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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

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FORM 10-Q

(Mark one)

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

For the quarterly period ended March 31, 2015

OR

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

For the transition period from  _ to _  .

Commission File Number: 000-49862

 

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PROCERA NETWORKS, INC.

(Exact name of registrant as specified in its charter)

 

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Delaware		33-0974674
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

47448 Fremont Boulevard, Fremont, California		94538
(Address of principal executive offices)		(Zip code)

(510) 230-2777

 (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 ☑    No ☐

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 ☑    No ☐

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.

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

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

As of April 30, 2015, the registrant had 20,788,385 shares of its common stock, par value $0.001, outstanding.

 

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PROCERA NETWORKS, INC.

FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2015

INDEX

 

			Page
PART I. FINANCIAL INFORMATION
	Item 1.	Condensed Consolidated Financial Statements
		Condensed Consolidated Balance Sheets as of March 31, 2015 (unaudited) and December 31, 2014	3
		Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2015 and 2014 (unaudited)	4
		Condensed Consolidated Statements of Comprehensive Income (Loss) for the Three Months Ended March 31, 2015 and 2014 (unaudited)	5
		Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2015 and 2014 (unaudited)	6
		Notes to Condensed Consolidated Financial Statements (unaudited)	7
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	32
	Item 4.	Controls and Procedures	32
PART II. OTHER INFORMATION
	Item 1.	Legal Proceedings	33
	Item 1A.	Risk Factors	33
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	53
	Item 3.	Defaults Upon Senior Securities	53
	Item 4.	Mine Safety Disclosures	54
	Item 5.	Other Information	54
	Item 6.	Exhibits	54
SIGNATURES			55

 

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PART I. FINANCIAL INFORMATION

Item 1.

Condensed Consolidated Financial Statements

Procera Networks, Inc.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except par value)

		March 31, 2015				December 31, 2014
		(unaudited)				(note)
ASSETS
Current assets:
Cash and cash equivalents		$	23,114			$	17,939
Short-term investments			84,537				84,542
Accounts receivable, net of allowance of $31 and $47 at March 31, 2015 and December 31, 2014, respectively			15,397				21,447
Inventories, net			14,949				14,837
Prepaid expenses and other			4,094				4,913
Total current assets			142,091				143,678
Property and equipment, net			7,172				8,322
Intangible assets, net			2,466				2,957
Goodwill			960				960
Other non-current assets			172				154
Total assets		$	152,861			$	156,071
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	3,434			$	5,207
Deferred revenue			13,577				11,821
Accrued liabilities			6,226				7,235
Total current liabilities			23,237				24,263
Non-current liabilities:
Deferred revenue			3,711				3,113
Deferred rent			520				583
Total liabilities			27,468				27,959
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.001 par value; 15,000 shares authorized; none issued and outstanding			—				—
Common stock, $0.001 par value; 32,500 shares authorized; 20,782 and 20,756 shares issued and outstanding at March 31, 2015 and December 31, 2014, respectively			21				21
Additional paid-in capital			226,417				225,313
Accumulated other comprehensive loss			(3,714	)			(3,190	)
Accumulated deficit			(97,331	)			(94,032	)
Total stockholders’ equity			125,393				128,112
Total liabilities and stockholders’ equity		$	152,861			$	156,071

Note: Amounts have been derived from the December 31, 2014 audited consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

 

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Procera Networks, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

		Three Months Ended
		March 31, 2015				March 31, 2014
Sales:
Product sales		$	15,172			$	9,504
Support sales			5,331				5,037
Total net sales			20,503				14,541
Cost of sales:
Product cost of sales			7,155				5,091
Support cost of sales			1,238				1,066
Total cost of sales			8,393				6,157
Gross profit			12,110				8,384
Operating expenses:
Research and development			3,431				4,548
Sales and marketing			7,159				6,877
General and administrative			4,217				3,110
Total operating expenses			14,807				14,535
Loss from operations			(2,697	)			(6,151	)
Interest and other income (expense), net			(591	)			28
Loss before income taxes			(3,288	)			(6,123	)
Income tax provision (benefit)			11				(147	)
Net loss		$	(3,299	)		$	(5,976	)
Net loss per share – basic		$	(0.16	)		$	(0.29	)
Net loss per share – diluted		$	(0.16	)		$	(0.29	)
Shares used in computing net loss per share:
Basic			20,674				20,329
Diluted			20,674				20,329

See accompanying notes to condensed consolidated financial statements.

 

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Procera Networks, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

(unaudited)

		Three Months Ended March 31,
		2015				2014
Net loss		$	(3,299	)		$	(5,976	)
Unrealized gain (loss) on short-term investments			39				(35	)
Foreign currency translation adjustments			(563	)			(635	)
Other comprehensive loss			(524	)			(670	)
Comprehensive loss		$	(3,823	)		$	(6,646	)

See accompanying notes to condensed consolidated financial statements.

 

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Procera Networks, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

		Three Months Ended March 31,
		2015				2014
Cash flows from operating activities:
Net loss		$	(3,299	)		$	(5,976	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation			664				565
Amortization of intangible assets			225				375
Stock-based compensation expense:
Stock options			651				915
Restricted stock and restricted stock unit awards			556				398
Amortization of premium on investments			207				136
Amortization of deferred compensation			—				65
Provision for (recovery of) bad debts			(22	)			5
Provision for excess and obsolete inventory			407				1
Loss on asset disposals			2				6
Changes in deferred taxes			—				(178	)
Changes in assets and liabilities:
Accounts receivable			5,413				11,965
Inventories			(729	)			(1,700	)
Prepaid expenses and other current assets			614				(264	)
Accounts payable			(1,772	)			(3,650	)
Accrued liabilities			(253	)			(766	)
Deferred revenue			2,803				(1,422	)
Net cash provided by operating activities			5,467				475
Cash flows from investing activities:
Purchase of property and equipment			(582	)			(839	)
Purchase of short-term investments			(18,919	)			(64,598	)
Maturities of short-term investments			18,755				7,000
Net cash used in investing activities			(746	)			(58,437	)
Cash flows from financing activities:
Proceeds from issuance of common stock – exercise of options			—				69
Restricted stock units withheld for employee taxes			(102	)			—
Net cash provided by (used in) financing activities			(102	)			69
Effect of exchange rates on cash and cash equivalents			556				(4	)
Net increase (decrease) in cash and cash equivalents			5,175				(57,897	)
Cash and cash equivalents, beginning of period			17,939				90,774
Cash and cash equivalents, end of period		$	23,114			$	32,877

See accompanying notes to condensed consolidated financial statements.

 

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Procera Networks, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

1.	DESCRIPTION OF BUSINESS

Procera Networks, Inc., a Delaware corporation (“Procera” or the “Company”), is a leading provider of Subscriber Experience Assurance (“SEA”) solutions, based on Deep Packet Inspection technology, that enable mobile and broadband network operators and enterprises managing private networks, including higher education institutions, businesses and government entities (collectively referred to as network operators), to gain enhanced visibility into, and control of, their networks and to create and deploy new services for their end user subscribers.  The Company sells its products through its direct sales force, resellers, distributors, systems integrators and other equipment manufacturers in the Americas, Asia Pacific and Europe.

Procera was incorporated in 2001 and its common stock currently trades on the NASDAQ Global Select Market under the trading symbol “PKT”. The Company reincorporated from the state of Nevada to the state of Delaware in June 2013.

Merger Agreement with Francisco Partners

On April 21, 2015, Procera entered into an Agreement and Plan of Merger (the “Merger Agreement”) with KDR Holding, Inc., a Delaware corporation (“Parent”), and KDR Acquisition, Inc., a Delaware corporation and a wholly owned subsidiary of Parent (“Purchaser”). Parent and Purchaser are beneficially owned by affiliates of Francisco Partners IV, L.P. and Francisco Partners IV-A, L.P. (collectively, “Francisco Partners”).

Pursuant to the terms of the Merger Agreement, Purchaser will commence a tender offer (the “Offer”) to purchase all of the outstanding shares of common stock, par value $0.001 per share, of Procera (the “Shares”), at a price of $11.50 per Share, net to the seller thereof in cash, without interest (such amount, as it may be adjusted on the terms set forth in the Merger Agreement, the “Offer Price”), and subject to deduction for any required withholding of taxes. Pursuant to the terms of the Merger Agreement, Purchaser is obligated to commence the Offer as promptly as practicable, but in no event later than May 5, 2015. The board of directors of Procera (the “Board”) has unanimously adopted the Merger Agreement.

The consummation of the Offer is subject to customary closing conditions, including, among other things: (i) the expiration or termination of the waiting period under any applicable antitrust laws; (ii) there having been validly tendered and not validly withdrawn prior to the expiration of the Offer that number of Shares representing one Share more than 50% of the total number of Shares then-outstanding on a fully diluted basis; (iii) the absence of a material adverse effect with respect to Procera; and (iv) other customary conditions to the Offer set forth in Annex A to the Merger Agreement. The consummation of the Offer is not subject to any financing condition.

Following the consummation of the Offer, and subject to the satisfaction or waiver of the conditions set forth in the Merger Agreement, Purchaser will be merged with and into Procera, with Procera continuing as the surviving corporation and a wholly owned subsidiary of Parent (the “Merger”). The Merger Agreement provides that the Merger will be effected pursuant to Section 251(h) of the General Corporation Law of the State of Delaware, without a vote of the stockholders of Procera.

At the effective time of the Merger (the “Effective Time”), each Share that is outstanding immediately prior to the Effective Time, other than the Shares owned by Procera, Parent or Purchaser, or by stockholders who have validly exercised and perfected their appraisal rights under Delaware law, will be canceled and converted into the right to receive the Offer Price, payable to the holder thereof on the terms and subject to the conditions set forth in the Merger Agreement.

 

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In addition, at the Effective Time, (i) each option to purchase Shares, to the extent vested as of the Effective Time (each, a “Vested Company Option”), will be canceled and converted into the right to receive an amount in cash equal to the product of (a) the excess, if any, of the Offer Price over the exercise price of such Vested Company Option and (b) the number of Shares that may be acquired upon exercise of such Vested Company Option, without interest and subject to deduction for any required withholding of taxes, and (ii) each restricted stock unit award, to the extent vested as of the Effective Time (but for which Shares have not yet been issued) (each, a “Vested Company RSU”), and each restricted stock award that remains subject to vesting conditions (each, an “Unvested Company RSA”), will be canceled and converted into the right to receive an amount in cash equal to the product of (y) the excess, if any, of the Offer Price over the purchase price payable for such Vested Company RSU or Unvested Company RSA, if any, and (z) the number of Shares subject to (or deliverable under) such Vested Company RSU or Unvested Company RSA, in each case without interest and subject to deduction for any required withholding of taxes. At the Effective Time, each option to purchase Shares that is unvested as of the Effective Time, each restricted stock unit award that is unvested as of the Effective Time, and each option to purchase Shares with an exercise price at or above of the Offer Price, will be canceled for no consideration.

Procera, Parent and Purchaser have made customary representations, warranties and covenants in the Merger Agreement. Procera’s covenants include, among other things, covenants regarding the operation of Procera’s business prior to the Effective Time and covenants not to solicit third party proposals relating to alternative transactions or provide information or enter into discussions in connection with alternative transactions, subject to exceptions to permit the Board to comply with its fiduciary duties

The Merger Agreement also includes customary termination rights in favor of each of Procera and Parent, including, among others, if the transactions contemplated by the Merger Agreement are not consummated on or before August 30, 2015 or if Procera terminates the Merger Agreement in compliance with its terms in order to accept a superior proposal. Upon termination of the Merger Agreement under certain circumstances, Procera has agreed to pay Parent a termination fee of approximately $7.2 million.

The foregoing description of the Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the Merger Agreement, which is filed as Exhibit 2.1 to this Quarterly Report on Form 10-Q and incorporated herein by reference.

If Procera consummates the Merger, Procera will become a wholly-owned subsidiary of Parent. Accordingly, the remainder of this Quarterly Report on Form 10-Q, which assumes Procera remains a standalone business, should be read with the understanding that should the Merger be completed, Parent will have the power to control the conduct of Procera’s business.

2.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

Procera has prepared the condensed consolidated financial statements included herein pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) applicable to interim financial information.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with United States generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to such rules and regulations.  However, in the opinion of management, the financial statements include all the normal and recurring adjustments that are necessary to fairly present the results of the interim periods presented. The interim results presented are not necessarily indicative of results for any subsequent interim period, the year ending December 31, 2015 or any other future period. The consolidated balance sheet at December 31, 2014 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in Procera’s Annual Report on Form 10-K for the year ended December 31, 2014, filed with the SEC on March 13, 2015.

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

 

Significant Accounting Policies

The accounting and reporting policies of the Company conform to GAAP.  There have been no significant changes in the Company’s significant accounting policies during the three months ended March 31, 2015 compared to what was previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014, filed with the SEC on March 13, 2015.

 

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Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers”, issued as a new Topic, Accounting Standards Codification (“ASC”) Topic 606.  The new revenue recognition standard provides a five-step analysis of transactions to determine when and how revenue is recognized.  The core principle of the guidance is that a company should recognize revenue to depict the transfer of promised goods and 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.  This ASU will be effective for fiscal 2018, including interim periods within that reporting period and can be adopted by the Company either retrospectively or as a cumulative-effect adjustment as of the date of adoption. The Company is currently evaluating the effect that adopting this new accounting guidance will have on its consolidated financial statements.

In June 2014, the FASB issued ASU No. 2014-12, “Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period” (ASU 2014-12).  The amendments in ASU 2014-12 require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition.  A reporting entity should apply the existing guidance in ASC Topic No. 718, “Compensation – Stock Compensation”, as it relates to awards with performance conditions that affect vesting to account for such awards.  The amendments in ASU 2014-12 are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015.  Early adoption is permitted.  Entities may apply the amendments in ASU 2014-12 either: (1) prospectively to all awards granted or modified after the effective date; or (2) retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter.  The adoption of ASU 2014-12 is not expected to have a material effect on the Company’s consolidated financial statements or disclosures.

In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements”, which provides new guidance related to the disclosures around going concern.  The new standard provides guidance around management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted.  The adoption of this standard is not expected to have a material impact on the Company’s consolidated financial statements.

3.	CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

The following is a summary of cash equivalents and short-term investments by type of instrument at March 31, 2015 and December 31, 2014 (in thousands):

		March 31, 2015
		Amortized				Gross Unrealized								Fair
		Cost				Gains				Losses				Value
Money market funds		$	62			$	—			$	—			$	62
Commercial paper			12,982				6				—				12,988
Treasury and agency notes and bills			55,942				15				(1	)			55,956
Corporate bonds			21,737				10				(4	)			21,743
Total investments		$	90,723			$	31			$	(5	)		$	90,749
Reported as:
Cash equivalents		$	6,211			$	1			$	—			$	6,212
Short-term investments			84,512				30				(5	)			84,537
Total investments		$	90,723			$	31			$	(5	)		$	90,749

 

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		December 31, 2014
		Amortized				Gross Unrealized								Fair
		Cost				Gains				Losses				Value
Money market funds		$	109			$	—			$	—			$	109
Commercial paper			10,794				2				—				10,796
Treasury and agency notes and bills			54,442				5				(6	)			54,441
Corporate bonds			25,419				2				(16	)			25,405
Total investments		$	90,764			$	9			$	(22	)		$	90,751
Reported as:
Cash equivalents		$	6,208			$	1			$	—			$	6,209
Short-term investments			84,556				8				(22	)			84,542
Total investments		$	90,764			$	9			$	(22	)		$	90,751

 

As of March 31, 2015 and December 31, 2014, all investments were classified as available-for-sale with unrealized gains and losses recorded as a separate component of accumulated other comprehensive income (loss).  Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase.  Short-term investments have a remaining maturity of greater than three months at the date of purchase and an effective maturity of up to 24 months.  The weighted average maturity of the portfolio does not exceed 12 months.  As of March 31, 2015 and December 31, 2014, the Company had certain investments with a maturity greater than one year.  As of March 31, 2015 and December 31, 2014, the Company had $10.7 million and $12.8 million, respectively, in investments with a maturity of greater than one year.  However, management has the ability, if necessary, to liquidate any of its investments in order to meet the Company’s liquidity needs in the next 12 months.  Accordingly, investments with contractual maturities greater than one year from the date of purchase are classified as short-term on the accompanying condensed consolidated balance sheets.  None of the Company’s short-term investments have been at a continuous unrealized loss position for greater than 12 months.

The Company reviews its investments for impairment quarterly.  For investments with an unrealized loss, the factors considered in the review include the credit quality of the issuer, the duration that the fair value has been less than the adjusted cost basis, severity of impairment, reason for the decline in value and potential recovery period, the financial condition and near-term prospects of the investees, and whether the Company would be required to sell an investment due to liquidity or contractual reasons before its anticipated recovery.  Based on its review, the Company did not identify any investments that were other-than-temporarily impaired during the three months ended March 31, 2015 and 2014.

The Company did not incur any material realized gains or losses in either of the three months ended March 31, 2015 or 2014.  The cost of securities sold was determined based on the specific identification method.

4.	FAIR VALUE MEASUREMENTS

Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  When determining fair value, the Company considers the principal or most advantageous market in which it would transact and considers assumptions that market participants would use when pricing the asset or liability.

The three levels of inputs that may be used to measure fair value are as follows:

Level 1-

Quoted prices in active markets for identical assets or liabilities.

Level 2-

Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets with insufficient volume or infrequent transactions (less active markets), or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities.

Level 3-

Unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of assets or liabilities.

 

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The following is a summary of cash equivalents and short-term investments by type of instrument as of March 31, 2015 and December 31, 2014, measured at fair value on a recurring basis (in thousands):

		March 31, 2015
		Level 1				Level 2				Level 3				Total
Money market funds		$	62			$	—			$	—			$	62
Commercial paper			—				12,988				—				12,988
Treasury and agency notes and bills			—				55,956				—				55,956
Corporate bonds			—				21,743				—				21,743
Total assets measured at fair value		$	62			$	90,687			$	—			$	90,749

		December 31, 2014
		Level 1				Level 2				Level 3				Total
Money market funds		$	109			$	—			$	—			$	109
Commercial paper			—				10,796				—				10,796
Treasury and agency notes and bills			—				54,442				—				54,442
Corporate bonds			—				25,404				—				25,404
Total assets measured at fair value		$	109			$	90,642			$	—			$	90,751

In general, and where applicable, the Company uses quoted market prices in active markets for identical assets to determine fair value.  This pricing methodology applies to Level 1 investments which are comprised of money market funds.  If quoted prices in active markets for identical assets are not available, then the Company uses quoted prices for similar assets or inputs other than quoted prices that are observable, either directly or indirectly.  These investments are included in Level 2 and consist of commercial paper, U.S. agency securities and U.S. Government and corporate bonds. U.S. agency securities and U.S. Government and corporate bonds are valued at a consensus price, which is a weighted average price based on market prices from a variety of industry standard data providers used as inputs to a distribution-curve based algorithm. Commercial paper is valued using market prices where available, adjusting for accretion of the purchase price to face value at maturity.

The Company did not have any transfers between Level 1 and Level 2 fair value instruments in either of the three months ended March 31, 2015 or 2014.

 

5.	INTANGIBLE ASSETS

Intangible assets are amortized on a straight-line basis over their estimated remaining useful lives.

The following table is a summary of acquired intangible assets with remaining net book values at March 31, 2015 and December 31, 2014 (in thousands, except weighted average remaining life):

		March 31, 2015
		Gross Carrying Value				Accumulated Amortization				Net Carrying Value				Weighted Average Remaining Life
Developed technology		$	3,931			$	(1,933	)		$	1,998				2.77
Customer relationships			1,231				(763	)			468				2.77
Balance at March 31, 2015		$	5,162			$	(2,696	)		$	2,466

 

		December 31, 2014
		Gross Carrying Value				Accumulated Amortization				Net Carrying Value				Weighted Average Remaining Life
Developed technology		$	4,323			$	(1,927	)		$	2,396				3.02
Customer relationships			1,354				(793	)			561				3.02
Balance at December 31, 2014		$	5,677			$	(2,720	)		$	2,957

 

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For the three months ended March 31, 2015 and 2014, amortization expense of $0.2 million and $0.3 million, respectively, related to developed technology was recorded in product cost of sales.  For the three months ended March 31, 2015 and 2014, amortization expense of $43,000 and $113,000, respectively, related to customer relationships was recorded in sales and marketing expense.

The changes in the carrying value of acquired intangible assets during the three months ended March 31, 2015 were as follows (in thousands):

		Gross Carrying Value				Accumulated Amortization				Net Carrying Value
Balance at December 31, 2014		$	5,677			$	(2,720	)		$	2,957
Additions			—				(225	)			(225	)
Translation adjustments			(515	)			249				(266	)
Balance at March 31, 2015		$	5,162			$	(2,696	)		$	2,466

The following table presents the estimated future amortization of intangible assets as of March 31, 2015 (in thousands):

Fiscal Year		Amortization
2015 (remaining nine months)		$	667
2016			890
2017			890
2018			19
Total		$	2,466

6.	CERTAIN FINANCIAL STATEMENT INFORMATION

Inventories

Inventories are stated at the lower of cost (on a specific identification or weighted average cost basis), or market. Inventories at March 31, 2015 and December 31, 2014 consisted of the following (in thousands):

		March 31, 2015				December 31, 2014
Finished goods		$	14,682			$	14,638
Raw materials			267				199
Inventories, net		$	14,949			$	14,837

Inventories also include demonstration units located at various customer locations and customer service inventories.  The demonstration units and customer service inventories are stated at lower of cost (on a specific identification or weighted average cost basis) or market.  The Company provides demonstration units to customers who evaluate the Company's products, and upon a successful trial, may purchase such products.  The Company carries customer service inventories because it generally provides product warranties for 12 months and earns revenue by providing enhanced and extended support contracts during and beyond this warranty period.  Customer service inventories are provided for customer use permanently or on a temporary basis while the defective unit is being repaired.  The Company reduces the carrying value of demonstration units and customer service inventories for differences between cost and estimated net realizable value, taking into consideration expected demand, technological obsolescence, the physical condition of the unit and other information.  If actual results vary significantly from expectations, additional write-downs may be required, resulting in additional charges to operations.

 

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Property and Equipment

The following is a summary of property and equipment as of March 31, 2015 and December 31, 2014 (in thousands):

		March 31, 2015				December 31, 2014
Machinery and equipment		$	10,050			$	10,787
Computer equipment			553				563
Office furniture and equipment			565				581
Leasehold improvements			1,758				1,894
Software			246				274
Accumulated depreciation			(6,000	)			(5,777	)
Property and equipment, net		$	7,172			$	8,322

Accrued Liabilities

Accrued liabilities at March 31, 2015 and December 31, 2014 consisted of the following (in thousands):

		March 31, 2015				December 31, 2014
Payroll and related		$	2,851			$	3,398
Sales commissions			1,487				1,778
Warranty			135				113
Audit and legal services			811				231
Other			942				1,715
Total accrued liabilities		$	6,226			$	7,235

Warranty Reserve

The Company warrants its products against material defects for a specific period of time, generally 12 months. The Company provides for the estimated future costs of warranty obligations in cost of sales when the related revenue is recognized. The accrued warranty costs represent the best estimate at the time of sale of the total costs that the Company expects to incur to repair or replace product parts which fail while still under warranty.  The amount of accrued estimated warranty costs is primarily based on current information on repair costs.  The Company periodically reviews the accrued balances and updates the historical warranty cost trends.

The following table summarizes warranty reserve activity during the three months ended March 31, 2015 and 2014 (in thousands):

		Three Months Ended March 31,
		2015				2014
Warranty accrual, beginning of period		$	113			$	131
Provision for current period sales			54				36
Changes in liability for pre-existing warranties			(19	)			(10	)
Deductions for warranty claims processed during the period			(13	)			(20	)
Warranty accrual, end of period		$	135			$	137

 

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Accumulated Other Comprehensive Income (Loss):

The components of accumulated other comprehensive loss as of March 31, 2015 and December 31, 2014, net of taxes, were as follows (in thousands):

		Foreign Currency Translation Adjustments				Net Unrealized Gain (Loss) on Short- Term Investments				Total
Accumulated other comprehensive loss as of December 31, 2014		$	(3,177	)		$	(13	)		$	(3,190	)
Other comprehensive income (loss), net of tax			(563	)			39				(524	)
Accumulated other comprehensive income (loss) as of March 31, 2015		$	(3,740	)		$	26			$	(3,714	)

The Company did not have any reclassifications out of accumulated other comprehensive loss in either of the three months ended March 31, 2015 or 2014.  The Company did not have any other-than-temporary loss on its available-for-sale securities for all periods presented.

7.	STOCKHOLDERS’ EQUITY

Common Stock Transactions

On January 9, 2013, pursuant to the Company’s acquisition of Vineyard, the Company issued 825,000 unregistered shares of its common stock with a value of approximately $14.3 million as part of the purchase consideration in exchange for 100% of the outstanding securities of Vineyard and deferred compensation to the founders of Vineyard. On February 13, 2013, the Company filed with the SEC a Registration Statement on Form S-3 covering the resale of these shares. The Registration Statement on Form S-3 was declared effective by the SEC on March 7, 2013.  Pursuant to the Vineyard acquisition agreement, 518,000 shares were transferred to the former Vineyard shareholders at closing, with the remainder being held in escrow for a period of 12, 18 or 36 months from the closing of the acquisition.  In January 2014, 178,000 shares were released from the escrow related to the retention agreements with Vineyard’s three founders after one year of continuous employment with the Company.  In July 2014, 124,000 shares were released from escrow related to the resolution of certain contingencies. As of March 31, 2015, 5,000 shares remain in escrow.

Stock Incentive Plans

The Company’s 2007 Equity Incentive Plan, as amended (the “Plan”), provides for the grant of stock options, restricted stock awards and restricted stock unit awards to eligible employees, consultants and non-employee directors of the Company.  As of March 31, 2015, 224,000 shares of the Company’s common stock were available for future grant under the Plan.

The following table summarizes the Company’s stock option activity for the three months ended March 31, 2015 and 2014 (in thousands, except per share data):

		Three Months Ended March 31,
		2015								2014
		Options				Weighted Average Exercise Price				Options				Weighted Average Exercise Price
Outstanding at the beginning of the period			1,645			$	14.71				1,824			$	15.07
Granted			70				9.28				74				12.25
Exercised			—				—				(8	)			8.56
Cancelled			(30	)			15.19				(67	)			16.53
Outstanding at the end of the period			1,685			$	14.47				1,823			$	14.93
Vested and expected to vest at the end of the period			1,590			$	14.57				1,714			$	14.86
Exercisable at the end of the period			957			$	14.83				792			$	13.31

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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As of March 31, 2015, the aggregate intrinsic value of the Company’s options outstanding, options vested and expected to vest and options exercisable were $1.1 million, $1.1 million and $0.8 million, respectively.  As of March 31, 2015, the weighted average remaining contractual life of options outstanding, options vested and expected to vest and options exercisable was 7.52 years, 7.44 years and 6.70 years, respectively. The total intrinsic value of options exercised during the three months ended March 31, 2015 and 2014 was $0 and $24,000, respectively.

The weighted average remaining contractual life and weighted average per share exercise price of options outstanding and of options exercisable as of March 31, 2015 were as follows (in thousands, except exercise prices and years):

 

				Options Outstanding												Options Exercisable
Range of Exercise Prices				Number of Shares				Weighted Average Remaining Contractual Life (years)				Weighted Average Exercise Price				Number of Shares				Weighted Average Exercise Price
$	4.30 – $5.70				132				4.68			$	5.08				131			$	5.08
	6.00 – 9.70				308				7.85				7.57				98				7.13
	9.76 – 14.49				457				8.60				13.82				262				13.99
	14.50 – 30.32				788				7.27				19.12				466				19.67
$	4.30 – $30.32				1,685				7.52			$	14.47				957			$	14.83

 

The following table summarizes the Company’s restricted stock award and restricted stock unit activity for the three months ended March 31, 2015 and 2014 (in thousands, except per share data):

		Three Months Ended March 31,
		2015								2014
		Awards				Weighted- Average Grant Date Fair Value				Awards				Weighted- Average Grant Date Fair Value
Unvested outstanding at the beginning of the period			586			$	11.58				302			$	16.63
Granted			—				—				121				11.57
Vested			(39	)			10.75				(7	)			14.41
Cancelled			(4	)			12.18				(1	)			16.95
Unvested outstanding at the end of the period			543			$	11.63				415			$	15.20

The weighted average remaining contractual term for the unvested restricted stock awards and restricted stock units outstanding as of March 31, 2015 was 2.65 years.  As of March 31, 2015, the aggregate pre-tax intrinsic value of the unvested restricted stock awards and restricted stock units outstanding was $5.1 million.

8.	NET INCOME (LOSS) PER SHARE

Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted net income per share reflects the potential dilution that could occur from common shares issuable upon the exercise of outstanding stock options or warrants and the vesting of restricted stock awards and restricted stock units, which are reflected in diluted earnings per share by application of the treasury stock method.  Under the treasury stock method, the amount that the employee must pay for exercising stock options or warrants, the amount of stock-based compensation cost for future services that the Company has not yet recognized, and the amount of tax benefit that would be recorded in additional paid-in capital upon exercise of options and warrants are assumed to be used to repurchase shares.

 

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The following table sets forth the computation of basic and diluted net loss per share and potential shares of common stock that are not included in the diluted net loss per share calculation because their effect is anti-dilutive (in thousands, except per share data):

		Three Months Ended March 31,
		2015				2014
Numerator:
Net loss		$	(3,299	)		$	(5,976	)
Denominator:
Weighted average common shares - basic			20,674				20,329
Weighted average common shares - diluted			20,674				20,329
Net loss per share:
Basic		$	(0.16	)		$	(0.29	)
Diluted		$	(0.16	)		$	(0.29	)
Antidilutive securities:
Options, restricted stock and restricted stock units			1,413				1,427

9.	STOCK-BASED COMPENSATION

The following table summarizes employee stock-based compensation expense, net of income tax, as it relates to the Company’s statement of operations for the three months ended March 31, 2015 and 2014 (in thousands):

		Three Months Ended March 31,
		2015				2014
Cost of goods sold		$	111			$	97
Research and development			359				388
Sales and marketing			297				408
General and administrative			440				420
Total stock-based compensation expense		$	1,207			$	1,313

No income tax benefits were recognized in either of the three months ended March 31, 2015 or 2014 due to operating losses.  No stock-based compensation has been capitalized in inventory due to the immateriality of such amounts.

As of March 31, 2015, total unrecognized compensation cost related to unvested stock options was $5.0 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 2.30 years, and total unrecognized compensation cost related to unvested restricted stock awards and restricted stock units was $4.4 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 2.65 years.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model.  The fair value of each restricted stock award and restricted stock unit is calculated based upon the closing stock price of the Company’s common stock on the date of the grant.  The expense for stock-based awards is recognized over the requisite service period using the straight-line attribution approach.

 

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The following assumptions were used in determining the fair value of stock options granted during the three months ended March 31, 2015 and 2014:

		Three Months Ended March 31,
		2015				2014
Expected term (years)			5.27				4.91
Expected volatility			62.1	%			70.42	%
Risk-free interest rate			1.44	%			1.56	%
Expected dividend yield			0	%			0	%

The weighted average grant date fair value of options granted during the three months ended March 31, 2015 and 2014 was $4.99 and $7.09, respectively.

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

10.	COMMITMENTS AND CONTINGENCIES

Legal

The Company is periodically involved in legal actions and claims that arise as a result of events that occur in the normal course of operations.  Except as set forth under the caption “Litigation Relating to the Company’s Pending Merger with Francisco Partners” below, the Company does not believe that any of its legal actions and claims will have, individually or in the aggregate, a material adverse effect on the Company’s financial position or results of operations.

Litigation Relating to the Company’s Pending Merger with Francisco Partners

                                                          

In general, the Complaints allege that the members of the Board breached their fiduciary duties to the Company’s stockholders by taking one or more of the following actions: (i) agreeing to an unfair and inadequate Offer Price for the Shares, (ii) accepting unreasonable deal protection measures in the Merger Agreement that dissuades other potential bidders from making competing offers, (iii) failing to properly value the Company and take steps to maximize the value of the Company, (iv) engaging in self-dealing, and (v) ignoring the conflicts of interest present in the Company’s financial advisor.

 

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The Complaints also allege that one or more of the following defendants: the Company, Francisco Partners, Francisco Partners Management, L.P., Parent and Purchaser aided and abetted the members of the Board in breaching their fiduciary duties to the Company’s stockholders.

                                                             

These lawsuits are in their early stages and it is not possible to determine the potential outcome of any of these lawsuits or to make any estimate of probable losses at this time. Each of the Company, the Board, Francisco Partners, Francisco Partners Management, L.P., Parent and Purchaser believes that these lawsuits are completely without merit and each intends to vigorously defend against all allegations that have been asserted.

Operating Leases

The Company leases its operating and office facilities for various terms under long-term, non-cancelable operating lease agreements.  The leases expire at various dates through 2024.  In the normal course of business, it is expected that these leases will be renewed or replaced by leases on other properties.  The leases provide for increases in future minimum annual rental payments based on defined increases which are generally meant to correlate with the Consumer Price Index, subject to certain minimum increases.  Also, the agreements generally require the Company to pay executory costs (real estate taxes, insurance and repairs).

As of March 31, 2015, future minimum lease payments due under operating leases are as follows (in thousands):

Fiscal years ending December 31,		Amount
2015 (remaining nine months)		$	794
2016			919
2017			704
2018			476
2019			281
Thereafter			1,041
Total minimum lease payments		$	4,215

Purchase Commitments

The Company issues purchase orders to third-party suppliers that may not be cancelable.  As of March 31, 2015, the Company had open non-cancelable purchase orders amounting to approximately $11.4 million, primarily with the Company’s third-party suppliers.

Concentrations

For the three months ended March 31, 2015, revenue from Itochu Techno-Solutions Corp. represented 14% of net revenue, British Telecommunications plc represented 13% of net revenue, and revenue from Shaw Communications, Inc. and one other customer each represented 11% of net revenue with no other single customer accounting for more than 10% of net revenue.  For the three months ended March 31, 2014, no customer accounted for more than 10% of net revenue.

At March 31, 2015, accounts receivable from two customers represented 30% and 10%, respectively, of total accounts receivable, with no other single customer accounting for more than 10% of the accounts receivable balance.  At December 31, 2014, accounts receivable from one customer represented 13% of total accounts receivable with no other single customer accounting for more than 10% of the accounts receivable balance.  As of March 31, 2015 and December 31, 2014, approximately 92% and 93%, respectively, of the Company’s total accounts receivable were due from customers outside the United States.

 

11.	INCOME TAXES

The Company’s effective tax rate was approximately zero percent for the three months ended March 31, 2015 and 2% for the three months ended March 31, 2014.  For the three months ended March 31, 2015, the Company recorded an income tax expense of $11,000 on a loss before provision for income taxes of $3.3 million.  For the three months ended March 31, 2014, the Company recorded an income tax benefit of $0.1 million on a loss before provision for income taxes of $6.1 million. The effective tax rate for each of the three months ended March 31, 2015 and 2014 differs from the federal statutory tax rate as a result of the income tax expense related to the amortization of the indefinite life intangibles, state taxes and earnings taxed in foreign jurisdictions and unbenefited losses due to full valuation allowances in the US, Canada and Sweden.

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

The Company recognizes interest and penalties related to uncertain tax positions in income tax expense.  As of March 31, 2015, the Company had no accrued interest or penalties related to uncertain tax positions.   The federal returns for the years ended 2011 through the current period and most state returns for the years ended 2010 through the current period remain open to examination.  In addition, all of the net operating losses and research and development credit carryforwards that may be used in future years are still subject to adjustment.  The Company is also subject to examinations in Australia, Canada, Japan, Singapore and Sweden beginning in 2007 through the current period.

At March 31, 2015, the Company had $196,000 of unrecognized tax benefits, none of which would affect the Company’s effective tax rate if recognized.  The Company currently has a full valuation allowance against its U.S. net deferred tax assets which would impact the timing of the effective tax rate benefit should any of these uncertain tax positions be favorably settled in the future.  The Company does not anticipate that the total unrecognized tax benefits will change significantly over the next twelve months.

12.	SEGMENT INFORMATION

The Company has one reportable operating segment representing the PacketLogic business. The Company’s Chief Operating Decision Maker (“CODM”) evaluates the performance of segments and makes decisions regarding allocation of resources based on certain metrics including segment revenue, gross profit and operating income (loss) measures before other income (expense), net and income taxes. Certain operating expenses, including stock-based compensation expenses; business development expenses; cost reduction efforts; acquisition-related intangible asset and impairment charges, and deferred compensation amortization are not allocated to segments.  The CODM does not review asset information by segment.

The following table presents information for the Company’s reportable segment (All Other represents the Company’s NAVL business; amounts in thousands):

		PacketLogic				All Other				Total
Three months ended March 31, 2015:
Sales		$	19,534			$	969			$	20,503
Gross profit			11,601				802				12,403
Profit (loss) from operations		$	(468	)		$	394			$	(74	)
Three months ended March 31, 2014:
Sales		$	13,505			$	1,036			$	14,541
Gross profit			8,081				899				8,980
Loss from operations		$	(3,584	)		$	(270	)		$	(3,854	)

 

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The following table reconciles segment gross profit and segment operating loss to consolidated results (in thousands):

		Three Months Ended March 31,
		2015				2014
Segment gross profit		$	12,403			$	8,980
Unallocated amounts:
Stock-based compensation			(111	)			(97	)
Amortization of intangibles			(182	)			(262	)
Cost reduction efforts			—				(237	)
Consolidated gross profit			12,110				8,384
Segment operating loss			(74	)			(3,854	)
Unallocated amounts:
Stock-based compensation			(1,207	)			(1,313	)
Amortization of intangibles			(225	)			(375	)
Cost reduction efforts			—				(544	)
Deferred compensation			—				(65	)
Business development expenses			(1,191	)			—
Consolidated operating loss		$	(2,697	)		$	(6,151	)

Sales for geographic regions are based upon the customer’s location.  The following are summaries of net sales by geographical region (in thousands):

		Three Months Ended March 31,
		2015				2014
Sales:
United States		$	2,840			$	2,954
Canada and Latin America			3,031				2,906
Europe, Middle East and Africa			9,249				5,455
Asia Pacific			5,383				3,226
Total		$	20,503			$	14,541

The location of long-lived assets is based on the physical location of the Company’s regional offices.  The following are summaries of property and equipment, net, by geographical region (in thousands):

		March 31, 2015				December 31, 2014
Property and equipment, net:
United States		$	1,016			$	1,207
Canada			2,514				2,811
Europe			3,635				4,299
Asia Pacific			7				5
Total		$	7,172			$	8,322

13.	SUBSEQUENT EVENTS

The information under “Merger Agreement with Francisco Partners” in Note 1 above is incorporated into this Note 13 by reference.

 

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Item 2.

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

The following unaudited discussion and analysis of financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2014, filed with the Securities and Exchange Commission (“SEC”) on March 13, 2015.

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

Cautionary Note Regarding Forward-Looking Statements

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

●

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

●

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

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

●

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

●

our liquidity and financial resources, including anticipated capital expenditures, funding of capital expenditures and anticipated levels of indebtedness; and

●

our expectations regarding our financial results for fiscal year 2015 and subsequent periods.

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

We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K. We also provide cautionary discussion of risks and uncertainties related to our businesses which are identified under the caption “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q.  We believe these factors, individually or in the aggregate, as well as general risks and uncertainties such as those relating to general economic conditions and demand for our products and services, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties.

 

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Overview

Recent Developments – Entry into Merger Agreement with Francisco Partners

The information set forth in Note 1 of the Notes to Condensed Consolidated Financial Statements under the caption “Merger Agreement with Francisco Partners” included in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.

Our Business

We are a leading provider of Subscriber Experience Assurance, or SEA, solutions designed for network operators worldwide.  Our PacketLogic solutions enable network operators to gain insights, make decisions and take actions to ensure a high quality experience for Internet connected devices.  Network operators deploy our technology to gain insights on their subscribers and networks, make decisions on service packaging and then deliver those solutions to subscribers connected to their network.  We believe that the intelligence our products provide about subscribers and their experience enables our network operator customers to make better-informed business decisions and increases customer satisfaction in the highly competitive worldwide broadband market.  Our network operator customers include service provider customers and enterprises.  Our service provider customers include mobile service providers and broadband service providers, which include cable multiple system operators, telecommunications companies, Wi-Fi network operators and Internet service providers.  Our enterprise customers include educational institutions, commercial enterprises, government and municipal agencies.  We sell our products directly to network operators; through partners, value added resellers and system integrators; and to other network solution suppliers for incorporation into their network solutions.  Our products are delivered to network operators through pre-packaged hardware or as virtualized software, which we expect will become a large part of our business going forward and open up new partnership opportunities.

Our SEA solutions are part of the high-growth market for mobile packet and broadband core and access products.  This market is composed of three separate addressable market opportunities:

Deep Packet Inspection (“DPI”) Market

Our products are sold either bundled with hardware or as pure software to deliver a solution that is a key element of the mobile packet and broadband core ecosystems.  Our solutions are often integrated with additional elements in the mobile packet and broadband core, including Policy Management and Charging functions, and are compliant with the widely adopted 3rd Generation Partnership Program standard.  In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, service providers are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers.  We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products. We also sell our embedded Network Application Visibility Library, or NAVL, solutions to other network equipment vendors.  Our embedded solutions enable network solutions suppliers to more quickly add application awareness to their platforms, since our NAVL DPI engine products have been designed to be highly portable among many platforms and processors. NAVL eliminates the need for network solutions providers to research and develop their own DPI technology, saving significant time and resources while enabling them to more effectively compete in their market space.  NAVL enables us to achieve indirect market share in the DPI market by supplying embedded solutions with our DPI engine.  The market for DPI products was $852.0 million in 2014 and, according to Infonetics Research, is expected to grow to just under $2.0 billion by 2019.

Customer Experience Management (“CEM”) Market

In 2014, we launched two significant products that increase our total addressable market: RAN Perspectives and our Insights Product Family.  RAN Perspectives is a Subscriber Identity Module, or SIM-based applet, that a mobile operator can deploy on devices connected to their network.  The applet will report the subscriber’s location and the signal strength and quality that their device has with the mobile network.  This enables our solutions to have real-time location awareness and visibility into the Radio Access Network, or RAN, to complement our existing visibility into the broadband data network.  By combining these two intelligence metrics, we are now competing in the CEM, market with companies such as Gigamon, NetScout, Ericsson, Huawei and other larger telecom vendors.  MarketsandMarkets forecasts the CEM market to grow from $3.77 billion in 2014 to $8.39 billion in 2019.  This represents a CAGR of 17.3% from 2014 to 2019.

 

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Telecom Big Data Analytics Market

Our Insights Product Family consists of unique visualization of our SEA solutions based on different roles inside of a network operator – Engineering, Customer Care, Marketing and Executives.  These products will compete with traditional big data products from companies such as IBM, Guavus and Zettics.  Mind Commerce expects the Big Data driven telecom analytics market to grow at a CAGR of nearly 50% between 2014 and 2019.  By the end of 2019, the market will eventually account for $5.4 billion in annual revenue.

Our products are marketed under the PacketLogic and NAVL brand names.  We have a broad spectrum of products delivering SEA at the access, edge and core layers of the network.  Our products are designed to offer maximum flexibility to our customers and enable differentiated services and revenue-enhancing applications, all while delivering a high quality of experience for subscribers.  These products are offered as virtual or hardware appliances to customers, enabling them to choose their platform based upon their deployment needs and preferences.

Our Company is headquartered in Fremont, California and we have key operating entities in Kelowna, Canada and Varberg, Sweden, as well as a geographically dispersed sales force.  We sell our products through our direct sales force, resellers, distributors, systems integrators and other equipment manufacturers in the Americas, Asia Pacific and Europe.

Critical Accounting Estimates

The discussion and analysis of our financial condition and results of operations are based upon financial statements that have been prepared in accordance with United States generally accepted accounting principles, or GAAP.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities.  On an ongoing basis, we evaluate these estimates.  We base our estimates on historical experience and on assumptions that are believed to be reasonable.  These estimates and assumptions provide a basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions, and these differences may be material.

We believe the following critical accounting policies reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements:

 

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Revenue Recognition;

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Accounting for Income Taxes.

These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2014, filed with the SEC on March 13, 2015.

Results of Operations

Comparison of Three Months Ended March 31, 2015 and 2014

 

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Revenue

Revenue for the three months ended March 31, 2015 and 2014 was as follows (in thousands, except percentages):

		Three Months Ended March 31,
		2015				2014				Increase/ (Decrease)
Net product revenue		$	15,172			$	9,504				60	%
Net support revenue			5,331				5,037				6	%
Total revenue		$	20,503			$	14,541				41	%

Our revenue is derived from two sources: (1) product revenue, which includes sales of our hardware appliances bundled with software licenses, separate software licenses and software upgrades; and (2) service revenue, which consists primarily of software maintenance and customer support revenue and secondarily of professional services.  Maintenance and customer support revenue is recognized over the support period, which is typically 12 months. Our product revenues tend to vary seasonally and are typically higher in the second half of the year as compared to the first half of the year.

                                              

For the year ending December 31, 2015, we expect total revenue to increase approximately 15% compared to total revenue for the year ended December 31, 2014.

Cost of Sales

Cost of sales includes material costs and direct labor for products sold, amortization of acquired developed technology, costs expected to be incurred for warranty, adjustments to inventory values, including the write-down of slow moving or obsolete inventory, and costs for support and professional services personnel.

The following table presents the breakdown of cost of sales by category for the three months ended March 31, 2015 and 2014 (in thousands, except percentages):

		Three Months Ended March 31,
		2015				2014				Increase/ (Decrease)
Product costs		$	7,155			$	5,091				41	%
Percent of net product revenue			47	%			54	%
Support costs		$	1,238			$	1,066				16	%
Percent of net support revenue			23	%			21	%
Total cost of sales		$	8,393			$	6,157				36	%
Percent of total net revenue			41	%			42	%

 

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Total cost of sales in the three months ended March 31, 2015 increased by $2.2 million, compared to the three months ended March 31, 2014.  Cost of sales as a percentage of revenue decreased by 1 percentage point for the three months ended March 31, 2015, compared to the same period in the prior year.  The increase in cost of sales in the first quarter of 2015 primarily reflected an increase in material costs associated with an increase in product sales.  The decrease in cost of sales as a percentage of revenue was primarily due to higher margin earned on product sales in the three months ended March 31, 2015 as compared to the corresponding period of 2014.  Stock-based compensation recorded to cost of sales in each of the three months ended March 31, 2015 and 2014 was $0.1 million.
                                                                   

Gross Profit

Gross profit for the three months ended March 31, 2015 and 2014 was as follows (in thousands, except percentages):

		Three Months Ended March 31,
		2015				2014				Increase
Gross profit		$	12,110			$	8,384				44	%
Percent of total net revenue			59	%			58	%

Our total gross profit margin for the three months ended March 31, 2015 increased by 1 percentage point, compared to the three months ended March 31, 2014.  The increase resulted from higher margins earned on product sales in the three months ended March 31, 2015 and the absence of severance costs associated with our cost reduction efforts, which totaled $0.2 million in the three months ended March 31, 2014. On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangibles and cost reduction efforts, the gross margin rate for the three months ended March 31, 2015 was 60%, as compared to 62% for the three months ended March 31, 2014.  (See page 28 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.)
                                                                         

Our gross margin rate in any given period is impacted by the product mix in that period, and we expect variability in our gross margin rate to continue in the future.

Operating Expenses

Operating expenses for the three months ended March 31, 2015 and 2014 were as follows (in thousands, except percentages):

 

		Three Months Ended March 31,
		2015				2014				Increase/ (Decrease)
Research and development		$	3,431			$	4,548				(25	)%
Sales and marketing			7,159				6,877				4	%
General and administrative			4,217				3,110				36	%
Total		$	14,807			$	14,535				2	%

                                                         

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Research and Development

Research and development expenses include costs associated with personnel focused on the development or improvement of our products, prototype materials, initial product certifications, testing equipment and software costs.  Research and development costs include sustaining and enhancement efforts for products already released and development costs associated with planned new products.  Research and development expenses for the three months ended March 31, 2015 and 2014 were as follows (in thousands, except percentages):

		Three Months Ended March 31,
		2015				2014				Increase
Research and development		$	3,431			$	4,548				(25	)%
As a percentage of net revenue			17	%			31	%

                                                             

Sales and Marketing

Sales and marketing expenses primarily include personnel costs, sales commissions and marketing expenses, such as trade shows, channel development and literature.  Sales and marketing expenses for the three months ended March 31, 2015 and 2014 were as follows (in thousands, except percentages):

		Three Months Ended March 31,
		2015				2014				Increase
Sales and marketing		$	7,159			$	6,877				4	%
As a percentage of net revenue			35	%			47	%

                                                          

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General and Administrative

General and administrative expenses consist primarily of personnel and facilities costs related to our executive and finance functions and fees for professional services.  Professional services include costs for legal advice and services, accounting and tax professionals, independent auditors and investor relations. General and administrative expenses for the three months ended March 31, 2015 and 2014 were as follows (in thousands, except percentages):

		Three Months Ended March 31,
		2015				2014				Decrease
General and administrative		$	4,217			$	3,110				36	%
As a percentage of net revenue			21	%			21	%

                                                            

General and administrative expenses for the three months ended March 31, 2015 increased by $1.1 million, compared to the three months ended March 31, 2014, due to $1.2 million in business development costs comprised of legal, investment banking fees and consultation costs primarily associated with our strategic review process resulting in entering into the Merger Agreement with Francisco Partners.  In connection with the proposed Merger, we entered into retention agreements with certain of our employees, excluding our CEO and CFO, to retain their services through the completion of the Merger.  We expect that in 2015, general and administrative expenses will increase as a result of the merger-related transaction costs associated with the Merger Agreement with Francisco Partners.  Stock-based compensation recorded to general and administrative expense in each of the three months ended March 31, 2015 and 2014 was $0.4 million.  General and administrative expenses as a percentage of revenue remained unchanged for the three months ended March 31, 2015, compared to the corresponding period in 2014 as the increase in general and administrative expense corresponded with increased revenue.  On a non-GAAP basis, after adjusting for stock-based compensation, cost reduction efforts and business development costs, general and administrative expenses for the three months ended March 31, 2015 were $2.6 million, which is a decrease of $0.1 million as compared to $2.7 million in the three months ended March 31, 2014.  (See page 28 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.)
                                                           

Interest and Other Income (Expense), Net

		Three Months Ended March 31,
		2015				2014				Increase
	($ in thousands)
Interest and other income (expense), net		$	(591	)		$	28				(2,211	)%

Interest and other income expense, net increased in the three months ended March 31, 2015 compared to the three months ended March 31, 2014 due to an increase in foreign currency losses associated with the weakening of foreign currencies against the U.S. dollar.
                                                                            

Provision (Benefit) from Income Taxes

		Three Months Ended March 31,
		2015				2014				Decrease
	($ in thousands)
Provision (benefit) from income taxes		$	11			$	(147	)			107	%

We are subject to taxation primarily in the U.S., Australia, Canada, Japan, Singapore and Sweden, as well as in a number of U.S. states, including California.  The tax provision for the three months ended March 31, 2015 primarily reflects state taxes and earnings taxed in foreign jurisdictions.

 

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We have established a valuation allowance for substantially all of our deferred tax assets.  We calculated the valuation allowance in accordance with the provisions of Accounting Standards Codification Topic 740, which requires that a valuation allowance be established or maintained when it is “more likely than not” that all or a portion of deferred tax assets will not be realized.  We will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal.

In this Quarterly Report on Form 10-Q, we include non-GAAP financial measures.  Our management believes that certain non-GAAP financial measures provide investors with additional useful information and regularly uses these supplemental non-GAAP financial measures internally to understand and manage our business and forecast future periods.  In addition, our management believes that these non-GAAP financial measures, when taken together with the corresponding GAAP measures, provide additional insight into the underlying factors and trends affecting both our performance and our cash-generating potential.

Our non-GAAP financial measures include adjustments for stock-based compensation expenses; business development expenses; cost reduction efforts; acquisition-related intangible asset and deferred compensation amortization; and income tax effects. We have excluded the effect of stock-based compensation, the cost of outside professional services for negotiating and performing legal, accounting and tax due diligence for potential mergers and acquisitions and other strategic transactions, expenses connected with cost reduction efforts, acquisition-related intangible asset and deferred compensation amortization, impairment of goodwill and intangible assets and income tax effects from our non-GAAP gross profit, operating expenses and net income measures. Stock-based compensation, which represents the estimated fair value of stock options, restricted stock and restricted stock units granted to employees, is excluded since grant activities vary significantly from quarter to quarter in both quantity and fair value. In addition, although stock-based compensation will recur in future periods, excluding this expense allows us to better compare core operating results with those of our competitors who also generally exclude stock-based compensation from their core operating results and who may have different granting patterns and types of equity awards and who may use different option valuation assumptions than we do. Business development expenses are necessary as part of certain growth strategies, such as through mergers and acquisitions and other strategic transactions, and will occur when such transactions are pursued. We have excluded these expenses because they can vary materially from period-to-period and transaction-to-transaction and expenses associated with these business development activities are not considered a key measure of our operating performance. Cost reduction efforts occur with shifts in objectives and evolving requirements of the business and can result in fluctuating expenses connected with reducing employment in certain areas.  We have excluded these expenses because they can vary significantly from period-to-period and are not considered a key measure of our operating performance.  Acquisition-related intangible assets and deferred compensation amortization and income tax effects represent non-cash charges and benefits that result from the accounting for acquisitions. We have excluded these items because, in any period, they may not directly correlate to the underlying performance of our business and can vary materially from period-to-period and transaction-to-transaction. In addition, we exclude these acquisition-related costs and benefits when evaluating our current operating performance.

Our non-GAAP financial measures may not reflect the full economic impact of our activities. Further, these non-GAAP financial measures may be unique to us as they may differ from non-GAAP financial measures used by other companies, including our competitors. As such, this presentation of non-GAAP financial measures may not enhance the comparability of our results to the results of other companies. Therefore, these non-GAAP financial measures are limited in their usefulness and investors are cautioned not to place undue reliance on our non-GAAP financial measures. In addition, investors are cautioned that these non-GAAP financial measures are not intended to be considered in isolation and should be read in conjunction with our consolidated financial statements prepared in accordance with GAAP.

 

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A reconciliation of unaudited non-GAAP financial measures to the most directly comparable GAAP financial measure, net loss, is as follows:

		Three Months Ended March 31,
		2015				2014
		($ in thousands)
Sales:
Product sales		$	15,172			$	9,504
Support sales			5,331				5,037
Total sales			20,503				14,541
Cost of sales:
Product cost of sales, GAAP			7,155				5,091
Non-GAAP adjustments:
Stock-based compensation (1)			(9	)			(15	)
Amortization of intangibles (2)			(182	)			(262	)
Cost reduction efforts (3)			—				(237	)
Product cost of sales, non-GAAP			6,964				4,577
Support cost of sales, GAAP			1,238				1,066
Non-GAAP adjustments:
Stock-based compensation (1)			(102	)			(82	)
Support cost of sales, non-GAAP			1,136				984
Total cost of sales, non-GAAP			8,100				5,561
Gross profit, non-GAAP			12,403				8,980
Operating expenses:
Research and development, GAAP			3,431				4,548
Non-GAAP adjustments:
Stock-based compensation (1)			(359	)			(388	)
Cost reduction efforts (3)			—				(206	)
Deferred compensation (4)			—				(65	)
Research and development, non-GAAP			3,072				3,889
Sales and marketing, GAAP			7,159				6,877
Non-GAAP adjustments:
Stock-based compensation (1)			(297	)			(408	)
Amortization of intangibles (2)			(43	)			(113	)
Cost reduction efforts (3)			—				(74	)
Sales and marketing, non-GAAP			6,819				6,282
General and administrative, GAAP			4,217				3,110
Non-GAAP adjustments:
Stock-based compensation (1)			(440	)			(420	)
Cost reduction efforts (3)			—				(27	)
Business development expenses (5)			(1,191	)			—
General and administrative, non-GAAP			2,586				2,663
Total operating expenses, non-GAAP			12,477				12,834
Loss from operations, non-GAAP			(74	)			(3,854	)
Interest and other income (expense), net			(591	)			28
Income tax provision (benefit)			11				(147	)
Non-GAAP adjustments (6):			—				179
Income tax provision, non- GAAP			11				32
Non-GAAP net loss		$	(676	)		$	(3,858	)
Non-GAAP net loss per common share – diluted		$	(0.03	)		$	(0.19	)
Weighted average number of shares used in per share calculation-diluted			20,674				20,329
Reconciliation of net income (loss):
U.S. GAAP as reported		$	(3,299	)		$	(5,976	)
Non-GAAP adjustments:
Stock-based compensation (1)			1,207				1,313
Amortization of intangibles (2)			225				375
Cost reduction efforts (3)			—				544
Deferred compensation (4)			—				65
Business development expenses (5)			1,191				—
Income tax provision, non-GAAP (6)			—				(179	)
As adjusted		$	(676	)		$	(3,858	)
Reconciliation of diluted net income (loss) per share:
U.S. GAAP as reported		$	(0.16	)		$	(0.29	)
Non-GAAP adjustments:
Stock-based compensation (1)			0.06				0.06
Amortization of intangibles (2)			0.01				0.02
Cost reduction efforts (3)			—				0.03
Deferred compensation (4)			—				—
Business development expenses (5)			0.06				—
Income tax provision, non-GAAP (6)			—				(0.01	)
As adjusted		$	(0.03	)		$	(0.19	)
Shares used in computing diluted net loss per share:
Diluted			20,674				20,329