plan, as amended (the "ESPP"), aggregating 44.1 million shares for the three and six months ended June 27, 2014 have not been included in the computation of diluted loss per share because their effect would have been antidilutive. Options to purchase the Company's common stock and unvested shares of restricted stock aggregating 36.0 million shares for the three and six months ended June 28, 2013 have not been included in the computation of diluted loss per share because their effect would have been antidilutive.


(4) CASH EQUIVALENTS, MARKETABLE SECURITIES AND INVESTMENTS

The Company invests in debt instruments, primarily U.S. government-backed, municipal and corporate obligations, which management believes to be high quality (investment grade) credit instruments.

12


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)


During the three months ended March 28, 2014, the Company sold $45.9 million of its available-for-sale securities and realized gross gains aggregating $46,000. The Company did not realize any gross losses on these sales. In addition, $41.7 million of the Company's available-for-sale securities matured during the three months ended March 28, 2014 and were redeemed upon maturity. The Company did not sell any of its available-for-sale securities during the three months ended June 27, 2014 or during the three or six months ended June 28, 2013, and accordingly, no such gains or losses were realized during such period.

Marketable securities and investments with continuous unrealized losses for one year or greater at June 27, 2014 were nominal. Since the Company currently does not intend to sell these securities and does not believe it will be required to sell any securities before they recover in value, it does not believe these declines are other-than-temporary.

On a quarterly basis, the Company reviews its marketable securities and investments to determine if there have been any events that could create a credit impairment. The increase in unrealized losses in the current year period primarily relates to the recent increase in interest rates. However, since the Company's entire investment portfolio has investment grade ratings with no indication of credit loss, the Company believes it will recover the entire amortized cost basis of these securities and does not believe these unrealized losses are other-than-temporary. Accordingly, the Company does not believe that any impairment existed with its current holdings at June 27, 2014.

The amortized cost, gross unrealized gains and losses and fair value of the Company's marketable debt securities and investments at June 27, 2014 and December 31, 2013 were comprised of the following (in thousands):
 
June 27, 2014
 
Amortized
cost
 
Unrealized
gains
 
Unrealized
losses
 
Fair
value
Cash equivalents
$
12,841

 
$

 
$

 
$
12,841

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
U.S. government agency notes
$
11,796

 
$
1

 
$

 
$
11,797

Corporate debt securities
35,266

 
15

 
(4
)
 
35,277

Commercial paper
4,592

 
1

 

 
4,593

Certificates of deposit
4,451

 

 

 
4,451

 
$
56,105

 
$
17

 
$
(4
)
 
$
56,118

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
2,983

 
$
1

 
$

 
$
2,984

Corporate debt securities
28,162

 
5

 
(32
)
 
28,135

Certificates of deposit
1,000

 

 

 
1,000

 
$
32,145

 
$
6

 
$
(32
)
 
$
32,119




13


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

 
December 31, 2013
 
Amortized
cost
 
Unrealized
gains
 
Unrealized
losses
 
Fair
value
Cash equivalents
$
50,404

 
$

 
$

 
$
50,404

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
U.S. government agency notes
$
47,895

 
$
15

 
$

 
$
47,910

Corporate debt securities
81,993

 
35

 
(8
)
 
82,020

Commercial paper
5,647

 
2

 

 
5,649

Certificates of deposit
3,300

 
3

 

 
3,303

 
$
138,835

 
$
55

 
$
(8
)
 
$
138,882

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
9,254

 
$
3

 
$

 
$
9,257

Foreign government notes
1,250

 

 

 
1,250

Corporate debt securities
23,848

 
17

 
(8
)
 
23,857

 
$
34,352

 
$
20

 
$
(8
)
 
$
34,364



The Company's available-for-sale debt securities classified as Investments in the condensed consolidated balance sheets at June 27, 2014 and December 31, 2013 had maturity dates after one year but within two years or less from the balance sheet date.

Fair Value Hierarchy

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability. The three-tier fair value hierarchy is based on the level of independent, objective evidence surrounding the inputs used to measure fair value. A financial instrument's categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The fair value hierarchy is as follows:

Level 1. Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities.

Level 2. Level 2 applies to assets or liabilities for which there are inputs that are directly or indirectly observable in the marketplace, such as quoted prices for similar assets or liabilities in active markets or quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets).

Level 3. Level 3 applies to assets or liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities.

The following table shows the fair value of the Company's financial assets at June 27, 2014 and December 31, 2013. These financial assets are comprised of the Company's available-for-sale debt securities and reported under the captions Cash and cash equivalents, Marketable securities and Investments in the consolidated balance sheets (in thousands):

14


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

 
 
 
Fair value measurements at
June 27, 2014 using:
 
Total carrying
value at
June 27,
2014
 
Quoted prices
in active
markets
(Level 1)
 
Significant other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Cash equivalents
$
12,841

 
$
12,841

 
$

 
$

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
U.S. government agency notes
$
11,797

 
$

 
$
11,797

 
$

Corporate debt securities
35,277

 

 
35,277

 

Commercial paper
4,593

 

 
4,593

 

Certificates of deposit
4,451

 

 
4,451

 

 
$
56,118

 
$

 
$
56,118

 
$

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
2,984

 
$

 
$
2,984

 
$

Corporate debt securities
28,135

 

 
28,135

 

Certificates of deposit
1,000

 

 
1,000

 

 
$
32,119

 
$

 
$
32,119

 
$



 
 
 
Fair value measurements at
December 31, 2013 using:
 
Total carrying
value at
December 31,
2013
 
Quoted prices
in active
markets
(Level 1)
 
Significant other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Cash equivalents
$
50,404

 
$
50,404

 
$

 
$

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
U.S. government agency notes
$
47,910

 
$

 
$
47,910

 
$

Corporate debt securities
82,020

 

 
82,020

 

Commercial paper
5,649

 

 
5,649

 

Certificates of deposit
3,303

 

 
3,303

 

 
$
138,882

 
$

 
$
138,882

 
$

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
9,257

 
$

 
$
9,257

 
$

Foreign government notes
1,250

 

 
1,250

 

Corporate debt securities
23,857

 

 
23,857

 

 
$
34,364

 
$

 
$
34,364

 
$



The Company's marketable securities and investments have been valued on the basis of valuations provided by third-party pricing services, as derived from such services' pricing models. Inputs to the models may include, but are not limited to, reported trades, executable bid and asked prices, broker/dealer quotations, prices or yields of securities with similar characteristics, benchmark curves or information pertaining to the issuer, as well as industry and economic events. The pricing services may use a matrix approach, which considers information regarding securities with similar characteristics to determine the valuation for a security. The Company is ultimately responsible for the condensed consolidated financial statements and underlying estimates. Accordingly, the Company assesses the reasonableness of the valuations provided by the third-party pricing services by reviewing actual trade data, broker/dealer quotes and other similar data, which are obtained from quoted market prices or other sources.



15


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

(5) INVENTORY

Inventory consists of the following (in thousands):
 
June 27,
2014
 
December 31,
2013
Raw materials
$
1,124

 
$

On-hand final assemblies and finished goods inventories
18,539

 
19,070

Deferred cost of goods sold
3,846

 
4,387

 
23,509

 
23,457

Less current portion
(23,509
)
 
(21,793
)
Noncurrent portion (included in Other assets)
$

 
$
1,664



(6) INTANGIBLE ASSETS AND GOODWILL

The Company's intangible assets at June 27, 2014 and December 31, 2013 consist of the following (dollars in thousands):
June 27, 2014
Weighted average amortization period
(years)
 
Cost
 
Accumulated
amortization
 
Net
carrying value
Intellectual property
5.00
 
$
999

 
$
999

 
$

Developed technology
6.18
 
22,280

 
3,912

 
18,368

Customer relationships
5.57
 
10,040

 
3,709

 
6,331

Internal use software
3.00
 
730

 
445

 
285

 
5.75
 
$
34,049

 
$
9,065

 
$
24,984


December 31, 2013
Weighted average amortization period
(years)
 
Cost
 
Accumulated
amortization
 
Net
carrying value
Intellectual property
5.00
 
$
999

 
$
999

 
$

Developed technology
5.03
 
9,080

 
2,729

 
6,351

Customer relationships
5.30
 
6,140

 
2,806

 
3,334

Internal use software
3.00
 
730

 
324

 
406

 
4.35
 
$
16,949

 
$
6,858

 
$
10,091



Amortization expense for intangible assets for the three and six months ended June 27, 2014 and June 28, 2013 was as follows (in thousands):
 
Three months ended
 
Six months ended
 
Statement of operations classification
 
June 27,
2014
 
June 28,
2013
 
June 27,
2014
 
June 28,
2013
 
Intellectual property
$

 
$
100

 
$

 
$
200

 
Research and development
Developed technology
613

 
499

 
1,183

 
999

 
Cost of revenue - product
Customer relationships
505

 
526

 
903

 
1,052

 
Sales and marketing
Internal use software
60

 
61

 
121

 
122

 
Cost of revenue - product
 
$
1,178

 
$
1,186

 
$
2,207

 
$
2,373

 
 


Estimated future amortization expense for the Company's intangible assets at June 27, 2014 is as follows (in thousands):


16


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

Years ending December 31,
 
Remainder of 2014
$
2,393

2015
5,644

2016
5,290

2017
5,257

2018
2,954

Thereafter
3,446

 
$
24,984



The changes in the carrying value of the Company's goodwill in the six months ended June 27, 2014 were as follows (in thousands):
Balance at January 1, 2014:
 
  Goodwill
$
35,485

  Accumulated impairment losses
(3,106
)
 
32,379

Acquisition of PT
8,725

Sale of MPS business
(1,897
)
Balance at June 27, 2014
$
39,207



There were no changes to the carrying value of the Company's goodwill in the six months ended June 28, 2013.


(7) ACCRUED EXPENSES
Accrued expenses consist of the following (in thousands):
 
June 27,
2014
 
December 31,
2013
Employee compensation and related costs
$
15,711

 
$
20,683

Other
13,146

 
13,343

 
$
28,857

 
$
34,026



(8) RESTRUCTURING ACCRUAL

The Company recorded restructuring expense of $0.4 million in the three months ended June 27, 2014 and $1.6 million in the six months ended June 27, 2014 for severance and related costs in connection with reducing its workforce. The Company recorded restructuring expense of $1.7 million in the three months ended June 28, 2013 and $3.6 million in the six months ended June 28, 2013. The amount for the three months ended June 28, 2013 is comprised of $1.4 million for severance and related costs and $0.3 million for facility costs. The amount for the six months ended June 28, 2013 is comprised of $3.3 million for severance and related costs and $0.3 million for facility costs.

The table below summarizes the restructuring accrual activity for the six months ended June 27, 2014 (in thousands):
 
Balance at
January 1,
2014
 
Initiatives
charged to
expense
 
Cash
payments
 
Balance at
June 27,
2014
Severance
$
1,333

 
$
1,560

 
$
(2,068
)
 
$
825

Facilities
3,012

 

 
(590
)
 
2,422

 
$
4,345

 
$
1,560

 
$
(2,658
)
 
$
3,247



17


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)


The Company expects to complete the restructuring payments related to severance in the first quarter of fiscal 2015 and the payments related to facilities in fiscal 2016. The portion of restructuring payments due more than one year from the balance sheet date is included in Other long-term liabilities in the Company's condensed consolidated balance sheets. The long-term portions of accrued restructuring were $1.4 million at June 27, 2014 and $1.8 million at December 31, 2013.


(9) DEBT

Credit Agreement

On June 27, 2014, the Company entered into a credit agreement (the "Credit Agreement") by and among the Company, as Borrower, Bank of America, N.A. ("Bank of America"), as Administrative Agent, Swing Line Lender and L/C Issuer, and the other lenders from time to time party thereto. The Credit Agreement provides for a revolving credit facility of up to $40 million and provides that the Company may select the interest rates under the credit facility equal to (1) the Eurodollar Rate (which is defined as the rate per annum equal to the London Interbank Offered Rate plus 1.5% per annum) for a Eurodollar Rate Loan; and (2) the highest of (a) the Federal Funds Rate plus 1/2 of 1%, (b) the rate of interest in effect on the borrowing date as publicly announced from time to time by Bank of America as its prime rate, and (c) the monthly Eurodollar Rate plus 1%. The Company will pay a 0.15% commitment fee on the unused commitments available for borrowing.

Borrowings under the Credit Agreement may be used for the general corporate purposes of the Company and its subsidiaries, including, without limitation, working capital, acquisitions, dividends and stock repurchases, to the extent permitted under the Credit Agreement.

The obligations of the Company under the Credit Agreement are guaranteed by Sonus International, Inc., Sonus Federal, Inc., Network Equipment Technologies, Inc. ("NET") and PT (collectively, together with the Company, the "Loan Parties") pursuant to a Master Continuing Guaranty and are secured by the assets of the Loan Parties pursuant to a Security and Pledge Agreement.

The Credit Agreement contains affirmative, negative and financial covenants customary for financings of this type. The negative covenants include limitations on liens, indebtedness, fundamental changes, dispositions, restricted payments, investments, transactions with affiliates, certain restrictive agreements and compliance with sanctions laws and regulations. The amount of cash and cash equivalents of the Loan Parties, subject to certain exclusions, cannot be less than an aggregate amount of $100 million at any time. The credit facility will become due on June 27, 2015, subject to acceleration upon certain specified events of default, including, without limitation, payment defaults, defaults in the performance of affirmative and negative covenants, the inaccuracy of representations or warranties, bankruptcy and insolvency-related defaults, defaults relating to judgments, an ERISA Event (as defined in the Credit Agreement), the failure to pay specified indebtedness and a change of control default.

The Company did not have any amounts outstanding under the Credit Agreement at June 27, 2014.

Assumed Debt - Acquisition

The Company has determined that the estimated fair value of its $2.4 million of aggregate principal amount of outstanding debt assumed in connection with the August 2012 acquisition of NET and due in December 2014 equaled its carrying value at both June 27, 2014 and December 31, 2013. Although the debt can be publicly traded, there have been no trading transactions since 2010 and accordingly, the Company has categorized it in Level 2 within the fair value hierarchy.


(10) STOCKHOLDER RIGHTS PLAN

On June 21, 2013, the Company entered into an amendment to its stockholder rights agreement, as amended (the "Rights Plan"), to extend the expiration date of the rights in such Rights Plan from June 26, 2013 to June 26, 2015. The amendment

18


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

was not in response to any acquisition proposal and no other amendments were made to the Rights Plan. The Rights Plan was originally adopted on June 26, 2008 and subsequently extended to June 26, 2013 on June 10, 2011.

Under the Rights Plan, preferred stock purchase rights (the "Rights") were distributed as a dividend at the rate of one Right per share of common stock held by stockholders of record as of the close of business on July 7, 2008. Each Right entitles the stockholder to purchase from the Company a unit consisting of one one-thousandth of a share (a "Unit") of preferred stock at a purchase price of $25.00, subject to adjustment.

The Rights generally will be exercisable only if a person or group acquires beneficial ownership of 15% or more of the Company's common stock (which includes for this purpose shares of common stock referenced in derivative transactions or securities), or commences or publicly announces a tender or exchange offer upon consummation of which they would beneficially own 15% or more of the Company's common stock. Subject to certain conditions, a person or group who beneficially owned 15% or more of the outstanding shares of the Company's common stock prior to the adoption of the Rights Plan did not cause the Rights to become exercisable upon adoption of the Rights Plan. Should the Rights become exercisable, the effect would be to dilute the ownership of the beneficial owner(s) who triggered the Rights, as that beneficial owner or group of owners would not receive the Units.


(11) COMMON STOCK REPURCHASES AND UNDERWRITTEN OFFERING

Stock Buyback Program

On July 29, 2013, the Company announced that its Board of Directors had authorized a stock buyback program to repurchase up to $100 million of the Company's common stock from time to time on the open market or in privately negotiated transactions. The timing and amount of any shares repurchased will be determined by the Company's management based on its evaluation of market conditions and other factors. The Company may elect to implement a 10b5-1 repurchase program, which would permit shares to be repurchased when the Company might otherwise be precluded from doing so under insider trading laws. The Company has not implemented such a 10b5-1 repurchase program to date. The stock buyback program may be suspended or discontinued at any time. The stock buyback program is being funded using the Company's working capital. During the six months ended June 27, 2014, the Company spent $8.2 million, including transaction fees, to repurchase and retire 2.3 million shares of its common stock under the stock buyback program. At June 27, 2014, the Company had $32.5 million remaining under the stock buyback program for future repurchases.

Underwritten Offering

On March 20, 2014, the Company announced the commencement of an underwritten public offering of 37.5 million shares of its common stock on behalf of Galahad Securities Limited and its affiliated entities (collectively, the "Legatum Group"). The underwriter of the offering was granted a 30-day option to purchase up to 5.625 million additional shares from the Legatum Group. The Legatum Group received all the proceeds from the underwritten offering; no shares in the underwritten offering were sold by Sonus or any of its officers or directors. Sonus purchased 21.5 million shares of its common stock from the underwriter for $3.4882 per share, the price equal to the price paid by the underwriter to the Legatum Group in the underwritten offering, for a total of $75.3 million, including transaction fees of $0.3 million. This repurchase was not completed under the Company's stock buyback program. Sonus funded the share repurchase with cash on hand. The repurchased shares were retired upon completion of the transaction.


(12) STOCK-BASED COMPENSATION PLANS

Stock Incentive Plans

The Company's 2007 Stock Incentive Plan, as amended (the "2007 Plan"), provides for the award of options to purchase the Company's common stock ("stock options"), stock appreciation rights ("SARs"), restricted common stock ("restricted stock"), performance-based awards, restricted stock units ("RSUs") and other stock-based awards to employees, officers, directors (including those directors who are not employees or officers of the Company), consultants and advisors of the

19


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

Company and its subsidiaries.

The Company's 2008 Stock Incentive Plan provides for the award of stock options, SARs, restricted stock, performance-based awards and RSUs to former employees of NET who subsequently became employees of Sonus and Sonus employees hired subsequent to the August 24, 2012, the date the Company acquired NET.

In connection with the acquisition of PT, the Company assumed PT's 2012 Amended Performance Technologies, Incorporated Omnibus Incentive Plan (the "PT 2012 Plan"), which provides for the award of stock options, SARs, restricted stock, performance-based awards and restricted stock units. The Company also assumed all of the outstanding options to purchase common stock under the Performance Technologies, Incorporated 2003 Omnibus Incentive Plan (the "PT 2003 Plan") and the Performance Technologies, Incorporated 2001 Stock Option Plan (the "PT 2001 Plan"); however, no future equity awards may be granted under either the PT 2003 Plan or the PT 2001 Plan.

The options to purchase PT common stock under the PT 2012 Plan, the PT 2003 Plan and the PT 2001 Plan were converted into options to purchase Sonus common stock (the "converted awards"), and the shares of PT common stock available for future grant under the PT 2012 Plan were converted into shares of Sonus common stock available for future grant, using a conversion factor of 1.23, which was calculated based on the acquisition consideration of $3.75 per share of PT's common stock divided by the average of the closing price of Sonus' common stock for the ten consecutive days ending with the third trading day that preceded the closing date. This conversion factor was also used to convert the exercise prices of PT stock options to Sonus stock option exercise prices. The converted awards will vest under the same schedules as the respective PT stock options.

The fair values of the PT stock options assumed were estimated using a Black-Scholes option pricing model. The Company recorded $1.7 million as additional purchase consideration for the fair value of the assumed equity awards. The fair value of the assumed awards attributable to future stock-based compensation expense totaled $0.9 million, which is being recorded over a weighted average period of approximately one year.

Executive and Board of Directors Equity Arrangements

On June 11, 2014, the Company modified the options outstanding as of that date that had been granted to the Company's non-employee members of the Board of Directors (the "Board Members") to extend the exercise period to the lesser of three years from the date that a Board Member stepped down from his or her position on the Board of Directors or the remaining contractual life of the respective stock options. In connection with this modification, the Company recorded $0.7 million of incremental stock-based compensation expense in the three months ended June 27, 2014. This expense is included as a component of General and administrative expense in the Company's condensed consolidated statements of operations for both the three and six months ended June 27, 2014.

On January 2, 2014, Raymond P. Dolan, the Company's President and Chief Executive Officer ("Mr. Dolan"), elected to accept shares of restricted stock in lieu of base salary for the period from January 1, 2014 through December 31, 2014. Accordingly, the Company granted Mr. Dolan 243,507 shares of restricted stock (the "2014 Dolan Salary Shares") on January 2, 2014. The number of shares granted was calculated by dividing an amount equal to 1.5 times Mr. Dolan's base salary for the period from January 1, 2014 through December 31, 2014 by $3.08, the closing price of the Company's common stock on the date of grant. The 2014 Dolan Salary Shares will vest on December 31, 2014. If Mr. Dolan's employment is terminated by Mr. Dolan with Good Reason (as defined in his employment agreement, as amended) or his employment is terminated by the Company without Cause (as defined in his employment agreement, as amended) before December 31, 2014, a pro rata portion of the 2014 Dolan Salary Shares will vest on the date of such termination. If Mr. Dolan terminates his employment without Good Reason or his employment is terminated by the Company for Cause before December 31, 2014, he will forfeit the 2014 Dolan Salary Shares. The Company is recording stock-based compensation expense related to the 2014 Dolan Salary Shares ratably for the period of January 1, 2014 through December 31, 2014. The 2014 Dolan Salary Shares are included in the amount reported as "Granted" in the restricted stock grant table below.

On January 22, 2014, 21 executives of the Company, including Mr. Dolan, were given the choice to receive all or half of their fiscal year 2014 bonuses (the "2014 Bonus"), if any are earned, in the form of shares of the Company's common stock (the "2014 Bonus Shares"). Each executive could also elect not to participate in this program and to earn his or her 2014 Bonus, if

20


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

any, in the form of cash. The amount of the 2014 Bonus, if any, for each executive shall be determined by the Compensation Committee of the Board of Directors of the Company (the "Compensation Committee"). The number of shares of the Company's common stock that will be granted to those executives who elected to receive their 2014 Bonus entirely in the form of shares of common stock will be calculated by dividing an amount equal to 1.5 times each executive's 2014 Bonus earned by $3.08, the closing price of the Company's common stock on January 2, 2014. The number of shares of the Company's common stock that will be granted to those executives who elected to receive one-half of their 2014 Bonus in the form of shares of common stock will be calculated by dividing an amount equal to 1.5 times one-half of each executive's 2014 Bonus earned by $3.08, with the cash portion equal 50% of their respective 2014 Bonus earned. The 2014 Bonus, if any, will be granted and/or paid on a date concurrent with the timing of the payout of bonuses under the Company-wide incentive bonus program. The 2014 Bonus Shares, if any are granted, will be fully vested on the date of grant. Of the eligible executives, 17 elected to receive their entire 2014 Bonus in shares of common stock and 4 elected to receive 50% of their 2014 Bonus in shares of common stock and 50% in cash. As of June 27, 2014, the Company determined that the grant date criteria for the 2014 Bonus Shares had not been met; accordingly, the Company is marking to market the 2014 Bonus Shares expected to be earned and recording expense based on the aggregate fair value of the 2014 Bonus Shares at June 27, 2014.

In March 2013, 21 executives of the Company, including Mr. Dolan, elected to receive their fiscal year 2013 bonuses (the "2013 Bonus"), if any were earned, in the form of shares of the Company's common stock (the "2013 Bonus Shares"). The 2013 Bonus Shares were granted on February 18, 2014 and vested immediately. The Company granted approximately one million 2013 Bonus Shares, with the number of shares granted calculated by dividing amounts equal to 1.5 times the respective 2013 Bonus amounts earned, as determined by the Compensation Committee, by $3.30, the closing price of the Company's common stock on the date of grant. The Company recorded stock-based compensation expense for the 2013 Bonus Shares from January 1, 2013 through the grant date. These shares are reported as both "Granted" and "Vested" in the restricted stock grant table below.

On February 14, 2013, the Compensation Committee determined that eight executives of the Company, excluding Mr. Dolan, would receive their bonuses with respect to fiscal 2012 in the form of restricted shares of the Company's common stock equal to 100% of their respective target bonus amounts for fiscal 2012 (the "Executive Bonus Shares"). 50% of the Executive Bonus Shares vested on August 15, 2013 and the remaining 50% vested on February 15, 2014. The Company recorded the unamortized expense related to the Executive Bonus Shares as stock-based compensation expense through February 15, 2014. These shares are reported as "Vested" in the restricted stock grant table below.

On August 7, 2012, Mr. Dolan elected to receive his fiscal year 2012 bonus, if earned, in the form of restricted shares of the Company's common stock (the “Dolan Bonus Shares”). 50% of the Dolan Bonus Shares vested on August 15, 2013 and the remaining 50% vested on February 15, 2014. The Company recorded the unamortized stock-based compensation expense related to the Dolan Bonus Shares through February 15, 2014.

On February 11, 2014, the Board of Directors increased its number of members from nine to eleven. In connection with their appointments, on February 18, 2014, each new director received a grant of shares of restricted stock with a grant date fair value of $100,000, with the number of shares granted calculated by dividing $100,000 by $3.30, the closing price of the Company's stock on the date of grant, and $100,000 of options to purchase the Company's common stock, with the number of shares calculated by dividing $100,000 by the grant date fair value of an option to purchase one share of common stock as determined by using the Black-Scholes valuation model. These awards vested on June 11, 2014, the date of the Company's 2014 Annual Meeting of Stockholders. Each of the new directors also elected to receive their 2014 annual retainers in shares of common stock in lieu of cash. Additionally, an incumbent member of the Board was appointed Chairman of a new committee and elected to receive his incremental retainer for this chairmanship in shares of the Company's common stock. These retainer shares were granted on February 18, 2014, of which 50% vested immediately and the remaining 50% vested on July 1, 2014. The Company granted options to purchase approximately 135,000 shares of common stock and 88,000 shares of restricted common stock in the three months ended March 28, 2014 in connection with these actions. These stock options and restricted stock awards are reported as "Granted" and, as applicable, as "Vested" in the respective tables below.


21


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

Stock Options

The activity related to the Company's outstanding stock options during the six months ended June 27, 2014 is as follows:
 
Number of
Shares
 
Weighted
Average
Exercise Price
 
Weighted
Average
Remaining
Contractual Term
(years)
 
Aggregate
Intrinsic Value
(in thousands)
Outstanding at January 1, 2014
33,136,112

 
$
3.22

 
 
 
 
Granted
10,950,616

 
$
3.59

 
 
 
 
PT outstanding options converted to Sonus options
1,283,058

 
$
1.73

 
 
 
 
Exercised
(1,903,055
)
 
$
2.41

 
 
 
 
Forfeited
(1,295,826
)
 
$
2.80

 
 
 
 
Expired
(550,019
)
 
$
5.04

 
 
 
 
Outstanding at June 27, 2014
41,620,886

 
$
3.30

 
7.27
 
$
21,175

Vested or expected to vest at June 27, 2014
39,613,270

 
$
3.32

 
7.21
 
$
19,706

Exercisable at June 27, 2014
18,299,837

 
$
3.50

 
5.14
 
$
10,896



The grant date fair values of options to purchase common stock granted in the three and six months ended June 27, 2014 were estimated using the Black-Scholes valuation model with the following assumptions:
 
Three months ended
 
Six months ended
 
June 27,
2014
 
June 27,
2014
Risk-free interest rate
1.66%
 
1.53% - 2.70%
Expected dividends
 
Weighted average volatility
53.0%
 
61.3%
Expected life (years)
4.5
 
4.5 - 6.0


Additional information regarding the Company's stock options for the three and six months ended June 27, 2014 is as follows:
 
Three months ended
 
Six months ended
 
June 27,
2014
 
June 27,
2014
Weighted average grant date fair value of stock options granted
$
1.48

 
$
1.66

Total intrinsic value of stock options exercised (in thousands)
$
820

 
$
2,409

Cash received from the exercise of stock options (in thousands)
$
1,097

 
$
4,541




22


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

Restricted Stock Awards

The activity related to the Company's unvested restricted stock awards for the six months ended June 27, 2014 is as follows:
 
Shares
 
Weighted
Average
Grant Date
Fair Value
Unvested balance at January 1, 2014
1,238,765

 
$
2.82

Granted
1,907,097

 
$
3.31

Vested
(1,631,790
)
 
$
3.17

Forfeited

 
$

Unvested balance at June 27, 2014
1,514,072

 
$
3.06



The total fair value of shares of restricted stock that vested during the six months ended June 27, 2014 was $5.2 million.

Performance-Based Stock Awards

The activity related to the Company's performance-based stock awards for the six months ended June 27, 2014 is as follows:
 
Shares
 
Weighted
Average
Grant Date
Fair Value
Unvested balance at January 1, 2014
1,059,541

 
$
2.60

Granted

 
$

Vested
(422,562
)
 
$
2.60

Forfeited
(205,729
)
 
$
2.43

Unvested balance at June 27, 2014
431,250

 
$
2.72



Employee Stock Purchase Plan

At the February 2014 meeting of the Board of Directors, the ESPP was amended, effective March 1, 2014, to provide for six-month offering periods with the purchase price of the stock equal to 85% of the lesser of the market price on the first or last day of the offering period. The maximum number of shares of common stock an employee may purchase during each offering period is 2,500, subject to certain adjustments pursuant to the ESPP.

Stock-Based Compensation

The condensed consolidated statements of operations include stock-based compensation for the three and six months ended June 27, 2014 and June 28, 2013 as follows (in thousands):
 
Three months ended
 
Six months ended
 
June 27,
2014
 
June 28,
2013
 
June 27,
2014
 
June 28,
2013
Product cost of revenue
$
104

 
$
30

 
$
183

 
$
82

Service cost of revenue
412

 
252

 
691

 
462

Research and development
1,749

 
820

 
3,062

 
1,499

Sales and marketing
1,303

 
1,219

 
2,552

 
2,318

General and administrative
3,370

 
2,219

 
6,224

 
4,403

 
$
6,938

 
$
4,540

 
$
12,712

 
$
8,764



23


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

There is no income tax benefit for employee stock-based compensation expense for the three and six months ended June 27, 2014 or June 28, 2013 due to the valuation allowance recorded.

At June 27, 2014, there was $38.6 million, net of expected forfeitures, of unrecognized stock-based compensation expense related to unvested stock options and restricted stock awards. This expense is expected to be recognized over a weighted average period of approximately three years.


(13) MAJOR CUSTOMERS

The following customers each contributed 10% or more of the Company's revenue in at least one of the three or six month periods ended June 27, 2014 and June 28, 2013:
 
Three months ended
 
Six months ended
 
 
June 27,
2014
 
June 28,
2013
 
June 27,
2014
 
June 28,
2013
 
AT&T Inc.
20%
 
22%
 
24%
 
17%
 
Verizon
*
 
11%
 
*
 
10%
 
__________________________________

* Represents less than 10% of revenue

At June 27, 2014, two customers each accounted for 10% or more of the Company's accounts receivable balance, representing approximately 31% in the aggregate of the Company's accounts receivable balance. At December 31, 2013, one customer accounted for 10% or more of the Company's accounts receivable balance, representing approximately 13% of the Company's accounts receivable balance. The Company performs ongoing credit evaluations of its customers and generally does not require collateral on accounts receivable. The Company maintains an allowance for doubtful accounts and such losses have been within management's expectations.


(14) GEOGRAPHIC INFORMATION

The Company's classification of revenue by geographic area is determined by the location to which the product is shipped or where the services are performed. The following table summarizes revenue by geographic area as a percentage of total revenue:

 
Three months ended
 
Six months ended
 
 
June 27,
2014
 
June 28,
2013
 
June 27,
2014
 
June 28,
2013
 
United States
71
%
 
74
%
 
72
%
 
72
%
 
Europe, Middle East and Africa
14

 
11

 
13

 
10

 
Japan
9

 
10

 
8

 
13

 
Other Asia Pacific
4

 
4

 
4

 
4

 
Other
2

 
1

 
3

 
1

 
 
100
%
 
100
%
 
100
%
 
100
%
 


International revenue, both as a percentage of total revenue and absolute dollars, may vary from one period to the next, and accordingly, historical data may not be indicative of future periods.


(15) INCOME TAXES

The Company's income tax provisions for the six months ended June 27, 2014 and June 28, 2013 reflect the Company's

24


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

estimates of the effective rates expected to be applicable for the respective full years, adjusted for any discrete events, which are recorded in the period that they occur. These estimates are reevaluated each quarter based on the Company's estimated tax expense for the full year. The estimated effective rates for the six months ended June 27, 2014 and June 28, 2013 do not include any benefit for the Company's domestic losses, as the Company has concluded that a valuation allowance on any domestic benefit is required.


(16) COMMITMENTS AND CONTINGENCIES

The Company is often a party to disputes and legal proceedings that it considers routine and incidental to its business. In the normal course of business, the Company enters into contractual commitments to purchase services, materials, components, and finished goods from suppliers. Under agreements with certain contract manufacturers, the Company may be liable for purchased raw materials procured for the Company by the applicable contract manufacturer. Management does not expect the results of any of these actions to have a material effect on the Company's business or consolidated financial statements.


Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations


The following discussion of the financial condition and results of operations of Sonus Networks, Inc. should be read in conjunction with the condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and the audited financial statements and notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2013, which was filed with the U.S. Securities and Exchange Commission effective February 28, 2014.

Overview

We are a leading provider of networked solutions for communications service providers (e.g., telecommunications, wireless and cable service providers) and enterprises to help them advance, protect and unify their voice and data communication networks, reduce expenses and position themselves to provide new services to their customers. We help many of the world's leading communications service providers and enterprises implement the next generation of Session Initiation Protocol ("SIP")-based solutions, including Voice over IP ("VoIP") and Unified Communications ("UC") through secure, reliable and scalable Internet Protocol ("IP") networks. We also provide tightly integrated signaling and advanced routing capabilities and applications that span the mission-critical demands of both existing and next-generation 4G LTE and IMS telecommunications networks. Our products include session border controllers ("SBCs"), diameter signaling controllers ("DSCs"), policy/routing servers, media and signaling gateways and network analytics tools. Our solutions address the need for communications service providers and enterprises to seamlessly link and leverage multivendor, multiprotocol communications systems and applications across a single network infrastructure. Previously, companies were required to implement separate networks for their voice and data applications. In a rapidly changing ecosystem of IP-enabled devices such as smartphones and tablets, companies want an infrastructure that enables the integration of voice and data capability into a single application on one integrated network. Our solutions help our customers realize the intended value and benefits of UC, both in public and private clouds, by enabling disparate vendor communications environments, commonplace in most enterprises today, to work seamlessly together. Likewise, our solutions enable the deployment and adoption of cloud-based communications.


We utilize both direct and indirect sales channels to reach our target customers. Customers and prospective customers in the service provider space are traditional and emerging communications service providers, including long distance carriers, local exchange carriers, Internet service providers, wireless operators, cable operators, international telephone companies and carriers that provide services to other carriers. Enterprise customers and target enterprise customers include financial institutions, retailers, state and local governments, and other multinational corporations. We collaborate with our customers to identify and develop new, advanced services and applications that can help to reduce costs, improve productivity and generate new revenue.


25


We have traditionally sold our products principally through a global direct sales force, with additional sales support from regional channel partners throughout the world. In 2012, we launched an expanded channel partner program, the Sonus Partner Assure Program, to expand our coverage of the service provider and enterprise market opportunities. We continue to expand this program, including the introduction in 2013 of a two-tier distribution channel model.

In concert with our Sonus Partner Assure Program, we enhanced our flagship SBC 5200 to be more enterprise- and channel-centric and launched a new SBC, the Sonus SBC 5100, to address the enterprise requirements for smaller regional office and branch offices as a result of their VoIP and SIP deployments.

On July 30, 2014, we announced that on July 29, 2014, Todd Abbott ("Mr. Abbott") stepped down as Executive Vice President of Strategy and Go-to-Market. Mr. Abbott will remain with the Company in an advisory role to assist in the transition of his duties until October 17, 2014.

On February 19, 2014 (the "PT Acquisition Date"), we completed the acquisition of Performance Technologies, Incorporated ("PT"), a Delaware corporation, for $3.75 per share, or approximately $34 million in cash, net of PT's cash and excluding acquisition-related costs. This acquisition has enabled us to expand and diversify our portfolio with an integrated, virtualized Diameter and SIP-based solution and deliver strategic value to service providers seeking to offer new multimedia services through mobile, cloud-based real-time communications. The financial results of PT are included in our condensed consolidated financial statements for the three months ended June 27, 2014 and for the period subsequent to the PT Acquisition Date for the six months ended June 27, 2014.

On June 20, 2014, we sold the PT Multi-Protocol Server ("MPS") business for $2.0 million to an affiliate of Sunhillo Corporation. We had acquired the MPS business in connection with the acquisition of PT. The results of operations of the MPS business are excluded from our consolidated results for the period subsequent to the June 20, 2014.

On February 24, 2014, we announced our new Sonus SBC 7000 (the "SBC 7000"), which is designed to address scalability requirements for real-time, multimedia communications with the capability to license up to 150,000 sessions. The SBC 7000 is purpose-built to support emerging services such as high definition voice and video, Voice over Long-Term Evolution ("VoLTE") and Rich Communications Services ("RCS"). During the second quarter of fiscal 2014, this product became generally available for purchase by our customers.

Our strategy is designed to capitalize on our technology and market lead, and build a premier franchise in multimedia infrastructure solutions. We are currently focusing our major efforts on the following aspects of our business which enable next generation communications including SIP- and 4G/LTE-based networks.

expanding our communications network solutions to address emerging UC-, IP- and cloud-based enterprise and service providers;
embracing the principles outlined by 3GPP, 4GPP2 and LTE architectures and delivering the industry's most advanced IMS (IP Multimedia Subsystem)-ready SBC and DSC product suites;
leveraging our TDM (time division multiplexing)-to-IP gateway technology leadership with service providers to accelerate adoption of SIP-enabled Unified Communication services;
expanding and broadening our customer base by targeting the enterprise market for SIP trunking and access solutions;
assisting our customers' ability to differentiate themselves by offering a sophisticated application development platform and service creation environment;
expanding our global sales distribution, marketing and support capabilities, including continued expansion of our indirect sales channel program;
actively contributing to the SIP standards definition and adoption process;
pursuing strategic transactions and alliances; and
delivering sustainable profitability by continuing to improve our overall performance.

We reported losses from operations of $4.8 million for the three months ended June 27, 2014 and $4.6 million for the three months ended June 28, 2013. We reported losses from operations of $10.6 million for the six months ended June 27, 2014 and $18.1 million for the six months ended June 28, 2013.

We reported net losses of $5.5 million for the three months ended June 27, 2014 and $4.9 million for the three months ended June 28, 2013. We reported net losses of $9.5 million for the six months ended June 27, 2014 and $18.6 million for the six months ended June 28, 2013.


26


Our revenue was $75.6 million in the three months ended June 27, 2014 and $69.2 million in the three months ended June 28, 2013. Our revenue was $146.3 million in the six months ended June 27, 2014 and $132.5 million in the six months ended June 28, 2013.

Our gross profit was $47.3 million in the three months ended June 27, 2014 and $44.0 million in the three months ended June 28, 2013. Our gross profit was $93.7 million in the six months ended June 27, 2014 and $81.8 million in the six months ended June 28, 2013.

Our gross profit as a percentage of revenue ("total gross margin") was 62.6% in the three months ended June 27, 2014 and 63.6% in the three months ended June 28, 2013. Our total gross margin was 64.0% in the six months ended June 27, 2014 and 61.8% in the six months ended June 28, 2013.

Our operating expenses were $52.1 million in the three months ended June 27, 2014, compared to $48.6 million in the three months ended June 28, 2013, and $104.3 million in the six months ended June 27, 2014, compared to $99.9 million in the six months ended June 28, 2013. Our operating expenses for the three months ended June 27, 2014 include $0.4 million of restructuring expense. Our operating expenses for the three months ended June 28, 2013 include $1.7 million of restructuring expense. Our operating expenses for the six months ended June 27, 2014 include $1.3 million of acquisition-related expense and $1.6 million of restructuring expense. Our operating expenses for the six months ended June 28, 2013 include $3.6 million of restructuring expense.

We recorded stock-based compensation expense of $6.9 million in the three months ended June 27, 2014 and $4.5 million in the three months ended June 28, 2013. We recorded stock-based compensation expense of $12.7 million in the six months ended June 27, 2014 and $8.8 million in the six months ended June 28, 2013. The stock-based compensation actions described below increased stock-based compensation expense while reducing cash salary and bonus expenses in both three and six month periods.

See "Results of Operations" in this Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") for a discussion of these changes in our revenue and expenses.

In the three months ended March 28, 2014, we reached a settlement agreement for $2.25 million to recover a portion of our losses related to the impairment of certain prepaid royalties which we had written off in fiscal 2012. This amount is included in Other income in our condensed consolidated statement of operations for the six months ended June 27, 2014.

On June 11, 2014, the Company modified the stock options outstanding as of that date that had been granted to the Company's non-employee members of the Board of Directors (the "Board Members") to extend the exercise period to the lesser of three years from the date that a Board Member stepped down from his or her position on the Board of Directors or the remaining contractual life of the respective stock options. In connection with this modification, the Company recorded $0.7 million of incremental stock-based compensation expense in the three months ended June 27, 2014. This expense is included as a component of General and administrative expense in the Company's condensed consolidated statements of operations for both the three and six months ended June 27, 2014.

On January 2, 2014, Raymond P. Dolan, our President and Chief Executive Officer ("Mr. Dolan") elected to accept shares of restricted stock in lieu of base salary for the period from January 1, 2014 through December 31, 2014. Accordingly, we granted Mr. Dolan 243,507 shares of restricted stock (the "2014 Dolan Salary Shares") on January 2, 2014. The number of shares granted was calculated by dividing an amount equal to 1.5 times Mr. Dolan's base salary for the period from January 1, 2014 through December 31, 2014 by $3.08, the closing price of our common stock on the date of grant. The 2014 Dolan Salary Shares will vest on December 31, 2014. If Mr. Dolan's employment is terminated by Mr. Dolan with Good Reason (as defined in his employment agreement, as amended) or his employment is terminated by us without Cause (as defined in his employment agreement, as amended) before December 31, 2014, a pro rata portion of the 2014 Dolan Salary Shares will vest on the date of such termination. If Mr. Dolan terminates his employment without Good Reason or his employment is terminated by us for Cause before December 31, 2014, he will forfeit the 2014 Dolan Salary Shares. We are recording stock-based compensation expense related to the 2014 Dolan Salary Shares ratably for the period of January 1, 2014 through December 31, 2014.

On January 22, 2014, 21 of our executives, including Mr. Dolan, were given the choice to receive all or half of their fiscal year 2014 bonuses (the "2014 Bonus"), if any are earned, in the form of shares of our common stock (the "2014 Bonus Shares"). Each executive could also elect not to participate in this program and to earn his or her 2014 Bonus, if any, in the form of cash. The amount of the 2014 Bonus, if any, for each executive shall be determined by the Compensation Committee of our Board of Directors (the "Compensation Committee"). The number of shares of our common stock that will be granted to

27


those executives who elected to receive their 2014 Bonus entirely in the form of shares of common stock will be calculated by dividing an amount equal to 1.5 times each executive's 2014 Bonus earned by $3.08, the closing price of our common stock on January 2, 2014. The number of shares of common stock that will be granted to those executives who elected to receive one-half of their 2014 Bonus in the form of shares of common stock will be calculated by dividing an amount equal to 1.5 times one-half of each executive's 2014 Bonus earned by $3.08, with the cash portion equal 50% of their respective 2014 Bonus earned. The 2014 Bonus, if any, will be granted and/or paid on a date concurrent with the timing of the payout of bonuses under the Company-wide incentive bonus program. The 2014 Bonus Shares, if any are granted, will be fully vested on the date of grant. Of the eligible executives, 17 elected to receive their entire 2014 Bonus in shares of common stock and 4 elected to receive 50% of their 2014 Bonus in shares of common stock and 50% in cash. As of June 27, 2014, we determined that the grant date criteria for the 2014 Bonus Shares had not been met; accordingly, we are marking to market the 2014 Bonus Shares expected to be earned and recording expense based on the aggregate fair value of the 2014 Bonus Shares at June 27, 2014.

In March 2013, 21 executives of the Company, including Mr. Dolan, elected to receive their fiscal year 2013 bonuses (the "2013 Bonus"), if any were earned, in the form of shares of our common stock (the "2013 Bonus Shares"). The 2013 Bonus Shares were granted on February 18, 2014 and vested immediately. We granted approximately one million 2013 Bonus Shares, with the number of shares granted calculated by dividing amounts equal to 1.5 times the respective 2013 Bonus amounts earned, as determined by the Compensation Committee, by $3.30, the closing price of our common stock on the date of grant. We recorded stock-based compensation expense for the 2013 Bonus Shares from January 1, 2013 through the grant date.

On February 14, 2013, the Compensation Committee determined that eight executives of the Company, excluding Mr. Dolan, would receive their bonuses with respect to fiscal 2012 in the form of restricted shares of our common stock equal to 100% of their respective target bonus amounts for fiscal 2012 (the "Executive Bonus Shares"). 50% of the Executive Bonus Shares vested on August 15, 2013 and the remaining 50% vested on February 15, 2014. We recorded the unamortized expense related to the Executive Bonus Shares as stock-based compensation expense through February 15, 2014.

On August 7, 2012, Mr. Dolan elected to receive his fiscal year 2012 bonus, if earned, in the form of restricted shares of our common stock (the “Dolan Bonus Shares”). 50% of the Dolan Bonus Shares vested on August 15, 2013 and the remaining 50% vested on February 15, 2014. We recorded the unamortized stock-based compensation expense related to the Dolan Bonus Shares through February 15, 2014.

On February 11, 2014, the Board of Directors increased its number of members from nine to eleven. In connection with their appointments, on February 18, 2014, each new director received a grant of shares of restricted stock with a grant date fair value of $100,000, with the number of shares granted calculated by dividing $100,000 by $3.30, the closing price of our common stock on the date of grant, and $100,000 of options to purchase our common stock, with the number of shares calculated by dividing $100,000 by the grant date fair value of an option to purchase one share of common stock as determined by using the Black-Scholes valuation model. These awards vested on June 11, 2014, the date of our 2014 Annual Meeting of Stockholders. Each of the new directors also elected to receive their 2014 annual retainers in shares of common stock in lieu of cash. Additionally, an incumbent member of the Board was appointed Chairman of a new committee and elected to receive his incremental retainer for this chairmanship in shares of our common stock. These retainer shares were granted on February 18, 2014, with50% vesting immediately while the remaining 50% vested on July 1, 2014. We granted options to purchase approximately 135,000 shares of common stock and 88,000 shares of restricted common stock in the first quarter of fiscal 2014 in connection with these actions.


Critical Accounting Policies and Estimates

Management's discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. We consider the following accounting policies to be both those most important to the portrayal of our financial condition and those that require the most subjective judgment. If actual results differ significantly from management's estimates and projections, there could be a material effect on our condensed consolidated financial statements. The significant accounting policies that we believe are the most critical include the following:

Revenue recognition;

28


Valuation of inventory;
Loss contingencies and reserves;
Stock-based compensation;
Business combinations;
Goodwill and intangible assets; and
Accounting for income taxes.

For a further discussion of our critical accounting policies and estimates, please refer to our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. There were no significant changes to our critical accounting policies from December 31, 2013 through June 27, 2014.

Results of Operations

Three and six months ended June 27, 2014 and June 28, 2013

Revenue. Revenue for the three and six months ended June 27, 2014 and June 28, 2013 was as follows (in thousands, except percentages):

 
Three months ended
 
Increase
from prior year
 
June 27,
2014
 
June 28,
2013
 
$
 
%
Product
$
45,845

 
$
42,939

 
$
2,906

 
6.8
%
Service
29,725

 
26,254

 
3,471

 
13.2
%
Total revenue
$
75,570

 
$
69,193

 
$
6,377

 
9.2
%

 
 
 
 
 
 
 
 
 
Six months ended
 
Increase
from prior year
 
June 27,
2014
 
June 28,
2013
 
$
 
%
Product
$
90,985

 
$
80,735

 
$
10,250

 
12.7
%
Service
55,327

 
51,746

 
3,581

 
6.9
%
Total revenue
$
146,312

 
$
132,481

 
$
13,831

 
10.4
%


Product revenue is comprised of sales of our communication infrastructure products. Our Legacy product offerings, primarily trunking and SS7 signaling, include our GSX9000 and GSX4000 Open Services Switches, our ASX Voice Application Server and our STP Signal Transfer Point solution. Our Growth-related product offerings include our Session Border Controllers, including the SBC 9000, our newly released SBC 7000, and the SBC 5200, SBC 5100, SBC 2000 and SBC 1000, SBC SWe, and SBC VX; and our Diameter Signaling Controller, the DSC 8000.

Certain of our products may be incorporated into either our Legacy product revenue or Growth-related product revenue categories, depending on the application of the product within a customer’s network. These products include, but are not limited to, our PSX Policy & Routing Server, GSX 9000, SGX Signaling Gateway, Sonus Insight Management System, ASX Access Gateway Control Function and our suite of network analytical products. Sales of gateway products used in connection with a Time Division Multiplexing ("TDM") network are classified as Legacy product revenue. The key differentiator for the Growth-related product revenue is whether the products we provide are used as solutions, which enable next-generation networks such as SIP and 4G/LTE.

Product revenue for the three and six months ended June 27, 2014 and June 28, 2013 was comprised of the following (in thousands, except percentages):


29


 
Three months ended
 
Increase (decrease)
from prior year
 
June 27,
2014
 
June 28,
2013
 
$
 
%
Legacy product revenue
$
17,215

 
$
22,490

 
$
(5,275
)
 
(23.5
)%
Growth-related product revenue
28,630

 
20,449

 
8,181

 
40.0
 %
 
$
45,845

 
$
42,939

 
$
2,906

 
6.8
 %


 
 
 
 
 
 
 
 
 
Six months ended
 
Increase (decrease)
from prior year
 
June 27,
2014
 
June 28,
2013
 
$
 
%
Legacy product revenue
$
29,532

 
$
36,776

 
$
(7,244
)
 
(19.7
)%
Growth-related product revenue
61,453

 
43,959

 
17,494

 
39.8
 %
 
$
90,985

 
$
80,735

 
$
10,250

 
12.7
 %


We have anticipated that as a result of the transition of our customers, our business and the overall market to SBC and Diameter, our revenue from sales of our Legacy products will decrease over time, with the decline more than offset by increases in sales of our Growth-related products. This decline is not expected to be completely linear, as customers will from time to time require additional capacity and expansion to their existing legacy applications infrastructures. We expect that our product revenue in fiscal 2014 will increase from fiscal 2013 levels, primarily due to increased sales of our Growth-related products resulting from our continued and increasing focus on expanding our product offerings to address emerging Unified Communication and IP-based markets, such as SBC, in the enterprise and service provider markets, as well as sales from Diameter products as a result of our recent acquisition of PT.

The transition to all-IP networks, which the industry is trending toward over time, is an important part of both our customers' and our strategy for growth. This trend has led to increased capital expenditures from certain customers as they continue to migrate their legacy networks. During the first half of fiscal 2014 we received various purchase orders for our GSX 9000 product solution from a large customer that required additional capacity to scale its IP infrastructure and support its transition to an all-IP network. We have determined that based upon the usage case that drove the customer's purchasing decision, these orders would be more accurately reflected within the Growth-related product revenue category rather than the Legacy revenue product category, as the GSX 9000 product will be used to help secure, manage, control or migrate traffic to IP network infrastructures. Accordingly, we have adjusted the product revenue components reported for the three months ended March 28, 2014 by reclassifying $6.6 million of product revenue from Legacy to Growth-related. This adjustment is reflected in the product revenue components reported above for the six months ended June 27, 2014.

In the three months ended June 27, 2014, approximately 29% of product revenue was from indirect sales through our channel program, compared to approximately 16% in the three months ended June 28, 2013. Approximately 24% of product revenue in the six months ended June 27, 2014 was from indirect sales through our channel program, compared to approximately 16% in the six months ended June 28, 2013. These increases were due to the actions that we have taken to expand both our SBC portfolio and our sales opportunities.

In the three months ended June 27, 2014, our product revenue from sales to enterprise customers was approximately 20% of our total product revenue, compared too approximately 21% in the three months ended June 28, 2013. Approximately 20% of our product revenue was from sales to enterprise customers in the six months ended June 27, 2014, compared to approximately 32% in the six months ended June 28, 2013. These sales were made both through our direct sales team and indirect sales channel partners.

We recognized product revenue totaling $6.6 million from 227 new customers in the three months ended June 27, 2014 and $4.5 million from 190 new customers in the three months ended June 28, 2013. We recognized product revenue totaling $9.9 million from 400 new customers in the six months ended June 27, 2014 and $5.8 million from 353 new customers in the six months ended June 28, 2013. New customers are those from whom we recognize revenue for the first time in a reporting period, although we may have had outstanding orders from such customers for several years, especially for certain multi-year projects. The timing of the completion of customer projects, revenue recognition criteria satisfaction and customer payments included in multiple element arrangements may cause our product revenue to fluctuate from one period to the next.


30


Service revenue is primarily comprised of hardware and software maintenance and support (“maintenance revenue”) and network design, installation and other professional services (“professional services revenue”).

Service revenue for the three and six months ended June 27, 2014 and June 28, 2013 was comprised of the following (in thousands, except percentages):
 
Three months ended
 
Increase
from prior year
 
June 27,
2014
 
June 28,
2013
 
$
 
%
Maintenance
$
23,032

 
$
20,843

 
$
2,189

 
10.5
%
Professional services
6,693

 
5,411

 
1,282

 
23.7
%
 
$
29,725

 
$
26,254

 
$
3,471

 
13.2
%

 
Six months ended
 
Increase
from prior year
 
June 27,
2014
 
June 28,
2013
 
$
 
%
Maintenance
$
43,557

 
$
41,691

 
$
1,866

 
4.5
%
Professional services
11,770

 
10,055

 
1,715

 
17.1
%
 
$
55,327

 
$
51,746

 
$
3,581

 
6.9
%


Our maintenance revenue increased in both the three and six month periods ended June 27, 2014 compared to the same prior year periods, primarily due to our larger installed customer base. The timing of the completion of projects for revenue recognition, customer payments and maintenance contracts may cause our services revenue to fluctuate from one period to the next. We expect that our service revenue in fiscal 2014 will increase slightly from fiscal 2013 levels as a result of our larger installed customer base.

The following customers each contributed 10% or more of our revenue in at least one of the three and six month periods ended June 27, 2014 and June 28, 2013:
 
Three months ended
 
Six months ended
Customer
June 27,
2014
 
June 28,
2013
 
June 27,
2014
 
June 28,
2013
AT&T Inc.
20%
 
22%
 
24%
 
17%
Verizon
*
 
11%
 
*
 
10%

* Represents less than 10% of revenue

International revenue was approximately 29% of revenue in the three months ended June 27, 2014 and approximately 26% of revenue in the three months ended June 28, 2013. International revenue was approximately 28% of revenue in the six months ended June 27, 2014 and approximately 28% of revenue in the six months ended June 28, 2013. Due to the timing of project completions, we expect that the domestic and international components as a percentage of our revenue will fluctuate from quarter to quarter and year to year.

Our deferred product revenue was $6.6 million at June 27, 2014 and $14.8 million at December 31, 2013. Our deferred service revenue was $44.2 million at June 27, 2014 and $36.9 million at December 31, 2013. Our deferred revenue balance may fluctuate as a result of the timing of revenue recognition, customer payments, maintenance contract renewals, contractual billing rights and maintenance revenue deferrals included in multiple element arrangements.

Cost of Revenue/Gross Margin. Our cost of revenue consists primarily of amounts paid to third-party manufacturers for purchased materials and services, royalties, manufacturing and professional services personnel and related costs, and provision for inventory obsolescence. Our cost of revenue and gross margins for the three and six months ended June 27, 2014 and June 28, 2013 were as follows (in thousands, except percentages):

31


 
Three months ended
 
Increase (decrease)
from prior year
 
June 27,
2014
 
June 28,
2013
 
$
 
%
Cost of revenue
 
 
 
 
 
 
 
Product
$
16,811

 
$
13,534

 
$
3,277

 
24.2
 %
Service
11,471

 
11,651

 
(180
)
 
(1.5
)%
Total cost of revenue
$
28,282

 
$
25,185

 
$
3,097

 
12.3
 %
Gross margin
 
 
 
 
 
 
 
Product
63.3
%
 
68.5
%
 
 
 
 
Service
61.4
%
 
55.6
%
 
 
 
 
Total gross margin
62.6
%
 
63.6
%
 
 
 
 

 
 
 
 
 
 
 
 
 
Six months ended
 
Increase (decrease)
from prior year
 
June 27,
2014
 
June 28,
2013
 
$
 
%
Cost of revenue
 
 
 
 
 
 
 
Product
$
30,474

 
$
27,429

 
$
3,045

 
11.1
 %
Service
22,127

 
23,242

 
(1,115
)
 
(4.8
)%
Total cost of revenue
$
52,601

 
$
50,671

 
$
1,930

 
3.8
 %
Gross margin
 
 
 
 
 
 
 
Product
66.5
%
 
66.0
%
 
 
 
 
Service
60.0
%
 
55.1
%
 
 
 
 
Total gross margin
64.0
%
 
61.8
%
 
 
 
 


The decrease in product gross margin in the three months ended June 27, 2014 compared to the three months ended June 28, 2013 was primarily due to product and customer mix, including lower sales of higher-margin software products, which reduced our product gross margin by approximately four percentage points. The other key contributor to the decrease in product gross margin was higher manufacturing-related costs, which reduced our product gross margin by approximately one percentage point.

The slight increase in product gross margin in the six months ended June 27, 2014 compared to the six months ended June 28, 2013 was primarily due to higher product revenue against certain fixed costs, which increased our product gross margin by approximately one percentage point, partially offset by slightly higher manufacturing costs, which reduced our product gross margin by approximately one half of one percentage point.