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EX-32.1 - EXHIBIT 32.1 - Sonus, Inc.sons-ex32120170331.htm
EX-32.2 - EXHIBIT 32.2 - Sonus, Inc.sons-ex32220170331.htm
EX-31.2 - EXHIBIT 31.2 - Sonus, Inc.sons-ex31220170331.htm
EX-31.1 - EXHIBIT 31.1 - Sonus, Inc.sons-ex31120170331.htm

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
(Mark One)
x
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2017
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, smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer o
 
Accelerated filer x
 
Non-accelerated filer o
 (Do not check if a smaller
reporting company)
 
Smaller reporting company o
 
 
 
 
 
 
Emerging growth company o

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act) 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 April 21, 2017, there were 49,522,648 shares of the registrant's common stock, $0.001 par value, outstanding.
 



SONUS NETWORKS, INC.
FORM 10-Q
QUARTERLY PERIOD ENDED MARCH 31, 2017
TABLE OF CONTENTS

Item
 
Page
 
PART I FINANCIAL INFORMATION
 
 
 
 
 
 
 
 
 
 
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, plans for future cost reductions 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.
References in this Quarterly Report on Form 10-Q to “Sonus,” “Sonus Networks,” “Company,” “we,” “us,” and “our” are to Sonus Networks, Inc. and its subsidiaries, collectively, unless the context requires 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)

 
March 31,
2017
 
December 31,
2016
Assets
Current assets:
 
 
 
Cash and cash equivalents
$
31,931

 
$
31,923

Marketable securities
59,680

 
61,836

Accounts receivable, net of allowance for doubtful accounts of $10 at both March 31, 2017 and December 31, 2016
39,616

 
53,862

Inventory
17,671

 
18,283

Other current assets
12,988

 
12,010

Total current assets
161,886

 
177,914

Property and equipment, net
10,954

 
11,741

Intangible assets, net
27,938

 
30,197

Goodwill
49,891

 
49,393

Investments
37,193

 
32,371

Deferred income taxes
1,578

 
1,542

Other assets
4,914

 
4,901

 
$
294,354

 
$
308,059

Liabilities and Stockholders' Equity
Current liabilities:
 
 
 
Accounts payable
$
5,988

 
$
6,525

Accrued expenses
15,786

 
25,886

Current portion of deferred revenue
46,430

 
43,504

Current portion of long-term liabilities
1,172

 
1,154

Total current liabilities
69,376

 
77,069

Deferred revenue
8,142

 
7,188

Deferred income taxes
3,255

 
3,047

Other long-term liabilities
1,566

 
1,633

Total liabilities
82,339

 
88,937

Commitments and contingencies (Note 15)

 

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; 120,000,000 shares authorized; 49,297,373 shares issued and outstanding at March 31, 2017; 49,041,881 shares issued and outstanding at December 31, 2016
49

 
49

Additional paid-in capital
1,254,155

 
1,250,744

Accumulated deficit
(1,047,820
)
 
(1,037,174
)
Accumulated other comprehensive income
5,631

 
5,503

Total stockholders' equity
212,015

 
219,122

 
$
294,354

 
$
308,059


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
 
March 31,
2017
 
March 31,
2016
Revenue:
 
 
 
Product
$
25,395

 
$
34,769

Service
27,973

 
24,382

Total revenue
53,368

 
59,151

Cost of revenue:
 
 
 
Product
9,753

 
11,536

Service
9,867

 
9,212

Total cost of revenue
19,620

 
20,748

Gross profit
33,748

 
38,403

Operating expenses:
 
 
 
Research and development
20,209

 
17,318

Sales and marketing
14,676

 
16,595

General and administrative
9,019

 
8,371

Acquisition-related
56

 

Restructuring
570

 

Total operating expenses
44,530

 
42,284

Loss from operations
(10,782
)
 
(3,881
)
Interest income, net
258

 
164

Other income, net
1

 
103

Loss before income taxes
(10,523
)
 
(3,614
)
Income tax provision
(123
)
 
(1,040
)
Net loss
$
(10,646
)
 
$
(4,654
)
Loss per share:
 
 
 
Basic
$
(0.22
)
 
$
(0.09
)
Diluted
$
(0.22
)
 
$
(0.09
)
Shares used to compute loss per share:
 
 
 
Basic
49,114

 
49,484

Diluted
49,114

 
49,484


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
 
March 31,
2017
 
March 31,
2016
Net loss
$
(10,646
)
 
$
(4,654
)
Other comprehensive income, net of tax:
 
 
 
Foreign currency translation adjustments
125

 
173

Unrealized gain on available-for sale marketable securities, net of tax
3

 
235

Reclassification adjustment for realized losses included in net loss

 
18

Other comprehensive income, net of tax
128

 
426

Comprehensive loss, net of tax
$
(10,518
)
 
$
(4,228
)

See notes to the unaudited condensed consolidated financial statements.


6


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


 
Three months ended
 
March 31,
2017
 
March 31,
2016
Cash flows from operating activities:
 
 
 
Net loss
$
(10,646
)
 
$
(4,654
)
Adjustments to reconcile net loss to cash flows provided by operating activities:
 
 
 
Depreciation and amortization of property and equipment
1,823

 
1,981

Amortization of intangible assets
2,259

 
1,946

Stock-based compensation
3,263

 
4,415

Loss on disposal of property and equipment

 
14

Deferred income taxes
238

 
418

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
14,324

 
17,267

Inventory
315

 
(1,237
)
Other operating assets
(405
)
 
(3,531
)
Accounts payable
(651
)
 
(1,592
)
Accrued expenses and other long-term liabilities
(10,530
)
 
(13,855
)
Deferred revenue
3,614

 
2,142

Net cash provided by operating activities
3,604

 
3,314

Cash flows from investing activities:
 
 
 
Purchases of property and equipment
(998
)
 
(952
)
Business acquisition, net of cash acquired

 
(750
)
Purchases of marketable securities
(18,632
)
 
(29,574
)
Maturities/sales of marketable securities
15,693

 
21,867

Net cash (used in) provided by investing activities
(3,937
)
 
(9,409
)
Cash flows from financing activities:
 
 
 
Proceeds from sale of common stock in connection with employee stock purchase plan
593

 
632

Proceeds from exercise of stock options
51

 
5

Payment of tax withholding obligations related to net share settlements of restricted stock awards
(496
)
 
(786
)
Repurchase of common stock

 
(1,456
)
Principal payments of capital lease obligations
(10
)
 
(14
)
Net cash provided by (used in) financing activities
138

 
(1,619
)
Effect of exchange rate changes on cash and cash equivalents
203

 
252

Net increase (decrease) in cash and cash equivalents
8

 
(7,462
)
Cash and cash equivalents, beginning of year
31,923

 
50,111

Cash and cash equivalents, end of period
$
31,931

 
$
42,649

Supplemental disclosure of cash flow information:
 
 
 
Interest paid
$
66

 
$
9

Income taxes paid
$
490

 
$
248

Income tax refunds received
$
80

 
$
165

Supplemental disclosure of non-cash investing activities:
 
 
 
Capital expenditures incurred, but not yet paid
$
318

 
$
248

Property and equipment acquired under capital lease
$

 
$
36


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”) is a leading provider of networked solutions for communications service providers (e.g., telecommunications, wireless and cable service providers) and enterprises to help them secure and unify their real-time communications infrastructures. Sonus helps many of the world's leading communications service providers and enterprises embrace the next generation of Session Initiation Protocol ("SIP") and 4G/LTE (Long-Term Evolution)-based solutions, including Voice over IP ("VoIP"), Voice over WiFi ("VoWiFi"), video and Unified Communications ("UC") through secure, reliable and scalable Internet Protocol ("IP") networks. Sonus' products include session border controllers ("SBCs"), diameter signaling controllers ("DSCs") and VoWiFi solutions, which are supported by a global services team with experience in the design, deployment and maintenance of the world's largest IP networks.

Sonus' communications solutions provide a secure way for its customers to link and leverage multivendor, multiprotocol communications systems and applications across their networks, around the world and in a rapidly changing ecosystem of IP-enabled devices such as smartphones and tablets. Sonus' solutions help realize the intended value and benefits of UC platforms by allowing disparate communications environments, commonplace in most enterprises today, to work seamlessly together. Likewise, Sonus' solutions facilitate the evolution to cloud-based delivery of UC solutions.

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, 2016 (the "Annual Report"), which was filed with the SEC on February 27, 2017.

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 months ended March 31, 2017.

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.


8


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

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 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

In January 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment ("ASU 2017-04"), which removes the requirement to compare the implied fair value of goodwill with its carrying amount as part of step two of the goodwill impairment test. As a result, under ASU 2017-04, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, ASU 2017-04 clarifies the requirements for excluding and allocating foreign currency translation adjustments to reporting units in connection with an entity's testing of reporting units for goodwill impairment; clarifies that an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable; and makes minor changes to other related guidance within the Accounting Standards Codification ("ASC"). ASU 2017-04 is effective prospectively for the Company beginning January 15, 2020, with early adoption permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company elected to early-adopt ASU 2017-04 as of January 1, 2017; such early adoption did not have a material impact on the Company's consolidated financial results.

In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory ("ASU 2016-16"), which removes the prohibition in ASC 740, Income Taxes, against the immediate recognition of the current and deferred income tax effects of intra-entity transfers of assets other than inventory. ASU 2016-16 is intended to reduce the complexity of GAAP and diversity in practice related to the tax consequences of certain types of intra-entity asset transfers, particularly those involving intellectual property. ASU 2016-16 is effective for the Company beginning January 1, 2019 for both interim and annual reporting periods. The Company does not believe that the adoption of ASU 2016-16 will have a material impact on its consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments ("ASU 2016-15"), which amends the guidance in ASC 230 on the classification of certain cash receipts and payments in the statement of cash flows. The primary purpose of ASU 2016-15 is to reduce the diversity in practice that has resulted from the lack of consistent principles on this topic. ASU 2016-15 adds or clarifies guidance on eight cash flow issues, including debt prepayment or debt extinguishment costs, settlement of zero-coupon debt instruments or certain other debt instruments, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned life insurance policies, distributions received from equity method investees, beneficial interests in securitization transactions and separately identifiable cash flows and application of the predominance principle. ASU 2016-15 is effective for the Company beginning January 1, 2018 for both interim and annual reporting periods, with early adoption permitted. Entities must apply the guidance retrospectively to all periods presented but may apply it prospectively from the earliest date practicable if retrospective application would be impracticable. The Company does not expect the adoption of ASU 2016-15 will have a material impact on its consolidated financial statements.


9


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

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"), which adds an impairment model that is based on expected losses rather than incurred losses. Under ASU 2016-13, an entity recognizes as an allowance its estimate of expected credit losses, which the FASB believes will result in more timely recognition of such losses. ASU 2016-13 is effective for the Company beginning January 1, 2020 for both interim and annual reporting periods, with early adoption permitted. The Company does not expect the adoption of ASU 2016-13 will have a material impact on its consolidated financial statements.

In March 2016, the FASB issued ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting ("ASU 2016-09"), which simplifies several aspects of the accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures and statutory tax withholding requirements, as well as classification in the statement of cash flows. ASU 2016-09 became effective for the Company beginning January 1, 2017 for both interim and annual reporting periods. Under ASU 2016-09, the Company will now recognize unrealized excess tax benefits. Due to the Company's full valuation allowance on its federal and state income taxes, the adoption of ASU 2016-09 did not have a material impact on the Company's accounting for income taxes. Without the valuation allowance, the Company would have recognized an increased deferred tax asset approximating $5 million. The Company has elected to continue to apply forfeiture rates to its expense attribution related to stock options, restricted stock awards and restricted stock units, as the Company believes that such continued application results in more accurate expense attribution over the life of these equity grants. The adoption of ASU 2016-09 did not have a material impact on the Company's consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) Section A - Leases: Amendments to the FASB Accounting Standards Codification ("ASU 2016-02"), its new standard on accounting for leases. ASU 2016-02 introduces a lessee model that brings most leases onto the balance sheet. The new standard also aligns many of the underlying principles of the new lessor model with those in ASC 606, the FASB's new revenue recognition standard (i.e., those related to evaluating when profit can be recognized). Furthermore, ASU 2016-02 addresses other concerns related to the current leases model. For example, ASU 2016-02 eliminates the current GAAP requirement for an entity to use bright-line tests in determining lease classification. ASU 2016-02 is effective for the Company for both interim and annual periods beginning January 1, 2019. The Company is currently assessing the potential impact of the adoption of ASU 2016-02 on its consolidated financial statements.

In July 2015, the FASB issued ASU 2015-11, Simplifying the Measurement of Inventory ("ASU 2015-11"), which simplifies the measurement of inventory by requiring entities to measure most inventory at the lower of cost and net realizable value, replacing the previous requirement to measure most inventory at the lower of cost or market. ASU 2015-11 does not apply to inventories that are measured by using either the last-in, first-out method or the retail inventory method. ASU 2015-11 became effective for the Company for both interim and annual reporting periods beginning January 1, 2017. The adoption of ASU 2015-11 did not have a material impact on the Company's consolidated financial statements.

In August 2014, the FASB issued ASU 2014-15, Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern ("ASU 2014-15"), which provides guidelines for determining when and how to disclose going concern uncertainties in the financial statements. The new standard requires management to perform interim and annual assessments of an entity's ability to continue as a going concern within one year of the date the financial statements are issued. An entity must provide certain disclosures if conditions or events raise substantial doubt about the entity's ability to continue as a going concern. ASU 2014-15 was effective for the Company beginning January 1, 2017. The adoption of ASU 2014-15 did not have a material impact on the Company's consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), its final standard on revenue from contracts with customers, along with additional ASUs which, among other things, clarified the implementation of the new revenue guidance and delayed the adoption by one year, to January 1, 2018 (collectively, the "New Revenue Standard"). The New Revenue Standard 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

10


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

performance obligation. The New Revenue Standard applies to all contracts with customers that are within the scope of other topics in the ASC. Certain of the New Revenue Standard'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. The Company continues to assess the potential impact of the adoption of the New Revenue Standard on its consolidated financial statements, and currently believes that such adoption will, in general, accelerate the recognition of revenue (i.e., more revenue will be recognized upon delivery than is currently recognized ratably or upon payment) compared to the current standards in effect, in particular, sales of software-only products and sales to customers currently accounted for on a cash basis. The Company currently expects to adopt the New Revenue Standard using the modified retrospective option.


(2) BUSINESS ACQUISITION

On September 26, 2017 (the "Taqua Acquisition Date"), the Company acquired Taqua, LLC ("Taqua"), a leading supplier of IP communications systems, applications and services to mobile and fixed operators. Taqua enables the transformation of software-based service provider networks to deliver next-generation voice, video and messaging services, including VoIP, VoWiFi and Voice over Long-Term Evolution ("VoLTE"). The acquisition of Taqua has, among other things, accelerated the Company's mobile strategy by adding a Virtualized Mobile Core ("VMC") Platform and an IP Multimedia Subsystem ("IMS") Service Core and expanded the Company's fixed portfolio by adding a Class 5 Softswitch (the T7000) for network transformation projects and a Multimedia Controller used in IP Peering applications (the T7100), both of which are complementary to Sonus' current product offerings. In consideration for the acquisition of Taqua, Sonus paid $19.9 million in cash to the sellers on the Taqua Acquisition Date, net of cash acquired. The Company also entered into an Earn-Out Agreement, dated as of September 26, 2016, with Taqua Holdings, LLC and Jeffrey L. Brawner, the seller representative in the transaction, under which there is the potential for additional cash payments of up to $65.0 million in the aggregate to the sellers if certain annual revenue thresholds are exceeded as measured annually through 2020. The Company had initially recorded $10.0 million of contingent consideration as of the Taqua Acquisition Date, with the estimate based on historical sales and probability weighted cash flows related to forecasted sales. During the fourth quarter of 2016, the Company reassessed the historical and updated forecasted sales and accordingly, reversed the previous estimated contingent consideration such that as of both March 31, 2017 and December 31, 2016, no incremental contingent consideration was recorded.

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

As of March 31, 2017, the valuation of acquired assets, identifiable intangible assets and certain accrued liabilities is preliminary. The Company is still in the process of investigating the facts and circumstances existing as of the Taqua Acquisition Date in order to finalize its valuation, particularly, short-term assets and liabilities, including accounts receivable, inventory and accrued expenses, and intangible assets. During both the first quarter of 2017 and the fourth quarter of 2016, the Company recorded changes to the initial preliminary purchase price allocation. The primary adjustments in the first quarter of 2017 were a $0.4 million increase to current liabilities and a $0.1 million increase to noncurrent liabilities. The primary adjustments recorded in the fourth quarter of 2016 were the reversal of the $10.0 million of previously recorded contingent consideration discussed above, a reduction of $12.1 million to the developed technology intangible asset and an increase of $5.5 million to the customer relationship intangible assets. These adjustments, as well as other immaterial adjustments to the balance sheet accounts, resulted in a net reduction to goodwill of $2.2 million since September 30, 2016. Based on this updated preliminary purchase price allocation, the Company recorded $9.6 million of goodwill, which is primarily due to expected synergies between the combined companies and expanded market opportunities resulting from the expanded product offering portfolio. The goodwill is deductible for tax purposes. The Company expects to finalize the valuation of the assets acquired and liabilities assumed in the second quarter of 2017.


11


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

A summary of the preliminary allocation of the purchase consideration for Taqua is as follows (in thousands):

Fair value of consideration transferred:
 
  Cash, net of cash acquired
$
19,919

 
 
Fair value of assets acquired and liabilities assumed:
 
  Current assets
$
3,347

  Property and equipment
1,478

  Intangible assets:
 
    Developed technology
2,100

    Customer relationships
9,510

  Goodwill
9,581

  Other noncurrent assets
23

  Current liabilities
(5,435
)
  Long-term liabilities
(685
)
 
$
19,919



The valuation of the acquired intangible assets is inherently subjective and relies on significant unobservable inputs. The Company used an income approach to value the acquired developed technology and customer relationship intangible assets. The preliminary 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 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 financial information, as the historical amount are not significant to the Company's consolidated financial statements.

Acquisition-Related Expenses

Acquisition-related expenses include those expenses related to acquisitions 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, as well as cash payments to certain employees of acquired companies in connection with change of control agreements. The Company recorded $56,000 of acquisition-related expenses in the three months ended March 31, 2017 related to professional fees in connection with the acquisition of Taqua. The Company did not record acquisition-related expenses in the three months ended March 31, 2016.

 
 
 
 
 
 
 
 


(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.


12


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

The calculations of shares used to compute basic and diluted loss per share are as follows (in thousands):
 
Three months ended
 
March 31,
2017
 
March 31,
2016
Weighted average shares outstanding—basic
49,114

 
49,484

Potential dilutive common shares

 

Weighted average shares outstanding—diluted
49,114

 
49,484



Options to purchase the Company's common stock, unvested shares of restricted stock, unvested shares of performance-based stock and shares in connection with future purchases under the Company's Amended and Restated 2000 Employee Stock Purchase Plan, as amended (the "ESPP"), totaling 8.4 million shares for the three months ended March 31, 2017 and 7.7 million shares for the three months ended March 31, 2016 have not been included in the computation of diluted loss per share because their effect would have been antidilutive.


(4) CASH EQUIVALENTS 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.

During the three months ended March 31, 2016, the Company sold $3.8 million of its available-for-sale securities and recognized gross losses aggregating $18,000, which is included as a component of Other income, net, in the Company's condensed consolidated statement of operations for that period. The Company did not sell any of its available-for-sale securities in the three months ended March 31, 2017. Investments with continuous unrealized losses for one year or greater at March 31, 2017 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. Based on its reviews, the Company does not believe that any impairment existed with its current holdings at March 31, 2017.

The amortized cost, gross unrealized gains and losses and fair value of the Company's marketable debt securities and investments at March 31, 2017 and December 31, 2016 were comprised of the following (in thousands):

 
March 31, 2017
 
Amortized
cost
 
Unrealized
gains
 
Unrealized
losses
 
Fair
value
Cash equivalents
$
4,822

 
$

 
$

 
$
4,822

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
Municipal obligations
$
2,672

 
$

 
$
(1
)
 
$
2,671

U.S. government agency notes
20,880

 

 
(21
)
 
20,859

Corporate debt securities
35,696

 
2

 
(39
)
 
35,659

Certificates of deposit
491

 

 

 
491

 
$
59,739

 
$
2

 
$
(61
)
 
$
59,680

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
17,609

 
$
6

 
$
(41
)
 
$
17,574

Corporate debt securities
14,550

 
2

 
(29
)
 
14,523

Certificates of deposit
5,096

 

 

 
5,096

 
$
37,255

 
$
8

 
$
(70
)
 
$
37,193




13


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

 
December 31, 2016
 
Amortized
cost
 
Unrealized
gains
 
Unrealized
losses
 
Fair
value
Cash equivalents
$
6,619

 
$

 
$

 
$
6,619

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
Municipal obligations
$
3,264

 
$

 
$
(3
)
 
$
3,261

U.S. government agency notes
16,477

 
3

 
(3
)
 
16,477

Corporate debt securities
41,893

 
4

 
(45
)
 
41,852

Certificates of deposit
246

 

 

 
246

 
$
61,880

 
$
7

 
$
(51
)
 
$
61,836

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
19,473

 
$
3

 
$
(39
)
 
$
19,437

Corporate debt securities
10,520

 

 
(44
)
 
10,476

Certificates of deposit
2,458

 

 

 
2,458

 
$
32,451

 
$
3

 
$
(83
)
 
$
32,371



The Company's available-for-sale debt securities classified as Investments in the condensed consolidated balance sheets at March 31, 2017 and December 31, 2016 had maturity dates after one year but within approximately 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 March 31, 2017 and December 31, 2016. 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 condensed consolidated balance sheets (in thousands):

14


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

 
 
 
Fair value measurements at
March 31, 2017 using:
 
Total carrying
value at
March 31, 2017
 
Quoted prices
in active
markets
(Level 1)
 
Significant other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Cash equivalents
$
4,822

 
$
4,822

 
$

 
$

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
Municipal obligations
$
2,671

 
$

 
$
2,671

 
$

U.S. government agency notes
20,859

 

 
20,859

 

Corporate debt securities
35,659

 

 
35,659

 

Certificates of deposit
491

 

 
491

 

 
$
59,680

 
$

 
$
59,680

 
$

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
17,574

 
$

 
$
17,574

 
$

Corporate debt securities
14,523

 

 
14,523

 

Certificates of deposit
5,096

 

 
5,096

 

 
$
37,193

 
$

 
$
37,193

 
$



 
 
 
Fair value measurements at
December 31, 2016 using:
 
Total carrying
value at
December 31,
2016
 
Quoted prices
in active
markets
(Level 1)
 
Significant other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Cash equivalents
$
6,619

 
$
6,619

 
$

 
$

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
Municipal obligations
$
3,261

 
$

 
$
3,261

 
$

U.S. government agency notes
16,477

 

 
16,477

 

Corporate debt securities
41,852

 

 
41,852

 

Certificates of deposit
246

 

 
246

 

 
$
61,836

 
$

 
$
61,836

 
$

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
19,437

 
$

 
$
19,437

 
$

Corporate debt securities
10,476

 

 
10,476

 

Certificates of deposit
2,458

 

 
2,458

 

 
$
32,371

 
$

 
$
32,371

 
$


The Company's marketable securities and investments have been valued with the assistance 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 at March 31, 2017 and December 31, 2016 consists of the following (in thousands):
 
March 31,
2017
 
December 31,
2016
On-hand final assemblies and finished goods inventories
$
16,554

 
$
15,346

Deferred cost of goods sold
2,717

 
4,237

 
19,271

 
19,583

Less current portion
(17,671
)
 
(18,283
)
Noncurrent portion (included in Other assets)
$
1,600

 
$
1,300



(6) INTANGIBLE ASSETS AND GOODWILL

The Company's intangible assets at March 31, 2017 and December 31, 2016 consist of the following (dollars in thousands):
March 31, 2017
Weighted average amortization period
(years)
 
Cost
 
Accumulated
amortization
 
Net
carrying value
Developed technology
6.54
 
$
34,980

 
$
18,019

 
$
16,961

Customer relationships
5.78
 
19,540

 
8,563

 
10,977

Internal use software
3.00
 
730

 
730

 

 
6.23
 
$
55,250

 
$
27,312

 
$
27,938


December 31, 2016
Weighted average amortization period
(years)
 
Cost
 
Accumulated
amortization
 
Net
carrying value
Developed technology
6.54
 
$
34,980

 
$
16,453

 
$
18,527

Customer relationships
5.78
 
19,540

 
7,870

 
11,670

Internal use software
3.00
 
730

 
730

 

 
6.23
 
$
55,250

 
$
25,053

 
$
30,197



Amortization expense for intangible assets for the three months ended March 31, 2017 and 2016 was as follows (in thousands):
 
Three months ended
 
Statement of operations classification
 
March 31,
2017
 
March 31,
2016
 
Developed technology
$
1,566

 
$
1,627

 
Cost of revenue - product
Customer relationships
693

 
319

 
Sales and marketing
 
$
2,259

 
$
1,946

 
 


Estimated future amortization expense for the Company's intangible assets at March 31, 2017 is as follows (in thousands):


16


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

Years ending December 31,
 
Remainder of 2017
$
6,878

2018
6,615

2019
5,608

2020
4,166

2021
2,395

Thereafter
2,276

 
$
27,938



The changes in the carrying value of the Company's goodwill in the three months ended March 31, 2017 were as follows (in thousands):
 
 
Balance at January 1, 2017
 
  Goodwill
$
52,499

  Accumulated impairment losses
(3,106
)
 
49,393

Purchase accounting adjustments - Taqua
498

Balance at March 31, 2017
$
49,891

 
 
Balance at March 31, 2017
 
  Goodwill
$
52,997

  Accumulated impairment losses
(3,106
)
 
$
49,891


There were no changes in the carrying value of the Company's goodwill in the three months ended March 31, 2016.
 
 


(7) ACCRUED EXPENSES
Accrued expenses at March 31, 2017 and December 31, 2016 consist of the following (in thousands):
 
March 31,
2017
 
December 31,
2016
Employee compensation and related costs
$
9,200

 
$
15,879

Other
6,586

 
10,007

 
$
15,786

 
$
25,886



(8) RESTRUCTURING ACCRUAL

2016 Restructuring Initiative

In July 2016, the Company announced a program to further accelerate its investment in new technologies as the communications industry migrates to a cloud-based architecture (the "2016 Restructuring Initiative"). The Company expects to record between $3 million and $4 million of restructuring expense in the aggregate in connection with this action, resulting in expected annual savings of approximately $6 million to $8 million. To date, the Company has recorded $1.7 million of restructuring expense in the aggregate in connection with this initiative and expects to record the remaining $1.3 million to $2.3 million by the end of the third quarter of 2017. The Company intends to utilize the majority of these savings to shift headcount toward new strategic initiatives, such as new products and an expanded go-to-market footprint in selected geographies and discrete vertical markets. In connection with this restructuring initiative, the Company recorded $0.2 million of restructuring expense in the three months ended March 31, 2017. A summary of the 2016 Restructuring Initiative accrual activity for the

17


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

three months ended March 31, 2017 is as follows (in thousands):


 
Balance at
January 1,
2017
 
Initiatives
charged to
expense
 
Adjustments for changes in estimate
 
Cash
payments
 
Balance at
March 31, 2017
Severance
$
497

 
$
236

 
$
(26
)
 
$
(420
)
 
$
287


The Company expects that the amounts accrued under the 2016 Restructuring Initiative will be paid by end of the fourth quarter of 2017.

Taqua Restructuring Initiative

In connection with the acquisition of Taqua, the Company's management approved a restructuring plan in the third quarter of 2016 to eliminate certain redundant positions within the combined companies. On October 24, 2016, the Audit Committee of the Company's Board of Directors approved a broader Taqua restructuring plan related to headcount and redundant facilities (both restructuring plans, the "Taqua Restructuring Initiative"). In connection with this initiative, the Company recorded $0.4 million of restructuring expense in the three months ended March 31, 2017. The Company anticipates it will record additional future expense in connection with this initiative for headcount and redundant facilities aggregating approximately $1 million through the third quarter of 2017. A summary of the Taqua Restructuring Initiative accrual activity for the three months ended March 31, 2017 is as follows (in thousands):

 
Balance at
January 1,
2017
 
Initiatives
charged to
expense
 
Adjustments for changes in estimate
 
Cash
payments
 
Balance at
March 31, 2017
Severance
$
384

 
$
39

 
$
(49
)
 
$
(365
)
 
$
9

Facilities
218

 
370

 

 
(94
)
 
494

 
$
602

 
$
409

 
$
(49
)
 
$
(459
)
 
$
503



2015 Restructuring Initiative

To better align the Company's cost structure to its current revenue expectations, in April 2015, the Company announced a cost reduction review and restructuring initiative (the "2015 Restructuring Initiative"). A summary of the 2015 Restructuring Initiative accrual activity for the three months ended March 31, 2017 is as follows (in thousands):

 
Balance at
January 1,
2017
 
Initiatives
charged to
expense
 
Adjustments for changes in estimate
 
Cash
payments
 
Balance at
March 31, 2017
Severance
$
168

 
$

 
$

 
$
(168
)
 
$



Balance Sheet Classification

At March 31, 2017, the Company's restructuring accruals aggregated $0.8 million, of which approximately $0.2 million was included in Other long-term liabilities and represented future lease payments on restructured facilities. At December 31, 2016, the Company's restructuring accruals aggregated $1.3 million, of which approximately $62,000 was included in Other long-term liabilities and represented future lease payments on restructured facilities. The remainder of the restructuring accruals at both March 31, 2017 and December 31, 2016 are included in Accrued expenses in the condensed consolidated balance sheets.


18


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


(9) DEBT

The Company entered into a 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 on June 27, 2014 (the "Credit Agreement"), which agreement was amended by a First Amendment to Credit Agreement on June 26, 2015 (the "First Amendment") and further amended by a Second Amendment to Credit Agreement on June 13, 2016 (the "Second Amendment" and collectively with the Credit Agreement and the First Amendment, the "Amended Credit Agreement"). Certain terms of the Credit Agreement have been amended by the Second Amendment, including, among other things: (i) an increase of the commitments from $15 million to $20 million; (ii) an extension of the maturity date from June 30, 2016 to June 30, 2017; (iii) a reduction to the aggregate amount of cash and cash equivalents that the Loan Parties (as defined below) are required to hold at any time from $85 million to $50 million; and (iv) a reduction of the commitment fee on the unused commitments available for borrowing from 0.15% to 0.1125%. The Amended Credit Agreement provides that the Company may select the interest rates under the credit facility from among the following options: (i) 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 (ii) 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 obligations of the Company under the Amended Credit Agreement are guaranteed by Sonus International, Inc., Sonus Federal, Inc., Network Equipment Technologies, Inc. ("NET") and Taqua (collectively 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 Amended 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 total revenues of the Loan Parties cannot be less than an aggregate of $50 million as of the last day of the Loan Parties' fiscal quarter, computed on a fiscal quarterly basis. The credit facility will become due on June 30, 2017, 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 of warranties, bankruptcy and insolvency-related defaults, defaults relating to judgments, an ERISA Event (as defined in the Amended Credit Agreement), the failure to pay specified indebtedness and a change of control default.

The Company did not have any amounts outstanding under the Amended Credit Agreement at either March 31, 2017 or December 31, 2016.


(10) COMMON STOCK REPURCHASES

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 funded with the Company's working capital. The Company did not repurchase any shares during the three months ended March 31, 2017. During the three months ended March 31, 2016, the Company spent $1.5 million, including transaction fees, to repurchase and retire 0.2 million shares of its common stock under the stock buyback program. At March 31, 2017, the Company had $5.4 million remaining under the stock buyback program for future repurchases.



19


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

(11) STOCK-BASED COMPENSATION PLANS

Amended and Restated Stock Incentive Plan

The Company's Amended and Restated Stock Incentive Plan, as amended (the "Plan"), provides for the award of options to purchase the Company's common stock ("stock options"), stock appreciation rights ("SARs"), restricted common stock awards ("RSAs"), restricted common stock units ("RSUs"), performance-based stock awards ("PSAs"), performance-based stock units ("PSUs") 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 Company and its subsidiaries.

Executive Equity Arrangements

On March 31, 2017, the Company granted an aggregate of 165,000 PSUs with both market and service conditions to five of its executives (the "2017 PSUs"). The terms of the 2017 PSUs are such that up to one-third of the shares subject to the 2017 PSUs will vest on each of the first, second and third anniversaries of the date of grant (collectively, the "2017 PSU Vesting Dates") to the extent of achievement of the Company's total shareholder return ("TSR") compared to the TSR of the companies included in the NASDAQ Telecommunications Index for the same fiscal year, measured by the Compensation Committee after each of the 2017, 2018 and 2019 fiscal years, respectively (as used in this paragraph, each, a "Performance Period"). The shares determined to be earned will vest on the anniversary of the grant date following each Performance Period. Shares subject to the 2017 PSUs that fail to be earned will be forfeited. The 2017 PSUs include a market condition that required the use of a Monte Carlo simulation approach to model future stock price movements based upon the risk-free rate of return, the volatility of each entity, and the pair-wise covariance between each entity. These results were then used to calculate the grant date fair values of the 2017 PSUs. Because the 2017 PSUs have market conditions, the Company is required to record expense for the 2017 PSUs through the final 2017 PSU Vesting Date of March 31, 2020, regardless of the number of shares that are ultimately earned.

On April 1, 2016, the Company granted an aggregate of 131,250 PSUs with both market and service conditions to six of its executives (the "2016 PSUs"). The terms of the 2016 PSUs are such that up to one-third of the shares subject to the 2016 PSUs will vest on each of the first, second and third anniversaries of the date of grant (collectively, the "2016 PSU Vesting Dates") to the extent of achievement of the Company's TSR compared to the TSR of the companies included in the NASDAQ Telecommunications Index for the same fiscal year, measured by the Compensation Committee of the Company's Board of Directors (the "Compensation Committee") after each of the 2016, 2017 and 2018 fiscal years, respectively (as used in this paragraph, each, a "Performance Period"). The shares determined to be earned will vest on the anniversary of the grant date following each Performance Period. Shares subject to the 2016 PSUs that fail to be earned will be forfeited. The 2016 PSUs include a market condition that required the use of a Monte Carlo simulation approach to model future stock price movements based upon the risk-free rate of return, the volatility of each entity, and the pair-wise covariance between each entity. These results were then used to calculate the grant date fair values of the 2016 PSUs. Because the 2016 PSUs have market conditions, the Company is required to record expense for the 2016 PSUs through the final 2016 PSU Vesting Date of April 1, 2019, regardless of the number of shares that are ultimately earned. In February 2017, the Compensation Committee determined that the performance metrics for the 2016 PSUs for the 2016 Performance Period had been achieved at the 90.4% level, and accordingly, 24,106 shares in the aggregate were released to the four executives holding such outstanding grants on March 16, 2017. The unearned shares relating to the 2016 Performance Period, aggregating 2,560 shares, were forfeited on March 16, 2017. These amounts are included in the performance-based units table below.

On March 16, 2015, the Company granted an aggregate of 131,250 PSUs with both market and service conditions to eight of its executives (the "2015 PSUs"). In 2015, subsequent to the grant date, two executives separated from the Company and, in accordance with their respective employment agreements with the Company, the Company accelerated the vesting of certain unvested 2015 PSUs. The terms of the 2015 PSUs are such that up to one-third of the shares subject to the 2015 PSUs will vest on each of the first, second and third anniversaries of the date of grant (collectively, the "2015 PSU Vesting Dates") to the extent of achievement of the Company's TSR compared to the TSR of the companies included in the NASDAQ Telecommunications Index for the same Performance Period, measured by the Compensation Committee at the end of each of the 2015, 2016 and 2017 fiscal years, respectively (as used in this paragraph, each, a "Performance Period"). The shares determined to be earned will vest on the anniversary of the grant date following each Performance Period. Shares subject to the 2015 PSUs that fail to be earned will be forfeited. The 2015 PSUs include a market condition that required the use of a Monte

20


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

Carlo simulation approach to calculate the grant date fair values of the 2015 PSUs. Because the 2015 PSUs have market conditions, the Company is required to record expense for the 2015 PSUs through the final 2015 PSU Vesting Date of March 16, 2018, regardless of the number of shares that are ultimately earned, if any. In February 2017, the Compensation Committee determined that the performance metrics for the 2015 PSUs for the 2016 Performance Period had been achieved at the 76.0% level, and accordingly, 23,750 shares in the aggregate were released to the four executives holding such outstanding grants on April 1, 2017. The unearned shares relating to the 2016 Performance Period, aggregating 7,500 shares, were forfeited on April 1, 2017. These amounts are included in the performance-based units table below.

Stock Options

The activity related to the Company's outstanding stock options for the three months ended March 31, 2017 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, 2017
5,610,106

 
$
15.73

 
 
 
 
Granted
3,920

 
$
6.10

 
 
 
 
Exercised
(13,430
)
 
$
3.80

 
 
 
 
Forfeited
(22,483
)
 
$
13.91

 
 
 
 
Expired
(50,425
)
 
$
21.50

 
 
 
 
Outstanding at March 31, 2017
5,527,688

 
$
15.70

 
5.08
 
$
98

Vested or expected to vest at March 31, 2017
5,480,151

 
$
15.73

 
5.05
 
$
97

Exercisable at March 31, 2017
4,890,476

 
$
15.79

 
4.75
 
$
92



The grant date fair values of options to purchase common stock granted in the three months ended March 31, 2017 were estimated using the Black-Scholes valuation model with the following assumptions:
 
Three months ended
 
March 31,
2017
Risk-free interest rate
1.95%
Expected dividends
Weighted average volatility
51.3%
Expected life (years)
5.0


Additional information regarding the Company's stock options for the three months ended March 31, 2017 is as follows:
 
Three months ended
 
March 31,
2017
Weighted average grant date fair value of stock options granted
$
2.81

Total intrinsic value of stock options exercised (in thousands)
$
37

Cash received from the exercise of stock options (in thousands)
$
51



Restricted Stock Awards and Units

The activity related to the Company's RSAs for the three months ended March 31, 2017 is as follows:

21


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

 
Shares
 
Weighted
Average
Grant Date
Fair Value
Unvested balance at January 1, 2017
2,030,028

 
$
9.69

Granted
518,560

 
$
6.58

Vested
(164,629
)
 
$
13.98

Forfeited
(7,092
)
 
$
16.60

Unvested balance at March 31, 2017
2,376,867

 
$
8.70



The activity related to the Company's RSUs for the three months ended March 31, 2017 is as follows:
 
Shares
 
Weighted
Average
Grant Date
Fair Value
Unvested balance at January 1, 2017
110,219

 
$
11.95

Granted

 
$

Vested
(11,185
)
 
$
16.05

Forfeited
(10,750
)
 
$
8.12

Unvested balance at March 31, 2017
88,284

 
$
11.89



The total fair value of shares of restricted stock granted under RSAs and RSUs that vested during the three months ended March 31, 2017 was $2.5 million.

Performance-Based Stock Units
 
 
 
 
The activity related to the Company's PSUs for the three months ended March 31, 2017 is as follows:
 
Shares
 
Weighted
Average
Grant Date
Fair Value
Unvested balance at January 1, 2017
147,085

 
$
12.11

Granted
165,000

 
$
8.41

Vested
(24,106
)
 
$
15.37

Forfeited
(2,560
)
 
$
15.37

Unvested balance at March 31, 2017
285,419

 
$
9.67



The total fair value of shares of restricted stock granted under PSUs that vested during the three months ended March 31, 2017 was $0.4 million.

The Company did not have outstanding PSAs during the three months ended March 31, 2017 or at December 31, 2016.

Employee Stock Purchase Plan

The Company's ESPP provides 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 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 months ended March 31, 2017 and 2016 as follows (in thousands):

22


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

 
Three months ended
 
March 31,
2017
 
March 31,
2016
Product cost of revenue
$
99

 
$
71

Service cost of revenue
317

 
332

Research and development
1,317

 
1,179

Sales and marketing
(88
)
 
1,020

General and administrative
1,618

 
1,813

 
$
3,263

 
$
4,415


The $0.1 million credit amount reported as sales and marketing stock-based compensation expense for the three months ended March 31, 2017 is comprised of $0.9 million of stock-based compensation expense, net of the reversal of $1.0 million of incremental expense to correct an error in 2016 related to the acceleration of certain stock awards held by an executive who separated from the Company in 2016. Management had reviewed and considered the impact of the error and determined that it was not material to the Company's consolidated financial results for the third and fourth quarters of 2016, as well as the 2016 fiscal year. Management has also determined that the correction of this error is not material to the results of operations for the three months ended March 31, 2017.

There is no income tax benefit for employee stock-based compensation expense for the three months ended March 31, 2017 or March 31, 2016 due to the valuation allowance recorded.

At March 31, 2017, there was $21.7 million, net of expected forfeitures, of unrecognized stock-based compensation expense related to unvested stock options, awards, units and ESPP shares. This expense is expected to be recognized over a weighted average period of approximately two years.


(12) MAJOR CUSTOMERS

The following customers contributed 10% or more of the Company's revenue in at least one of the three month periods ended March 31, 2017 and March 31, 2016:
 
Three months ended
 
March 31,
2017
 
March 31,
2016
Verizon Communications
17%
 
*
Level 3 Communications
*
 
19%
AT&T Inc.
*
 
11%
_______________________
* Represents less than 10% of revenue


At March 31, 2017, one customer accounted for 10% or more of the Company's accounts receivable balance, representing approximately 14% of the Company's accounts receivable balance. At December 31, 2016, no customer accounted for 10% or more 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.



23


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

(13) 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
 
March 31,
2017
 
March 31,
2016
United States
67
%
 
68
%
Europe, Middle East and Africa
12

 
13

Japan
14

 
13

Other Asia Pacific
4

 
4

Other
3

 
2

 
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.



(14) INCOME TAXES

The Company's income tax provisions for the three months ended March 31, 2017 and 2016 reflect the Company's 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 three months ended March 31, 2017 and 2016 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. Included in the Company's provision for the three months ended March 31, 2016 is a discrete charge of $0.7 million related to an uncertain tax position of the Company's subsidiary in France.


(15) COMMITMENTS AND CONTINGENCIES

On April 6, 2015, Ming Huang, a purported shareholder of the Company, filed a Class Action Complaint (Civil Action No. 3:15-02407), alleging violations of the federal securities laws (the "Complaint") in the United States District Court for the District of New Jersey (the "District of New Jersey"), against the Company and two of its officers, Raymond P. Dolan, the Company's President and Chief Executive Officer, and Mark T. Greenquist, the Company's former Chief Financial Officer (collectively, the "Defendants"). On September 21, 2015, in response to motions subsequently filed with the District of New Jersey by four other purported shareholders of the Company seeking status as lead plaintiff, the District of New Jersey appointed Richard Sousa as lead plaintiff (the "Plaintiff"). The Plaintiff claims to represent purchasers of the Company's common stock during the period from October 23, 2014 to March 24, 2015, and seeks unspecified damages. The principal allegation contained in the Complaint is that the Defendants made misleading forward-looking statements concerning the Company's fiscal first quarter of 2015 financial performance. On September 22, 2015, the Company filed a Motion to Transfer (the “Motion to Transfer”) this case to the United States District Court for the District of Massachusetts (the "District of Massachusetts"). On March 21, 2016, the District of New Jersey granted the Company's Motion to Transfer. Thus, this case will now be litigated in the District of Massachusetts (Civil Action No. 1:16-cv-10657-GAO). On May 4, 2016, the Plaintiff filed an amended complaint (the "Amended Complaint"), which is now the operative complaint in this litigation. On June 20, 2016, the Company and the other Defendants filed a Motion to Dismiss the Amended Complaint (the "Motion to Dismiss") and on July 25, 2016, the Plaintiff filed an opposition to the Motion to Dismiss. The Company filed its reply to the Plaintiff's opposition to the Motion to Dismiss on August 15, 2016. The Company filed its reply to the Plaintiff's opposition to the Motion to Dismiss on August 15, 2016. A hearing on the Motion to Dismiss was held on February 28, 2017, and the parties are now awaiting a decision from the District of Massachusetts. The Company believes that the Defendants have meritorious defenses

24


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

to the allegations made in the Amended Complaint and does not expect the results of this suit to have a material effect on its business or consolidated financial statements. The Company is also fully cooperating with an SEC inquiry regarding the development and issuance of the Company's first quarter 2015 revenue and earnings guidance. At this time, it is not possible to predict the outcome of the SEC's inquiry, including whether or not any proceedings will be initiated or, if so, when or how the matter will be resolved and therefore an estimate of the possible range of loss, if any, cannot be made.

In addition, the Company is often a party to disputes and legal proceedings that it considers routine and incidental to its business. 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, 2016, which was filed with the U.S. Securities and Exchange Commission on February 27, 2017.

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 secure and unify their real-time communications infrastructures. We help the world's leading communications service providers and enterprises embrace the next generation of Session Initiation Protocol ("SIP") and 4G/LTE (Long-Term Evolution)-based solutions, including Voice over Internet Protocol ("VoIP"), Voice over WiFi ("VoWiFi"), video and Unified Communications ("UC") by securing and enabling reliable and scalable Internet Protocol ("IP") networks. Our products include session border controllers ("SBCs"), diameter signaling controllers ("DSCs") and VoWiFi solutions, which are supported by a global services team with experience in design, deployment and maintenance of some of the world's largest IP networks.

Our solutions provide a secure way for our customers to link and leverage multivendor, multiprotocol communications systems and applications across their networks, around the world and in a rapidly changing ecosystem of IP-enabled devices such as smartphones and tablets. Our solutions help realize the intended value and benefits of UC platforms by enabling disparate communications environments, commonplace in most enterprises today, to work seamlessly together. Likewise, our solutions secure the evolution to cloud-based delivery of UC solutions - both for service providers transforming to a cloud-based network and for enterprises using cloud-based UC.

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.

We have traditionally sold our products through a global direct sales force, with additional sales support from regional channel partners throughout the world. Our channel partner program, Sonus Partner Assure, expands our coverage of the service provider and enterprise markets.

Business Acquisition


25


On September 26, 2016 (the "Taqua Acquisition Date"), we acquired Taqua, LLC ("Taqua"), a leading supplier of IP communications systems, applications and services to mobile and fixed operators. Taqua enables the transformation of software-based service provider networks to deliver next-generation voice, video and messaging services, including VoIP, VoWiFi and Voice over Long-Term Evolution ("VoLTE"). The acquisition of Taqua has, among other things, accelerated our mobile strategy by adding a Virtualized Mobile Core ("VMC") Platform and an IP Multimedia Subsystem ("IMS") Service Core and expanded our fixed portfolio by adding a Class 5 Softswitch (the T7000) for Network Transformation projects and a Multimedia Controller used in IP Peering applications (the T7100), both of which are complementary to our current product offerings. In consideration for the acquisition of Taqua, we paid $19.9 million in cash to the sellers on the Taqua Acquisition Date, net of cash acquired. We also entered into an Earn-Out Agreement, dated as of September 26, 2016, with Taqua Holdings, LLC and Jeffrey L. Brawner, the seller representative in the transaction, under which there is the potential for additional cash payments to the sellers if certain annual revenue thresholds are exceeded as measured annually through 2020. Based on historical and forecasted, no incremental contingent consideration was recorded as of either March 31, 2017 or December 31, 2016. The financial results of Taqua are included in our condensed consolidated financial statements starting on the Taqua Acquisition Date.

Corporate Strategy

Our strategy is designed to capitalize on our technology and market lead and to 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;
providing an environment for our customers to enable real-time communication to embed into their presence on the worldwide web;
expanding our global sales distribution, marketing and support capabilities;
actively contributing to the SIP standards definition and adoption process;
pursuing strategic transactions and alliances;
successfully implementing our cost reduction initiatives; and
delivering sustainable profitability by continuing to improve our overall performance.

Financial Overview

Restructuring and Cost Reduction Initiatives

We are, and have been, committed to streamlining our operations and reducing our operating costs.

To better align our cost structure to our then-current revenue expectations, in April 2015, we announced a cost reduction review and consequently, initiated a restructuring plan to reduce our workforce (the "2015 Restructuring Initiative"). At December 31, 2016, we had $168,000 accrued in connection with this initiative, which was paid in the first quarter of 2017.

On July 25, 2016, we announced a restructuring program to further accelerate our investment in new technologies as the communications industry migrates to a cloud-based architecture (the "2016 Restructuring Initiative"). We expect to record expense aggregating between $3 million and $4 million in connection with this action, resulting in anticipated annual savings of approximately $6 million to $8 million. To date, we have recorded $1.7 million of restructuring expense in the aggregate in connection with this initiative, comprised of $0.2 million in the three months ended March 31, 2017 and $1.5 million in 2016. We expect to record the remaining $1.3 million to $2.3 million by the end of the third quarter of 2017. We intend to utilize the majority of the savings to shift headcount toward new strategic initiatives, such as new products and expanded go-to-market footprint in selected geographies and discrete vertical markets.

In connection with the acquisition of Taqua, our management approved a restructuring plan in the third quarter of 2016 to eliminate certain redundant positions within the combined companies. On October 24, 2016, the Audit Committee of the Company's Board of Directors approved a broader Taqua restructuring plan related to headcount and redundant facilities (collectively, the "Taqua Restructuring Initiative"). To date, we have recorded $1.6 million of restructuring expense in the

26


aggregate in connection with this initiative, comprised of $0.4 million in the three months ended March 31, 2017 and $1.2 million in 2016. We anticipate recording additional future expense in connection with this initiative for headcount and redundant facilities aggregating approximately $1 million through the third quarter of 2017.

Financial Results

We reported losses from operations of $10.8 million for the three months ended March 31, 2017 and $3.9 million for the three months ended March 31, 2016.

We reported net losses of $10.6 million for the three months ended March 31, 2017 and $4.7 million for the three months ended March 31, 2016.

Our revenue was $53.4 million in the three months ended March 31, 2017 and $59.2 million in the three months ended March 31, 2016.

Our gross profit was $33.7 million in the three months ended March 31, 2017 and $38.4 million in the three months ended March 31, 2016. Our gross profit as a percentage of revenue ("total gross margin") was 63.2% in the three months ended March 31, 2017 and 64.9% in the three months ended March 31, 2016.

Our operating expenses were $44.5 million in the three months ended March 31, 2017 and $42.3 million in the three months ended March 31, 2016. Operating expenses for the three months ended March 31, 2017 included $0.6 million of restructuring expense as described above and $56,000 of acquisition-related expense in connection with the acquisition of Taqua. We did not record either restructuring or acquisition-related expense in the three months ended March 31, 2016.

We recorded stock-based compensation expense of $3.3 million in the three months ended March 31, 2017, compared to $4.4 million in the three months ended March 31, 2016. These amounts are included as components of both Cost of revenue and Operating expenses in our condensed consolidated statements of operations.

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.

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;
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, 2016. There were no significant changes to our critical accounting policies from December 31, 2016 through March 31, 2017.


27



Results of Operations

Three months ended March 31, 2017 and March 31, 2016

Revenue. Revenue for the three months ended March 31, 2017 and 2016 was as follows (in thousands, except percentages):
 
Three months ended
 
Increase (decrease)
from prior year
 
March 31,
2017
 
March 31,
2016
 
$
 
%
Product
$
25,395

 
$
34,769

 
$
(9,374
)
 
(27.0
)%
Service
27,973

 
24,382

 
3,591

 
14.7
 %
Total revenue
$
53,368

 
$
59,151

 
$
(5,783
)
 
(9.8
)%

 
 
 
 
 
 
 
 

Product revenue is comprised of sales of our communication infrastructure products. The decrease in product revenue in the three months ended March 31, 2017 compared to the three months ended March 31, 2016 was primarily the result of a decrease in sales of certain of our older products and our SBC 7000 series products aggregating $11.6 million, partially offset by a $1.3 million increase in sales of our SBC 5000 and $0.9 million related to products from our acquisition of Taqua. The decrease in the three months ended March 31, 2017 was consistent with our expectations that our revenue will be more heavily weighted to the second half of 2017 based on customer consolidations and other trends in the marketplace.

In the three months ended March 31, 2017, approximately 34% of our total product revenue was from indirect sales through our channel partner program, compared to approximately 21% in the three months ended March 31, 2016.

Our product revenue from sales to enterprise customers was approximately 28% of our total product revenue in the three months ended March 31, 2017, compared to approximately 18% in the three months ended March 31, 2016. These sales were made both through our direct sales team and indirect sales channel partners.

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. These complex arrangements are generally completed through our direct sales force.

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 months ended March 31, 2017 and 2016 was comprised of the following (in thousands, except percentages):
 
Three months ended
 
Increase
from prior year
 
March 31,
2017
 
March 31,
2016
 
$
 
%
Maintenance
$
21,756

 
$
20,750

 
$
1,006

 
4.8
%
Professional services
6,217

 
3,632

 
2,585

 
71.2
%
 
$
27,973

 
$
24,382

 
$
3,591

 
14.7
%

 
 
 
 
 
 
 
 

Our maintenance revenue increased in the three months ended March 31, 2017 compared to the three months ended March 31, 2016, primarily due to the inclusion of maintenance revenue from former Taqua customers in the three months ended March 31, 2017.

The increase in our professional services revenue in the three months ended March 31, 2017 compared to the three months ended March 31, 2016 was primarily due to higher professional services revenue from projects completed in the current year period compared to the same prior year period.


28


The timing of the completion of projects for revenue recognition, customer payments and maintenance contracts may cause our service revenue to fluctuate from one period to the next.

The following customers contributed 10% or more of our revenue in at least one of the three month periods ended March 31, 2017 and March 31, 2016:
 
Three months ended
Customer
March 31,
2017
 
March 31,
2016
Verizon Communications
17%
 
*
Level 3 Communications
*
 
19%
AT&T Inc.
*
 
11%
_______________________
* Represents less than 10% of revenue

International revenue was approximately 33% of revenue in the three months ended March 31, 2017 and approximately 32% of revenue in the three months ended March 31, 2016. 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 $8.9 million at March 31, 2017 and $6.9 million at December 31, 2016. Our deferred service revenue was $45.7 million at March 31, 2017 and $43.8 million at December 31, 2016. 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.

We expect that our product revenue in 2017 will be relatively flat compared to 2016 levels, primarily due to continued consolidation among our customers and their suppliers. We will continue to focus on expanding our product offerings to address the emerging UC and IP-based markets in both the enterprise and service provider markets, which we believe are aligned with the technology strategies of our customers.

We expect that our service revenue in 2017 will increase from 2016 levels as a result of the continued growth of our installed customer base, partially offset by lower revenue resulting from customer merger activities.

Overall, we expect that total revenue in 2017 will be flat to slightly higher, or low single digit growth, compared to 2016 total revenue.

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 months ended March 31, 2017 and 2016 were as follows (in thousands, except percentages):
 
Three months ended
 
Increase (decrease)
from prior year
 
March 31,
2017
 
March 31,
2016
 
$
 
%
Cost of revenue
 
 
 
 
 
 
 
Product
$
9,753

 
$
11,536

 
$
(1,783
)
 
(15.5
)%
Service
9,867

 
9,212

 
655

 
7.1
 %
Total cost of revenue
$
19,620

 
$
20,748

 
$
(1,128
)
 
(5.4
)%
Gross margin
 
 
 
 
 
 
 
Product
61.6
%
 
66.8
%
 
 
 
 
Service
64.7
%
 
62.2
%
 
 
 
 
Total gross margin
63.2
%
 
64.9
%
 
 
 
 

 
 
 
 
 
 
 
 

The decrease in product gross margin in the three months ended March 31, 2017 compared to the three months ended March 31, 2016 was primarily due to lower product revenue against certain fixed manufacturing costs, which decreased our product gross margin by approximately five and one-half percentage points, partially offset by the impact of product and customer mix, which increased our product gross margin by approximately one-half of one percentage point.


29


The increase in service gross margin in the three months ended March 31, 2017 compared to the three months ended March 31, 2016 was primarily due to higher revenue against relatively fixed costs, which increased our service gross margin by approximately three percentage points, partially offset by increased third-party installation costs, which decreased our service gross margin by approximately one-half of one percentage point. We believe that our total gross margin will continue to be comparable to historical levels on an annualized basis for the foreseeable future.

Research and Development Expenses. Research and development expenses consist primarily of salaries and related personnel expenses and prototype costs for the design, development, testing and enhancement of our products. Research and development expenses for the three months ended March 31, 2017 and 2016 were as follows (in thousands, except percentages):
 
 
 
Increase
from prior year
 
March 31,
2017
 
March 31,
2016
 
$
 
%
Three months ended
$
20,209

 
$
17,318

 
$
2,891

 
16.7
%


The increase in research and development expenses in the three months ended March 31, 2017 compared to the three months ended March 31, 2016 was attributable to $1.9 million of employee-related expenses and $1.0 million of higher product development (third-party development, prototype and equipment) costs. The increase in employee-related expenses was attributable to $2.4 million of higher salary and related expenses, $0.2 million of higher travel, training and other employee expenses, and $0.1 million of higher stock-based compensation expense. These increases were partially offset by $0.8 million of lower expense related to our Company-wide cash bonus program. The increase in employee salary and related expenses was primarily attributable to our increased investment in our security strategy, coupled with the inclusion of the Taqua research and development costs in the three months ended March 31, 2017.

Some aspects of our research and development efforts require significant short-term expenditures, the timing of which may cause significant variability in our expenses. We believe that rapid technological innovation is critical to our long-term success, and we are tailoring our investments to meet the requirements of our customers and the market. We believe that our research and development expenses in 2017 will increase from 2016 levels due to the full year impact in 2017 of Taqua research and development costs and our increased investment in our security strategy, partially offset by cost reductions resulting from our 2016 Restructuring Initiative and our Taqua Restructuring Initiative.

Sales and Marketing Expenses. Sales and marketing expenses consist primarily of salaries and related personnel costs, commissions, travel and entertainment expenses, promotions, customer trial and evaluations inventory and other marketing and sales support expenses. Sales and marketing expenses for the three months ended March 31, 2017 and 2016 were as follows (in thousands, except percentages):
 
 
 
Decrease
from prior year
 
March 31,
2017
 
March 31,
2016
 
$
 
%
Three months ended
$
14,676

 
$
16,595

 
$
(1,919
)
 
(11.6
)%


The decrease in sales and marketing expenses in the three months ended March 31, 2017 compared to the three months ended March 31, 2016 was attributable to $1.9 million of lower employee-related expenses and $0.4 million of net reductions in other sales and marketing expenses, partially offset by $0.4 million of higher amortization expense related to acquired intangible assets. The decrease in employee-related expense is comprised of $1.1 million of lower salary and commissions and related expenses and $1.1 million of lower stock-based compensation expense, partially offset by $0.3 million of higher travel, training and other employee expenses. The decrease in stock-based compensation expense was primarily attributable to the reversal in the three months ended March 31, 2017 of $1.0 million of incremental stock-based compensation expense to correct an error in 2016 related to the acceleration of certain stock awards held by an executive who separated from the Company in 2016. Management had reviewed and considered the impact of the error and determined that it was not material to the Company's consolidated financial results for the third and fourth quarters of 2016, as well as the 2016 fiscal year. Management has also determined that the correction of this error is not material to the results of operations for the three months ended March 31, 2017.


30


We believe that our sales and marketing expenses will increase in 2017 from 2016 levels due to the full year impact of the inclusion of Taqua expenses in 2017, partially offset by reductions resulting from our 2016 Restructuring Initiative and our Taqua Restructuring Initiative.

General and Administrative Expenses. General and administrative expenses consist primarily of salaries and related personnel costs for executive and administrative personnel, recruiting expenses and audit, legal and other professional fees. General and administrative expenses for the three months ended March 31, 2017 and 2016 were as follows (in thousands, except percentages):
 
 
 
Increase
from prior year
 
March 31,
2017
 
March 31,
2016
 
$
 
%
Three months ended
$
9,019

 
$
8,371

 
$
648

 
7.7
%


The increase in general and administrative expenses in the three months ended March 31, 2017 compared to the three months ended March 31, 2016 was attributable to $1.7 million of higher professional fees (i.e., legal, audit and outside services), partially offset a reversal of $0.7 million relating to a change in the previously accrued estimate related to certain legal matters and $0.4 million of lower employee-related expenses. The increase in professional fees was primarily attributable to higher legal fees in connection with ongoing litigation and an SEC inquiry. The decrease in employee-related expenses resulted from $0.3 million of lower expense related to our Company-wide cash bonus program and $0.2 million of lower stock-based compensation expense, partially offset by $0.1 million of higher salary and related expenses.

We believe that our general and administrative expenses will be relatively flat in 2017 compared to 2016.

Acquisition-Related Expenses. Acquisition-related expenses include those expenses related to business acquisitions that would not otherwise have been incurred by us. These expenses include professional and services fees, such as legal, audit, consulting, paying agent and other fees. We recorded acquisition-related expenses of $0.1 million in the three months ended March 31, 2017 for professional fees in connection with the acquisition of Taqua. We did not record any acquisition-related expenses in the three months ended March 31, 2016.

Restructuring Expense. We have been committed to streamlining operations and reducing operating costs by closing and consolidating certain facilities and reducing our worldwide workforce. Please see the additional discussion of our restructuring initiatives in the "Restructuring and Cost Reduction Initiatives" section of the Overview of this Management's Discussion and Analysis of Financial Condition and Results of Operations.

We recorded restructuring expense aggregating $0.6 million in the three months ended March 31, 2017, comprised of $0.4 million related to our Taqua Restructuring Initiative and $0.2 million related to our 2016 Restructuring Initiative. The amount related to the Taqua Restructuring Initiative is primarily related to the abandonment of a portion of the former Taqua San Jose facility. The amount related to the 2016 Restructuring Initiative represents severance and related costs. We expect to record additional restructuring expense, including expense related to the restructuring of certain redundant facilities as well as headcount-related actions, aggregating approximately $2 million to $4 million in connection with these initiatives.

We did not record restructuring expense in the three months ended March 31, 2016.

Although we have eliminated positions as part of our restructuring initiatives, we continue to hire in certain other areas that we believe are important to our future growth. We currently expect that the remaining restructuring accruals, all of which represent severance and related costs, will be paid by the end of the third quarter of 2017.

Interest Income (Expense), Net. Interest income and interest expense for the three months ended March 31, 2017 and 2016 were as follows (in thousands, except percentages):

31


 
Three months ended
 
Increase
from prior year
 
March 31,
2017
 
March 31,
2016
 
$
 
%
Interest income
$
268

 
$
173

 
$
95

 
54.9
%
Interest expense
(10
)
 
(9
)
 
1

 
11.1
%
Interest income, net
$
258

 
$
164

 
$
94

 
57.3
%

 
 
 
 
 
 
 
 

Interest income consists of interest earned on our cash equivalents, marketable securities and investments. Interest expense relates to interest on capital lease obligations and expense related to the amortization of debt issuance costs in connection with our revolving credit facility.

Income Taxes. We recorded provisions for income taxes of $0.1 million in the three months ended March 31, 2017 and $1.0 million in the three months ended March 31, 2016. These amounts reflect our estimates of the effective rates expected to be applicable for the respective full fiscal years, adjusted for any discrete events, which are recorded in the period that they occur. These estimates are reevaluated each quarter based on our estimated tax rate for the full fiscal year. The estimated amounts recorded do not include any benefit for our domestic losses, as we have concluded that a valuation allowance on any domestic benefit is required. Included in our provision for the three months ended March 31, 2017 was a discrete charge of $0.7 million related to an uncertain tax position of our subsidiary in France.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial position, changes in financial position, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Liquidity and Capital Resources

Our consolidated statements of cash flows are summarized as follows (in thousands):
 
Three months ended
 
 
 
March 31,
2017
 
March 31,
2016
 
Change
Net loss
$
(10,646
)
 
$
(4,654
)
 
$
(5,992
)
Adjustments to reconcile net loss to cash flows provided by operating activities
7,583

 
8,774

 
(1,191
)
Changes in operating assets and liabilities
6,667

 
(806
)
 
7,473

Net cash provided by operating activities
$
3,604

 
$
3,314

 
$
290

Net cash used in investing activities
$
(3,937
)
 
$
(9,409
)
 
$
5,472

Net cash provided by (used in) financing activities
$
138

 
$
(1,619
)
 
$
1,757



Our cash, cash equivalents, and short- and long-term investments totaled $128.8 million at March 31, 2017 and $126.1 million at December 31, 2016. We had cash and short-term investments held by our foreign subsidiaries aggregating approximately $6 million at March 31, 2017 and approximately $5 million at December 31, 2016. We do not intend to repatriate these funds and, as such, they are not available to finance our domestic operations. If we were to repatriate the funds, they would likely be treated as income for U.S. tax purposes, fully offset by our net operating losses. We do not believe this would have a material impact on our liquidity.

We entered into a 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 on June 27, 2014 (the "Credit Agreement"), which agreement was amended by a First Amendment to Credit Agreement on June 26, 2015 (the "First Amendment") and further amended by a Second Amendment to Credit Agreement on June 13, 2016 (the "Second Amendment" and collectively with the Credit Agreement and the First Amendment, the "Amended Credit Agreement"). Certain terms of the Amended Credit Agreement include, among other things: (i) an increase of the commitments from $15 million to $20 million; (ii) an extension of the maturity date from June 30, 2016 to June 30, 2017; (iii) a reduction to the aggregate amount of cash and cash equivalents that the Loan Parties (as defined below) are required to hold at

32


any time from $85 million to $50 million; and (iv) a reduction of the commitment fee on the unused commitments available for borrowing from 0.15% to 0.1125%. The Amended Credit Agreement provides that we may select the interest rates under the credit facility from among the following options: (i) 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 (ii) 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%. Our obligations under the Amended Credit Agreement are guaranteed by Sonus International, Inc., Sonus Federal, Inc., Network Equipment Technologies, Inc. and Taqua (collectively 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 Amended 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 total revenues of the Loan Parties cannot be less than an aggregate of $50 million as of the last day of the Loan Parties' fiscal quarter, computed on a quarterly basis. The credit facility will become due on June 30, 2017, 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, relating to judgments, and ERISA Event (as defined in the Credit Agreement), the failure to pay specified indebtedness and a change of control default. We did not have any amounts outstanding under the Amended Credit Agreement at March 31, 2017.

On July 29, 2013, we announced that our Board of Directors had authorized a stock buyback program to repurchase up to $100 million of our common stock from time to time on the open market or in privately negotiated transactions. The stock buyback program is being funded using our working capital. During the three months ended March 31, 2017, we did not repurchase any shares under our stock buyback program. During the three months ended March 31, 2016, we repurchased and retired 0.2 million shares under our stock buyback program for $1.5 million in the aggregate, including transaction fees, and this amount is included in financing activities in our condensed consolidated statement of cash flows for the three months ended March 31, 2016.

Our operating activities provided $3.6 million of cash in the three months ended March 31, 2017 and $3.3 million of cash in the three months ended March 31, 2016.

Cash provided by operating activities in the three months ended March 31, 2017 was primarily the result of our non-cash operating expenses, partially offset by our net loss, lower accounts receivable and higher deferred revenue. These amounts were partially offset by decreases in accrued expenses and other long-term liabilities and accounts payable and an increase in other operating assets. Our lower accounts receivable primarily reflected our focused collections efforts. The decrease in accrued expenses and other long-term liabilities was primarily related to employee compensation and related costs, including payments made in connection with our Company-wide cash bonus program and sales commissions, payments made in connection with our previously recorded restructuring initiatives and lower accruals for our Amended and Restated 2000 Employee Stock Purchase Plan, as amended ("ESPP"), as a purchase was completed on behalf of participating employees on February 28, 2017. Our net loss, adjusted for non-cash items such as depreciation, amortization and stock-based compensation, used $3.1 million of cash.

Cash provided by operating activities in the three months ended March 31, 2016 was primarily the result of lower accounts receivable and higher deferred revenue, partially offset by increases in other operating assets and inventory and decreases in accrued expenses and other long-term liabilities and accounts payable, as well as our net loss, net of non-cash operating expenses. Our lower accounts receivable reflects our focused collections efforts coupled with our historically higher revenue in the fourth quarter of the prior year. The increase in our inventory reflects our purchase in the quarter of last time buy materials required for certain of our products. We estimated that such materials would not be used until at least one year from the balance sheet date. The decrease in accrued expenses and other long-term liabilities was primarily related to employee compensation and related costs, including payments in connection with our Company-wide cash bonus program, payments in connection with our previously recorded restructuring initiatives and lower accruals for our ESPP, as a purchase was completed on behalf of participating employees on February 29, 2016. Our net loss, adjusted for non-cash items such as depreciation, amortization and stock-based compensation, used $4.1 million of cash.

Our investing activities used $3.9 million of cash in the three months ended March 31, 2017, comprised of $2.9 million of net purchases of marketable securities and $1.0 million of investments in property and equipment.


33


Our investing activities used $9.4 million of cash in the three months ended March 31, 2016, comprised of $7.7 million of net purchases of marketable securities, $1.0 million of investments in property and equipment and $0.8 million of cash paid as the final consideration installment for certain assets related to SDN technology.

Our financing activities provided $0.1 million of cash in the three months ended March 31, 2017, comprised of $0.6 million of proceeds from the sale of our common stock in connection with our ESPP and $0.1 million of proceeds from the exercise of stock options. These amounts were partially offset by $0.5 million used to pay withholding obligations related to the net share settlement of restricted stock awards upon vesting and approximately $10,000 for payments on our capital leases for office equipment.

Our financing activities used $1.6 million of cash in the three months ended March 31, 2016, comprised of $1.5 million, including transaction fees, for the repurchase of common stock, $0.8 million used to pay withholding obligations related to the net share settlement of restricted stock awards upon vesting and approximately $14,000 for payments on our capital leases for office equipment. These amounts were partially offset by $0.6 million of proceeds from the sale of our common stock in connection with our ESPP and approximately $5,000 of proceeds from the exercise of stock options.

Based on our current expectations, we believe our current cash, cash equivalents, marketable securities and long-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least twelve months, including any future stock repurchases under the aforementioned stock buyback program. It is difficult to predict future liquidity requirements with certainty. The rate at which we will consume cash will be dependent on the cash needs of future operations, including changes in working capital, which will, in turn, be directly affected by the successful implementation of our cost reduction initiatives, the levels of demand for our products, the timing and rate of expansion of our business, the resources we devote to developing our products and any settlements of legal proceedings. We anticipate devoting substantial capital resources to continue our research and development efforts, to maintain our sales, support and marketing, to improve our controls environment, for other general corporate activities and to vigorously defend against existing and potential litigation. See Note 15 to our condensed consolidated financial statements for a description of our contingencies.

Recent Accounting Pronouncements

In January 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment ("ASU 2017-04"). which removes the requirement to compare the implied fair value of goodwill with its carrying amount as part of step 2 of the goodwill impairment test. As a result, under ASU 2017-04, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, ASU 2017-04 clarifies the requirements for excluding and allocating foreign currency translation adjustments to reporting units in connection with an entity's testing of reporting units for goodwill impairment; clarifies that an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable; and makes minor changes to other related guidance within the Accounting Standards Codification ("ASC"). ASU 2017-04 is effective prospectively for us beginning January 15, 2020, with early adoption permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company elected to early-adopt ASU 2017-04; such early adoption to not have a material impact on the Company's consolidated financial results.

In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory ("ASU 2016-16"), which removes the prohibition in ASC 740, Income Taxes, against the immediate recognition of the current and deferred income tax effects of intra-entity transfers of assets other than inventory. ASU 2016-16 is intended to reduce the complexity of GAAP and diversity in practice related to the tax consequences of certain types of intra-entity asset transfers, particularly those involving IP. ASU 2016-16 is effective for us beginning January 1, 2019 for both interim and annual reporting periods. We do not believe that the adoption of this standard will have a material impact on our consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments ("ASU 2016-15"), which amends the guidance in Accounting Standards Codification ("ASC") 230 on the classification of certain cash receipts and payments in the statement of cash flows. The primary purpose of ASU 2016-15 is to reduce the diversity in practice that has resulted from the lack of consistent principles on this topic. ASU 2016-15 adds or clarifies guidance on eight cash flow issues, including debt prepayment or debt extinguishment costs, settlement of zero-coupon debt instruments or certain other debt instruments, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned life insurance

34


policies, distributions received from equity method investees, beneficial interests in securitization transactions and separately identifiable cash flows and application of the predominance principle. ASU 2016-15 is effective for us beginning January 1, 2018 for both interim and annual reporting periods, with early adoption permitted. Entities must apply the guidance retrospectively to all periods presented but may apply it prospectively from the earliest date practicable if retrospective application would be impracticable. We do not expect the adoption of ASU 2016-15 will have a material impact on our consolidated financial statements.

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"), which adds an impairment model that is based on expected losses rather than incurred losses. Under ASU 2016-13, an entity recognizes as an allowance its estimate of expected credit losses, which the FASB believes will result in more timely recognition of such losses. ASU 2016-13 is effective for us beginning January 1, 2020 for both interim and annual reporting periods, with early adoption permitted. We do not expect the adoption of ASU 2016-13 will have a material impact on our consolidated financial statements.

In March 2016, the FASB issued ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting ("ASU 2016-09"), which simplifies several aspects of the accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures and statutory tax withholding requirements, as well as classification in the statement of cash flows. ASU 2016-09 became effective for us beginning January 1, 2017 for both interim and annual reporting periods. Under ASU 2016-09, we will now recognize unrealized excess tax benefits. Due to the full valuation allowance on our federal and state income taxes, the adoption of ASU 2016-09 did not have a material impact on our accounting for income taxes. Without the valuation allowance, we would have recognized an increased deferred tax asset approximating $5 million. We have elected to continue to apply forfeiture rates to the expense attribution related to stock options, restricted stock awards and restricted stock units, as we believe that such continued application results in more accurate expense attribution over the life of these equity grants. The adoption of ASU 2016-09 did not have a material impact on our consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) Section A - Leases: Amendments to the FASB Accounting Standards Codification ("ASU 2016-02"), its new standard on accounting for leases. ASU 2016-02 introduces a lessee model that brings most leases onto the balance sheet. The new standard also aligns many of the underlying principles of the new lessor model with those in ASC 606, the FASB's new revenue recognition standard (i.e., those related to evaluating when profit can be recognized). Furthermore, ASU 2016-02 addresses other concerns related to the current leases model. For example, ASU 2016-02 eliminates the current GAAP requirement for an entity to use bright-line tests in determining lease classification. ASU 2016-02 is effective for us for both interim and annual periods beginning January 1, 2019. We are currently assessing the potential impact of the adoption of ASU 2016-02 on our consolidated financial statements.

In July 2015, the FASB issued ASU 2015-11, Simplifying the Measurement of Inventory ("ASU 2015-11"), which simplifies the measurement of inventory by requiring entities to measure most inventory at the lower of cost and net realizable value, replacing the previous requirement to measure most inventory at the lower of cost or market. ASU 2015-11 does not apply to inventories that are measured by using either the last-in, first-out method or the retail inventory method. ASU 2015-11 became effective for us for both interim and annual reporting periods beginning January 1, 2017. The adoption of ASU 2015-11 did not have a material impact on our consolidated financial statements.

In August 2014, the FASB issued ASU 2014-15, Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern ("ASU 2014-15"), which provides guidelines for determining when and how to disclose going concern uncertainties in the financial statements. The new standard requires management to perform interim and annual assessments of an entity's ability to continue as a going concern within one year of the date the financial statements are issued. An entity must provide certain disclosures if conditions or events raise substantial doubt about the entity's ability to continue as a going concern. ASU 2014-15 was effective for us for beginning January 1, 2017. The adoption of ASU 2014-15 did not have a material impact on our consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), its final standard on revenue from contracts with customers, along with additional ASUs which, among other things, clarified the implementation of the new revenue guidance and delayed the adoption by one year, to January 1, 2018 (collectively, the "New Revenue Standard"). The New Revenue Standard 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

35


transaction price to the performance obligations in the contract and recognizes revenue when (or as) the entity satisfies a performance obligation. The New Revenue Standard applies to all contracts with customers that are within the scope of other topics in the FASB ASC. Certain of the New Revenue Standard'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. We continue to assess the potential impact of the adoption of the New Revenue Standard on our consolidated financial statements, and currently believe that such adoption will, in general, accelerate the recognition of revenue (i.e., more revenue will be recognized upon delivery than is currently recognized ratably or upon payment) compared to the current standards in effect, in particular, sales of software-only products and sales to customers currently accounted for on a cash basis. We currently expect to adopt the New Revenue Standard using the modified retrospective option.

Item 3.    Quantitative and Qualitative Disclosures About Market Risk

We are exposed to a variety of market risks, including changes in interest rates affecting the return on our investments and foreign currency fluctuations. We do not believe that a hypothetical 10% adverse movement in interest rates and foreign currency exchange rates would have a materially different impact from what was disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016.



36


Item 4.    Controls and Procedures

Disclosure Controls and Procedures

Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our principal executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of March 31, 2017.

Changes in Internal Control over Financial Reporting. There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ended March 31, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


PART II OTHER INFORMATION

Item 1.    Legal Proceedings

On April 6, 2015, Ming Huang, a purported shareholder of ours, filed a Class Action Complaint (Civil Action No. 3:15-02407), alleging violations of the federal securities laws (the "Complaint") in the United States District Court for the District of New Jersey (the "District of New Jersey"), against us and two of our officers, Raymond P. Dolan, our President and Chief Executive Officer, and Mark T. Greenquist, our former Chief Financial Officer (collectively, the "Defendants"). On September 21, 2015, in response to motions subsequently filed with the District of New Jersey by four other purported shareholders of ours seeking status as lead plaintiff, the District of New Jersey appointed Richard Sousa as lead plaintiff (the "Plaintiff"). The Plaintiff claims to represent purchasers of our common stock during the period from October 23, 2014 to March 24, 2015, and seeks unspecified damages. The principal allegation contained in the Complaint is that the Defendants made misleading forward-looking statements concerning our fiscal first quarter of 2015 financial performance. On September 22, 2015, we filed a Motion to Transfer (the “Motion to Transfer”) this case to the United States District Court for the District of Massachusetts (the "District of Massachusetts"). On March 21, 2016, the District of New Jersey granted our Motion to Transfer. Thus, this case will now be litigated in the District of Massachusetts (Civil Action No. 1:16-cv-10657-GAO). On May 4, 2016, the Plaintiff filed an amended complaint (the "Amended Complaint"), which is now the operative complaint in this litigation. On June 20, 2016, the Company and the other Defendants filed a Motion to Dismiss the Amended Complaint (the "Motion to Dismiss") and on July 25, 2016, the Plaintiff filed an opposition to the Motion to Dismiss. We filed our reply to the Plaintiff's opposition to the Motion to Dismiss on August 15, 2016. A hearing on the Motion to Dismiss was held on February 28, 2017 and the parties are now awaiting a decision from the District of Massachusetts. We believe that the Defendants have meritorious defenses to the allegations made in the Amended Complaint and do not expect the results of this suit to have a material adverse effect on our business or consolidated financial statements.

We are often a party to disputes and legal proceedings that we consider routine and incidental to our business. Management does not expect the results of any of these actions to have a material effect on our business or consolidated financial statements.



Item 1A.    Risk Factors

We have revised and updated our discussion of the risk factors affecting our business since those presented in our Annual Report on Form 10-K, Part I, Item 1A. for the fiscal year ended December 31, 2016.  The following discussion includes two revised risk factors: “If in the future we do not have a sufficient number of shares available to issue to our employees, the limited number of shares we could issue may impact our ability to attract, retain and motivate key personnel” and "Restructuring activities could adversely affect our ability to execute our business strategy", each of which reflect a material development subsequent to the discussion of risk factors included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016.  Except for the two risk factors noted above, there have been no material changes in our assessment of our risk factors from those set forth in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016. For convenience, all of our risk factors are included below.

Investing in our common stock involves a high degree of risk. You should carefully consider the risks described below before

37


buying our common stock. If any of the following risks actually occurs, our business, financial condition, results of operations and cash flows could be materially adversely affected, the trading price of our common stock could decline materially and you could lose all or part of your investment.

Our quarterly revenue and operating results are unpredictable and may fluctuate significantly from quarter to quarter, which could adversely affect our business, consolidated financial statements and the trading price of our common stock.

Our revenues and operating results may vary significantly from quarter to quarter due to a number of factors, many of which are outside of our control and any of which may cause our stock price to fluctuate. The primary factors that may affect our revenues and operating results include, but are not limited to, the following:

consolidation within the telecommunications industry, including acquisitions of or by our customers;
general economic conditions in our markets, both domestic and international, as well as the level of discretionary IT spending;
competitive conditions in our markets, including the effects of new entrants, consolidation, technological innovation and substantial price discounting;
fluctuation in demand for our products and services, and the timing and size of customer orders;
fluctuations in foreign exchange rates;
cancellation or deferral of existing customer orders or the renegotiation of existing contractual commitments;
mix of product configurations sold;
length and variability of the sales cycle for our products;
application of complex revenue recognition accounting rules to our customer arrangements;
timing of revenue recognition;
changes in our pricing policies, the pricing policies of our competitors and the prices of the components of our products;
market acceptance of new products, product enhancements and services that we offer;
the quality and level of our execution of our business strategy and operating plan, and the effectiveness of our sales and marketing programs;
new product announcements, introductions and enhancements by us or our competitors, which could result in deferrals of customer orders;
our ability to develop, introduce, ship and successfully deliver new products and product enhancements that meet customer requirements in a timely manner;
our reliance on contract manufacturers for the production and shipment of our hardware products;
our or our contract manufacturers' ability to obtain sufficient supplies of sole or limited source components or materials;
our ability to attain and maintain production volumes and quality levels for our products;
variability and unpredictability in the rate of growth in the markets in which we compete;
costs related to acquisitions; and
corporate restructurings.

Equipment purchases by communications service providers and enterprises continue to be unpredictable. As with other telecommunications product suppliers, we typically recognize a portion of our revenue in a given quarter from sales booked and shipped in the last weeks of that quarter. As a result, delays in customer orders may result in delays in shipments and recognition of revenue beyond the end of a given quarter. Additionally, it can be difficult for us to predict the timing of receipt of major customer orders, and we are unable to control timing decisions made by our customers. Consequently, our quarterly operating results are difficult to predict even in the short term and a delay in an anticipated sale past the end of a particular quarter may negatively impact our results of operations for that quarter, or in some cases, that year. Therefore, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. If our revenue or operating results fall below the expectations of investors or securities analysts or below any guidance we may provide to the market, the price of our common stock could decline substantially. Such a stock price decline could also occur even if we meet our publicly stated revenue and/or earnings guidance.

A significant portion of our operating expenses is fixed in the short term. If revenues for a particular quarter are below expectations, we may not be able to reduce costs and expenses proportionally for that quarter. Any such revenue shortfall would, therefore, have a significant effect on our operating results for that quarter.

We have incurred net losses and may incur additional net losses.

We incurred net losses in the first quarter of 2017, as well as in fiscal years 2016 and 2015. We may incur additional net losses

38


in future quarters and years. Our revenues may not grow and we may never generate sufficient revenues to sustain profitability.

We will not be successful if we do not grow our customer base, especially since our revenue has historically been generated from a limited number of customers and the per-order revenue from orders placed by the majority of our new customers is generally lower than the per-order revenue generated from our historical sales. Additionally, if we are unable to generate recurring business from our existing customers, our consolidated financial statements could be materially and adversely affected.

Prior to our acquisition of Network Equipment Technologies, Inc. ("NET") in August 2012, we had shipped our products to a limited number of customers. Since the acquisition of NET, the number of customers to whom we have shipped our products has increased significantly. However, due to the nature of certain of our product offerings, the per-order revenue from orders placed by the majority of our new customers is generally lower than the per-order revenue generated from our historical customer orders.

Our future success will depend on our ability to attract additional customers beyond our current customer base. One customer, AT&T, contributed more than 10% of our revenue in each of the past three years, representing approximately 12% of our revenue in 2016, 13% of our revenue in 2015 and 19% of our revenue in 2014. Factors that may affect our ability to grow our customer base include but are not limited to the following:

economic conditions that discourage potential new customers from making the capital investments required to adopt new technologies;
deterioration in the general financial condition of service providers and enterprises, or their ability to raise capital or access lending sources;
new product introductions by our competitors; and
the development of our channel partner program.

If we are unable to expand our customer base, we will be forced to rely on generating recurring revenue from existing customers, which may not be successful. We expect to derive an increasing percentage of our revenue from engagements with our value-added resellers ("VAR") and global system integration partners; however, in the foreseeable future, the majority of our revenue will continue to depend on sales of our products to a limited number of existing customers or sales to customers with lower per-order revenue than those generated from our historical sales. Factors that may affect our ability to generate recurring revenues from our existing customers include but are not limited to the following:

customer willingness to implement our products;
pricing pressures due to the commoditization of our products;
the timing of industry transitions to new network technologies;
acquisitions of or by our customers;
delays or difficulties that we may incur in completing the development and introduction of our planned products or product enhancements;
failure of our products to perform as expected; and
difficulties we may incur in meeting customers' delivery requirements or with software development, hardware design, manufacturing or marketing of our products and/or services.

The loss of any significant customer, or any substantial reduction in purchase orders or deferral of purchasing decisions from these customers, could materially and adversely affect our consolidated financial statements.

We continue to enhance our sales strategy, which we expect will include more partner sales engagements to resell our products and services through authorized Sonus distributors, value added resellers, system integrators and other channel partners. Disruptions to, or our failure to effectively develop and manage, these partners and the processes and procedures that support them could adversely affect our ability to generate revenues from the sale of our products and services. If we do not have adequate personnel, experience and resources to manage the relationships with these partners and to fulfill our responsibilities under such arrangements, such shortcomings could lead to the decrease of the sales of our products and services and our operating results could suffer.

We continue to enhance our sales strategy, which we expect will include more partner sales engagements to resell our products and services through authorized Sonus distributors, value added resellers, system integrators and other channel partners. Our future success is dependent upon establishing and maintaining successful relationships with a variety of distributors, value added resellers, system integrators and other channel partners. We may also need to pursue strategic partnerships with vendors who have broader technology or product offerings in order to compete with end-to-end solution providers. In addition, many of

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the enterprise markets we are pursuing require a broad network of resale partners in order to achieve effective distribution.

Many of our distribution and channel partners sell competitive products and services and the loss of, or reduction in sales by, these partners could materially reduce our revenues. Our sales through channel partners typically involve the use of our products as components of a larger solution being implemented by the systems integrator. In these instances, the purchase and sale of our products are dependent on the channel partner, who typically controls the timing, prioritization and implementation of the project. Project delays, changes in priority or solution re-design decisions by the systems integrator can adversely affect our product sales. If we fail to maintain relationships with our distribution, VAR and systems integration partners; fail to develop new relationships with other partners in new markets; fail to manage, train or provide incentives to our existing partners effectively; or if these partners are not successful in their sales efforts, sales of our products and services may decrease and our operating results could suffer. Moreover, if we do not have adequate personnel, experience and resources to manage the relationships with our partners and to fulfill our responsibilities under such arrangements, any shortcomings could have a material adverse impact on our business and consolidated financial statements.

In addition, we recognize some of our revenue based on a drop-ship model using information provided by our partners. If those partners provide us with inaccurate or untimely information, the amount or timing of our revenues could be adversely affected. We may also be impacted by financial failure of our partners, which could result in our inability to collect accounts receivable in full.

As the telecommunications industry and the requirements of our current and potential customers evolve, we are redirecting certain of our resources to more readily respond to the changing environment through the research and development of innovative new products and the improvement of existing products. If our strategic plan is not aligned with the direction our customers take as they invest in the evolution of their networks, customers may not buy our products or use our services.

Success in our industry requires large investments in technology and creates exposure to rapid technological and market changes. We spend a significant amount of time, money and resources both developing new technology, products and solutions and acquiring new businesses or business assets, as applicable, such as NET in 2012, Performance Technologies, Incorporated ("PT") in 2014 and Taqua, LLC ("Taqua") in 2016. In 2015, we acquired from Treq Labs, Inc. ("Treq") certain assets related to Treq's business of designing, developing, marketing, selling, servicing and maintaining software-defined networking ("SDN") technology, SDN controller software and SDN management software (the "SDN Business"). Our strategic plan includes a significant shift in our investments from mature technologies that previously generated significant revenue for us toward certain next-generation technologies, as well as working with channel partners to sell our products. In order for us to be successful, our technologies, products and solutions must be accepted by relevant standardization bodies and by the industry as a whole. Our choices of specific technologies to pursue, and those to de-emphasize, may prove to be inconsistent with our customers' investment spending. Our success also depends upon our ability to integrate new and acquired products and services, as well as our ability to enhance our existing products and services. Moreover, if we invest in the development of technologies, products and solutions that do not function as expected, are not adopted by the industry, are not ready in time, are not accepted by our customers as quickly as anticipated, mature more quickly than we anticipated or are not successful in the marketplace, our sales and earnings may suffer and, as a result, our stock price could decline. As technology advances, we may not be able to respond quickly or effectively to developments in the market for our products, or new industry standards may emerge and could render our existing or future products and services obsolete. If our products and services become technologically obsolete or if we are unable to develop successor products and services that are accepted by our customers, we may be unable to sell our products and services in the marketplace and face declines in sales. We may also experience difficulties with software development, hardware design, manufacturing or marketing that could delay or prevent our development, introduction or marketing of new products and enhancements.

We believe the telecommunications industry is in the early stages of a major architectural shift to the virtualization of networks.  If the architectural shift does not occur, if it does not occur at the pace we predict, or if the products and services we have developed are not attractive to our customers after such shift takes place, our revenues could decline.

We believe the telecommunications industry is in the early stages of transitioning to the virtualization of networks, and we are developing products and services that we believe will be attractive to our customers and potential customers who make that shift.  While we anticipate that the industry shift to a software-centric cloud-based architecture is all but certain to happen, fundamental changes like this often take time to accelerate.  In addition, our customers may adapt to such changes at varying rates.  As our customers take time to determine their future network architectures, we may encounter delayed timing of orders, deferred purchasing decisions and reduced expenditures.  These longer decision cycles and reduced expenditures may negatively impact our revenues, or make it difficult for us to accurately predict our revenues, either of which could materially adversely affect our consolidated financial statements and cause our stock price to decline.


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In 2012, the macro-environment for our media gateway trunking business faced significant declining revenues that happened faster than we were anticipating. Since then, we have continued to experience significant declines in customer spending in our media gateway trunking business. Even though we continue to transform our company from a media gateway trunking business to an SBC and DSC security company, a portion of our current revenue remains dependent upon the commercial success of our voice infrastructure products, which we believe will remain true for the foreseeable future. If the market for these products continues to significantly decline and if our SBC and DSC sales do not accelerate as quickly as we forecast, our operating results could suffer.

While we continue to transform our company from a media gateway trunking business to a Session Border Controller ("SBC") and Diameter Signaling Controller ("DSC") security business, a portion of our current revenue still depends upon the commercial success of our TDM-to-IP and our all-IP voice infrastructure products and solutions, and we believe this will remain true for the foreseeable future. If the market for these products continues to significantly decline and if our SBC and DSC sales do not accelerate as quickly as we forecast, our operating results could suffer.

Restructuring activities could adversely affect our ability to execute our business strategy.

We recorded net restructuring expense of $11.1 million in the aggregate in the first quarter of 2017 and in fiscal 2016, 2015 and 2014, comprised of $10.1 million for severance and related costs, $0.8 million for the consolidation of certain facilities and $0.2 million for the write-off of assets associated with the headcount reduction and facilities consolidations. We expect to record approximately $2.3 million to $3.3 million of additional restructuring expense by the end of the third quarter of 2017.

Our current restructuring and any future restructuring, should it become necessary for us to continue to restructure our business due to worldwide market conditions or other factors that reduce the demand for our products and services, could adversely affect our ability to execute our business strategy in a number of ways, including through:

loss of key employees;
diversion of management's attention from normal daily operations of the business;
diminished ability to respond to customer requirements related to both products and services;
decrease in cash and profits related to severance payments and facility termination costs;
disruption of our engineering and manufacturing processes, which could adversely affect our ability to introduce new products and to deliver products both on a timely basis and in accordance with the highest quality standards; and/or
reduced ability to execute effectively internal administrative processes, including the implementation of key information technology programs.

If we fail to realize the anticipated benefits from our recent acquisitions on a timely basis, or at all, our business and financial condition may be adversely affected.

We may fail to realize the anticipated benefits from our recent acquisitions on a timely basis, or at all, for a variety of reasons, including but not limited to the following:

problems or delays in assimilating or transitioning to us the acquired assets, operations, systems, processes, controls, technologies, products or personnel;
loss of acquired customer accounts;
unanticipated costs associated with the acquisitions;
failure to identify in the due diligence process or assess the magnitude of certain liabilities we assumed in the acquisitions, which could result in unexpected litigation or regulatory exposure, unfavorable accounting treatment, unexpected increases in taxes due, significant issues with product quality or development or other adverse effects on our business or consolidated financial statements;
multiple or overlapping product lines as a result of the acquisitions that are offered, priced and supported differently, which could cause customer confusion and delays;
higher than anticipated costs in continuing support and development of acquired products;
diversion of management’s attention from our core business and the challenges of managing larger and more widespread operations from the acquisitions;
adverse effects on existing business relationships of Sonus, the SDN Business and/or Taqua with respective suppliers, licensors, contract manufacturers, customers, distributors, resellers and industry experts;
significant impairment, exit and/or restructuring charges if the products or technologies acquired in the acquisitions do not meet our sales expectations or are unsuccessful;
insufficient revenue to offset increased expenses associated with the acquisitions;
risks associated with entering markets in which we have no or limited prior experience;

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potential loss of the employees we acquired in the acquisitions or our own employees; and/or
failure to properly integrate internal controls and financial systems of the combined companies.

If we are not able to successfully manage these issues, the anticipated benefits and efficiencies of our recent acquisitions may not be realized fully or at all, or may take longer to realize than expected, and our ability to compete, our revenue and gross margins and our results of operations may be adversely affected.

The acquisition of Taqua may result in additional expenses that could adversely affect the financial results of the combined company.

The financial results of Sonus and Taqua as a combined company may be adversely affected by cash expenses and non-cash accounting charges incurred in connection with the combination. In addition to the amortization of intangible assets acquired in connection with this acquisition and other related expenses, we recorded $0.1million and $1.2 million of acquisition-related cash expense in the first quarter of 2017 and in 2016, respectively, in connection with this acquisition and may incur additional acquisition-related cash expense in the future. The price of our common stock could decline to the extent the combined company's financial results are materially affected by these charges.

Any future investments, mergers or acquisitions we make or enter into, as applicable, could be difficult to integrate, disrupt our business, dilute shareholder value and seriously harm our financial condition.

We are not currently a party to any material pending merger or acquisition agreements. However, we may merge with or acquire additional businesses, products or technologies in the future. No assurance can be given that any future merger or acquisition will be successful or will not materially and adversely affect our business, operating results or financial condition. We continue to review opportunities to merge with or acquire other businesses or technologies that would add to our existing product line, complement and enhance our current products, expand the breadth of our markets, enhance our technical capabilities or otherwise offer growth opportunities. If we enter into a merger or make acquisitions in the fu