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Table of Contents

 

 

 

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 July 31, 2010

 

OR

 

o

 

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

 

For the transition period from           to      

 

Commission file number 000-26209

 

 

Ditech Networks, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

 

94-2935531

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification Number)

 

825 East Middlefield Road

Mountain View, California 94043

(Address of principal executive offices) (Zip Code)

 

(650) 623-1300

(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 past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the 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  o   No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,”  “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company x

(Do not check if a smaller reporting company)

 

 

 

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

 

As of August 31, 2010, 26,494,438 shares of the Registrant’s common stock were outstanding.

 

 

 



Table of Contents

 

Ditech Networks, Inc.

FORM 10-Q for the Quarter Ended July 31, 2010

 

INDEX

 

 

 

 

Page

 

 

 

 

Part I.

 

Financial Information

 

 

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

 

 

Condensed Consolidated Statements of Operations for the three months ended July 31, 2010 and July 31, 2009

3

 

 

 

 

 

 

Condensed Consolidated Balance Sheets at July 31, 2010 and April 30, 2010

4

 

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the three months ended July 31, 2010 and July 31, 2009

5

 

 

 

 

 

 

Notes to Condensed Consolidated Financial Statements

6

 

 

 

 

 

Item 2.

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

19

 

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

36

 

 

 

 

 

Item 4.

Controls and Procedures

37

 

 

 

 

Part II.

 

Other Information

 

 

 

 

 

 

Item 1A.

Risk Factors

37

 

 

 

 

 

Item 6.

Exhibits

38

 

 

 

 

 

 

Signature

39

 

2



Table of Contents

 

PART I. FINANCIAL INFORMATION

 

ITEM I. Financial Statements

 

Ditech Networks, Inc.

Condensed Consolidated Statements of Operations

(in thousands, except per share data)

 

(unaudited)

 

 

 

Three Months Ended July 31,

 

 

 

2010

 

2009

 

 

 

 

 

 

 

Revenue

 

 

 

 

 

Product revenue

 

$

2,341

 

$

4,877

 

Service revenue

 

1,698

 

1,218

 

Total revenue

 

4,039

 

6,095

 

 

 

 

 

 

 

Cost of goods sold

 

 

 

 

 

Product revenue

 

1,074

 

2,459

 

Service revenue

 

1,165

 

163

 

Total cost of goods sold(1)

 

2,239

 

2,622

 

 

 

 

 

 

 

Gross profit

 

1,800

 

3,473

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

Sales and marketing(1)

 

2,030

 

2,224

 

Research and development(1)

 

2,188

 

2,808

 

General and administrative(1)

 

1,435

 

1,470

 

Amortization of purchased intangible assets

 

20

 

18

 

 

 

 

 

 

 

Total operating expenses

 

5,673

 

6,520

 

 

 

 

 

 

 

Loss from operations

 

(3,873

)

(3,047

)

Other income (expense), net

 

(9

)

(693

)

 

 

 

 

 

 

Loss before provision for income taxes

 

(3,882

)

(3,740

)

Provision for income taxes

 

1

 

33

 

 

 

 

 

 

 

Net loss

 

$

(3,883

)

$

(3,773

)

 

 

 

 

 

 

Per share data:

 

 

 

 

 

Basic:

 

 

 

 

 

Net loss

 

$

(0.15

)

$

(0.14

)

 

 

 

 

 

 

Diluted:

 

 

 

 

 

Net loss

 

$

(0.15

)

$

(0.14

)

 

 

 

 

 

 

Weighted shares used in per share calculation:

 

 

 

 

 

Basic and diluted

 

26,346

 

26,173

 

 


(1)           Stock-based compensation expense was as follows for the periods:

 

Cost of goods sold

 

$

21

 

$

42

 

Sales and marketing

 

109

 

130

 

Research and development

 

61

 

69

 

General and administrative

 

157

 

145

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

 

3



Table of Contents

 

Ditech Networks, Inc.

Condensed Consolidated Balance Sheets

(in thousands, except per share data)

 

(unaudited)

 

 

 

July 31,
2010

 

April 30,
2010

 

 

 

 

 

 

 

Assets

 

 

 

 

 

Cash and cash equivalents

 

$

26,908

 

$

29,634

 

Short-term investments

 

4,560

 

4,800

 

Accounts receivable, net of allowance for doubtful accounts of $250 at July 31, 2010 and April 30, 2010

 

3,600

 

2,440

 

Inventories

 

5,604

 

5,985

 

Other current assets

 

352

 

690

 

 

 

 

 

 

 

Total current assets

 

41,024

 

43,549

 

 

 

 

 

 

 

Long-term investments

 

100

 

100

 

Property and equipment, net

 

2,047

 

2,370

 

Purchased intangibles, net

 

502

 

522

 

Other assets

 

6,033

 

6,413

 

 

 

 

 

 

 

Total assets

 

$

49,706

 

$

52,954

 

 

 

 

 

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Accounts payable

 

$

1,280

 

$

892

 

Accrued expenses

 

2,738

 

2,695

 

Deferred revenue

 

848

 

890

 

Current portion of long-term debt

 

200

 

160

 

Income taxes payable

 

60

 

66

 

Total current liabilities

 

5,126

 

4,703

 

 

 

 

 

 

 

Long term accrued liabilities

 

3,359

 

3,505

 

 

 

 

 

 

 

Total liabilities

 

8,485

 

8,208

 

 

 

 

 

 

 

Commitments and contingencies (Note 9)

 

 

 

 

 

 

 

 

 

 

 

Common stock, $0.001 par value: 200,000 shares authorized and 26,493 and 26,393 shares issued and outstanding at July 31, 2010 and April 30, 2010, respectively

 

26

 

26

 

Additional paid-in capital

 

267,402

 

267,044

 

Accumulated deficit

 

(226,207

)

(222,324

)

 

 

 

 

 

 

Total stockholders’ equity

 

41, 221

 

44,746

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

49,706

 

$

52,954

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

 

4



Table of Contents

 

Ditech Networks, Inc.

Condensed Consolidated Statements of Cash Flows

(in thousands)

 

(unaudited)

 

 

 

Three months ended July 31,

 

 

 

2010

 

2009

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(3,883

)

$

(3,773

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

712

 

568

 

Accretion of interest on long-term note payable

 

41

 

 

Stock-based compensation expense

 

348

 

386

 

Impairment loss on investments

 

 

866

 

Amortization of purchased intangibles

 

20

 

18

 

Changes in assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(1,160

)

1,015

 

Inventories

 

380

 

1,545

 

Other current assets

 

338

 

(69

)

Income taxes payable

 

(6

)

25

 

Accounts payable

 

388

 

(562

)

Accrued expenses

 

(145

)

(493

)

Deferred revenue

 

(42

)

385

 

 

 

 

 

 

 

Net cash used in operating activities

 

(3,009

)

(89

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

(9

)

(351

)

Refund of facility lease deposit

 

 

72

 

Purchases of available for sale investments

 

(2,880

)

 

Sales and maturities of available for sale investments

 

3,120

 

 

 

 

 

 

 

 

Net cash provided by (used in) investing activities

 

231

 

(279

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from employee stock plan issuances

 

52

 

38

 

 

 

 

 

 

 

Net cash provided by financing activities

 

52

 

38

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

(2,726

)

(330

)

Cash and cash equivalents, beginning of period

 

29,634

 

38,586

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

26,908

 

$

38,256

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

 

5



Table of Contents

 

DITECH NETWORKS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

(unaudited)

 

1.             DESCRIPTION OF BUSINESS

 

Ditech Networks, Inc. (the “Company”) designs, develops and markets telecommunications equipment for use in wireline, wireless, satellite and IP telecommunications networks.  The Company’s products enhance and monitor voice quality and provide security in the delivery of voice services.  In addition, the Company has entered the voice services market of telecommunications by developing and marketing voice products that can be used by phone customers to interact with web-based applications using their voice instead of some form of keyboard interface device and to have voice messages transcribed into textual messages. The Company has established a direct sales force that sells its products in the U.S. and internationally. In addition, the Company utilizes value added resellers and distributors, primarily in the Company’s international markets.

 

2.             SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated. The accompanying condensed consolidated financial statements as of July 31, 2010, and for the three month periods ended July 31, 2010 and 2009, together with the related notes, are unaudited but include all adjustments (consisting only of normal recurring adjustments) which, in the opinion of management, are necessary for the fair statement, in all material respects, of the financial position and the operating results and cash flows for the interim date and periods presented. The April 30, 2010 condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Results for the interim period ended July 31, 2010 are not necessarily indicative of results for the entire fiscal year or future periods. These condensed consolidated financial statements should be read in conjunction with the financial statements and related notes thereto for the year ended April 30, 2010, included in the Company’s Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 14, 2010, file number 000-26209.

 

Computation of Loss per Share

 

Basic loss per share is calculated based on the weighted average number of shares of common stock outstanding during the period. Diluted loss per share for the three months ended July 31, 2010 and 2009 is calculated excluding the effects of all common stock equivalents, as their effect would be anti-dilutive.  For the three month periods ended July 31, 2010 and 2009, common stock equivalents, primarily options, totaling 5,695,000 shares and 5,517,000 shares, respectively, were excluded from the calculation of diluted loss per share, as their impact would be anti-dilutive. The diluted loss per share for the first quarter of fiscal 2011 also excludes the impact of 1,000,000 shares potentially issuable upon conversion of Simulscribe’s convertible note payable and 100,000 shares potentially issuable under the warrant issued as part of the Grid acquisition. See Notes 4 and 5 of these Notes to the Condensed Consolidated Financial Statements for a further discussion of the Simulscribe and Grid transactions.

 

A reconciliation of the numerator and denominator used in the calculation of the basic and diluted net loss per share follows (in thousands, except per share amounts):

 

 

 

Three Months Ended, July 31

 

 

 

2010

 

2009

 

Net loss per share, basic and diluted:

 

 

 

 

 

Net loss

 

$

(3,883

)

$

(3,773

)

 

 

 

 

 

 

Basic:

 

 

 

 

 

Weighted average shares outstanding

 

26,360

 

26,206

 

Less restricted stock included in weighted shares outstanding subject to vesting

 

(14

)

(33

)

Weighted average shares used in calculation of basic loss per share

 

26,346

 

26,173

 

 

 

 

 

 

 

Net loss per share

 

$

(0.15

)

$

(0.14

)

 

 

 

 

 

 

Diluted:

 

 

 

 

 

Shares used in calculation of basic loss per share

 

26,346

 

26,173

 

Restricted stock included in weighted shares outstanding subject to vesting

 

 

 

Dilutive effect of stock plans

 

 

 

Dilutive effect of convertible debentures

 

 

 

Shares used in calculation of diluted loss per share

 

26,346

 

26,173

 

 

 

 

 

 

 

Net loss per share

 

$

(0.15

)

$

(0.14

)

 

6



Table of Contents

 

Comprehensive Income (Loss)

 

For the three month period ended July 31, 2009, comprehensive loss was $(3.4) million and included the impact of unrealized gains and losses on available for sale investments, net of tax. There was no difference between reported net loss and comprehensive loss for the three months ended July 31, 2010.

 

Accounting for Stock-Based Compensation

 

Stock-based compensation expense recognized during the period is based on the fair value of the actual awards vested or expected to vest. Stock-based compensation expense recognized in the Company’s Condensed Consolidated Statements of Operations for the three months ended July 31, 2010 and 2009 included compensation expense for stock-based payment awards granted prior to, but not yet vested as of, April 30, 2006, the date of adoption of stock-based compensation accounting, based on the grant date fair value estimated in accordance with the predecessor stock-based compensation guidance, and compensation expense for the stock-based payment awards granted subsequent to April 30, 2006 based on the grant date fair value estimated in accordance with the provisions of current stock-based compensation guidance. Effective May 1, 2006, the Company changed its accounting policy of attributing the fair value of stock-based compensation to expense from the accelerated multiple-option approach provided by the predecessor stock-based compensation guidance, to the straight-line single-option approach.  Compensation expense for all stock-based payment awards expected to vest that were granted on or prior to April 30, 2006 will continue to be recognized using the accelerated attribution method. Compensation expense for all stock-based payment awards expected to vest that were granted or modified subsequent to April 30, 2006 is recognized on a straight-line basis. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

 

The fair value of stock-based payment awards is estimated on the date of grant using an option-pricing model. The Company uses the Black-Scholes option-pricing model to determine the fair-value of stock based awards. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Condensed Consolidated Statement of Operations. In the periods presented, the Company has issued non-vested stock options and restricted stock units with performance goals to certain senior members of management. The number of non-vested stock options or non-vested restricted stock units underlying each award may be determined based on a range of attainment within defined performance goals. The Company is required to estimate the attainment that will be achieved related to the defined performance goals and number of non-vested stock options or non-vested restricted stock units that will ultimately be awarded in order to recognize compensation expense over the vesting period. If the Company’s initial estimates of performance goal attainment change, the related expense may fluctuate from quarter to quarter based on those estimates and if the performance goals are not met, no compensation cost will be recognized and any previously recognized compensation cost will be reversed.

 

There was no tax benefit from the exercise of stock options related to deductions in excess of compensation cost recognized in the three months ended July 31, 2010 and 2009. The Company reflects the tax savings resulting from tax deductions in excess of expense reflected in its financial statements as a financing cash flow.

 

Investments

 

Investment securities that have maturities of more than three months at the date of purchase but current maturities of less than one year are considered short-term investments. Long-term investment securities include any investments with remaining maturities of one year or more and auction rate securities that failed to settle beginning in fiscal 2008, for which conditions leading to their failure at auction create uncertainty as to whether they will settle in the near-term. Auction rates securities, in which the Company invests, have underlying instruments that consist primarily of corporate notes and asset backed securities. The Company’s investment securities are maintained at two major financial institutions, are classified as available-for-sale, and are recorded on the Condensed Consolidated Balance Sheets at fair value, with unrealized gains and losses included in accumulated other comprehensive income (loss), a component of stockholders’ equity, net of tax. If the Company sells its investments prior to their maturity, it may record a realized gain or loss in the period the sale took place. In the first quarter of fiscal 2011 and 2010, the Company realized no gains or losses on its investments.

 

The Company evaluates its investments periodically for possible other-than-temporary impairment by reviewing factors such as the length of time and the extent to which the fair value has been below cost-basis, the financial condition of the issuer and the Company’s ability to hold the investment for a period of time, which may be sufficient for anticipated recovery of the market value. To the extent that the historical cost of the available for sale security exceeds the estimated fair market value, and the decline in value is deemed to be other-than-temporary, an impairment charge is recorded in the Condensed Consolidated Statement of Operations. Due to the Company’s understanding of declining financial health of the issuer of one of the auction rate securities held by the Company and the resulting severity of the decline in value of that auction rate security, in the first quarter of fiscal 2010, the Company recognized an impairment loss of $0.9 million.  Since the issue with auction rate securities first arose in the middle of fiscal 2008, the Company has recorded an aggregate impairment loss of $9.9 million associated with the investment in this auction rate security, which had an original recorded cost of $10 million.

 

7



Table of Contents

 

Impairment of Long-lived Assets

 

The Company evaluates the recoverability of its long-lived assets, including its purchased intangibles and intangible assets related to its exclusive distribution agreement, on an annual basis in the fourth quarter, or more frequently if indicators of potential impairment arise.  The Company evaluates the recoverability of its amortizable purchased intangible assets based on an estimate of undiscounted future cash flows resulting from the use of the related asset group and its eventual disposition. The asset group represents the lowest level for which cash flows are largely independent of cash flows of other assets and liabilities. Measurement of an impairment loss for long-lived assets that the Company expects to hold and use is based on the difference between the fair value and carrying value of the asset.  Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.

 

Recent Accounting Pronouncements

 

Recent Accounting Guidance Not Yet Effective

 

In October 2009, the FASB issued authoritative guidance on revenue recognition that will become effective for the Company beginning May 1, 2011, with earlier adoption permitted. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue recognition guidance. Additionally, the FASB issued authoritative guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. The Company is currently assessing the potential effect, if any, on its financial statements.

 

In April 2010, the Financial Accounting Standards Board (FASB) issued new authoritative guidance on the milestone method of revenue recognition. The milestone method applies to research and development arrangements in which one or more payments are contingent upon achieving uncertain future events or circumstances. This guidance defines a milestone and provides criteria for determining whether the milestone method is appropriate. This standard is effective for milestones achieved in fiscal years beginning on or after June 15, 2010, on a prospective basis, with earlier application permitted. As the Company is typically not a party to research and development arrangements, the Company believes this standard will not have a material impact on the Company’s financial statements.

 

3.             BALANCE SHEET ACCOUNTS

 

Inventories

 

Inventories comprised (in thousands):

 

 

 

July 31,
2010

 

April 30,
2010

 

 

 

 

 

 

 

Raw materials

 

$

206

 

$

305

 

Work in progress

 

 

 

Finished goods

 

5,398

 

5,680

 

 

 

 

 

 

 

Total

 

$

5,604

 

$

5,985

 

 

Stock-based compensation included in inventories was not material at July 31, 2010 and April 30, 2010, respectively.

 

Investments

 

The following table summarizes the Company’s investments as of July 31, 2010 (in thousands):

 

 

 

 

 

Gross

 

Gross

 

 

 

 

 

 

 

Unrealized

 

Unrealized

 

 

 

 

 

Cost

 

Gains

 

Losses

 

Fair Value

 

Certificates of deposit

 

$

4,560

 

$

 

$

 

$

4,560

 

Asset backed securities

 

9,975

 

 

(9,875

)

100

 

Total

 

$

14,535

 

$

 

$

(9,875

)

$

4,660

 

 

8



Table of Contents

 

The following table summarizes the Company’s investments as of April 30, 2010 (in thousands):

 

 

 

Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair Value

 

Certificates of deposit

 

$

4,800

 

$

 

$

 

$

4,800

 

Asset backed securities

 

9,975

 

 

(9,875

)

100

 

Total

 

$

14,775

 

$

 

$

(9,875

)

$

4,900

 

 

The asset backed securities are auction rate securities with an aggregate par value of $10.0 million at July 31, 2010 and April 30, 2010. For the three months ended July 31, 2010 and 2009, no gains or losses were realized on the sale of short-term and long-term investments. There were no unrealized holding gains or losses included in accumulated other comprehensive loss in the accompanying Condensed Consolidated Balance Sheets as of July 31, 2010 and April 30, 2010.    An “other than temporary” impairment loss of $0.9 million was recognized as a component of other expense, net in the Condensed Consolidated Statements of Operations in the three months ended July 31, 2009, for two auction rate instruments that failed to settle at auction since the second quarter of fiscal 2008.

 

Auction rate securities, which have failed to settle at auction and for which management does not have a clear near-term exit strategy, are included in long-term investments based on uncertainty as to when they will next settle and on the term of the security underlying the auction rate security. These securities are variable rate debt instruments, which bear interest rates that reset approximately every 7, 28 or 35 days. The underlying securities have contractual maturities which are generally greater than ten years and are primarily issued by municipalities. Typically, the carrying value of auction rate securities approximates fair value due to the frequent resetting of the interest rates. At July 31, 2010 and April 30, 2010, $0.1 million of auction rate securities were classified as long-term investments, consistent with the maturities of the securities underlying the auction rate instruments, due to uncertainty as to when they may settle.

 

The Company uses the concepts of fair value based on estimated discounted future cash flows to value its auction-rate securities that included the following significant inputs and considerations, which have been applied on a consistent basis for all periods presented:

 

·                      projected interest income and principal payments through the expected holding period;

 

·                      the impact of penalty interest provisions on the likelihood and timing of redemption of the underlying security by its issuer;

 

·                      a market risk adjusted discount rate, which was based on actual securities traded in the open market that had similar collateral composition to the auction-rate securities as of April 30, 2010, adjusted for an expected yield premium to compensate for the current lack of liquidity resulting from failing auctions for such securities; and

 

·                      in the case of one of the Company’s auction rate securities which was converted into AMBAC preferred shares, default or collateral value risk adjustments were considered for the discount rate, because AMBAC continues to be down graded by rating agencies and is experiencing increasing liquidity issues.

 

The accounting guidance on fair value accounting clarifies that fair value is an exit price, representing the amount 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 liability. As a basis for considering such assumptions, the guidance on fair value accounting establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which requires the Company to develop its own assumptions. This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. On a recurring basis, the Company measures certain financial assets and liabilities at fair value, including its short-term and long-term investments.

 

When available, the Company uses quoted market prices to determine fair value of certain of its cash and cash equivalents including money market funds; such items are classified in Level 1 of the fair value hierarchy. At July 31, 2010 and April 30, 2010, there were no active markets for these auction rate securities or comparable securities due to current market conditions. Therefore, until such a market becomes active, the Company is determining their fair value based on expected discounted cash flows. Such items are classified in Level 3 of the fair value hierarchy.

 

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Table of Contents

 

The following table presents for each of the fair value hierarchy levels, the assets and liabilities that are measured at fair value on a recurring basis as of July 31, 2010 (in thousands):

 

 

 

Fair Value

 

Level 1

 

Level 2

 

Level 3

 

 

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

Money market funds-recurring

 

$

24,975

 

$

24,975

 

$

 

$

 

Certificates of deposit-recurring

 

4,560

 

4,560

 

 

 

Auction rate securities-recurring

 

100

 

 

 

100

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

29,635

 

$

29,535

 

$

 

$

100

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Long-term convertible note payable-non-recurring

 

$

3,319

 

$

 

$

 

$

3,319

 

Total

 

$

3,319

 

$

 

$

 

$

3,319

 

 

The following table presents for each of the fair value hierarchy levels, the assets and liabilities that are measured at fair value on a recurring basis as of April 30, 2010 (in thousands):

 

 

 

Fair Value

 

Level 1

 

Level 2

 

Level 3

 

 

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

Money market funds-recurring

 

$

25,702

 

$

25,702

 

$

 

$

 

Certificates of deposit-recurring

 

4,800

 

4,800

 

 

 

Auction rate securities-recurring

 

100

 

 

 

100

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

30,602

 

$

30,502

 

$

 

$

100

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Long-term convertible note payable-non-recurring

 

$

3,277

 

$

 

$

 

$

3,277

 

Total

 

$

3,277

 

$

 

$

 

$

3,277

 

 

The following table presents the changes in the Level 3 fair value category for the three months ended July 31, 2010 (in thousands):

 

 

 

 

 

Net Realized/Unrealized

 

 

 

 

 

 

 

 

 

 

 

Gains (Losses) included in

 

 

 

 

 

 

 

 

 

 

 

Impairment
Loss

 

Unrealized Gain
Recognized in
Other

 

Purchases, (Sales), Accretion of
Interest,

 

Transfers in

 

 

 

 

 

April 30,

 

Recognized in

 

Comprehensive

 

Issuances and

 

and/or (out)

 

July 31,

 

 

 

2010

 

Earnings

 

Income (Loss)

 

(Settlements)

 

of Level 3

 

2010

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

Auction rate securities

 

$

100

 

$

 

$

 

$

 

$

 

$

100

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

Long-term convertible note payable

 

$

3,277

 

 

 

$

42

(1)

 

$

3,319

 

 


(1)                                 Reflects the accretion of interest on the convertible note payable to Simulscribe in conjunction with the Company’s exclusive distribution agreement. The carrying value of the note payable as of July 31, 2010 of $3.3 million approximates its fair value.

 

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Table of Contents

 

The following table presents the changes in the Level 3 fair value category for the year ended April 30, 2010 (in thousands):

 

 

 

 

 

Net Realized/Unrealized

 

 

 

 

 

 

 

 

 

 

 

Gains (Losses) included in

 

 

 

 

 

 

 

 

 

 

 

Impairment
Loss

 

Unrealized Gain
Recognized in
Other

 

Purchases, (Sales),
Accretion of
Interest,

 

Transfers in

 

 

 

 

 

May 1,

 

Recognized in

 

Comprehensive

 

Issuances and

 

and/or (out)

 

April 30,

 

 

 

2009

 

Earnings

 

Income (Loss)

 

(Settlements)

 

of Level 3

 

2010

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

Auction rate securities

 

$

4,448

 

$

(977

)

$

329

 

$

(3,700

)(1)

$

 

$

100

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

Long-term convertible note payable

 

 

 

 

$

3,277

(2)

 

$

3,277

 

 


(1)         Reflects sale of one Auction Rate Security at original purchase cost, resulting in no realized gain or loss.

(2)         Reflects the issuance of a $3.5 million non-interest bearing convertible note payable to Simulscribe in conjunction with the Company’s exclusive distribution agreement.  The note was recorded at an initial fair value of $3.2 million and approximately $0.1 million of interest has been accreted.

 

Accrued expenses

 

Accrued expenses comprised (in thousands):

 

 

 

July 31,
2010

 

April 30,
2010

 

Accrued employee compensation

 

$

1,158

 

$

1,247

 

Accrued warranty

 

254

 

301

 

Accrued restructuring costs

 

173

 

217

 

Other accrued expenses

 

1,153

 

930

 

Total

 

$

2,738

 

$

2,695

 

 

Warranty Accrual.    The Company provides for future warranty costs upon shipment of its products. The specific terms and conditions of those warranties may vary depending on the product sold, the customer and the country in which it does business. However, the Company’s hardware warranties generally start from the shipment date and continue for a period of two to five years while the software warranty is generally ninety days to one year.

 

Because the Company’s products are manufactured to a standardized specification and products are internally tested to these specifications prior to shipment, the Company historically has experienced minimal warranty costs. Factors that affect the Company’s warranty liability include the number of installed units, historical experience and management’s judgment regarding anticipated rates of warranty claims and cost per claim. The Company assesses the adequacy of its recorded warranty liabilities every quarter and makes adjustments to the liability, if necessary.

 

Changes in the warranty accrual, which is included as a component of “Accrued expenses” on the Condensed Consolidated Balance Sheet, were as follows (in thousands):

 

 

 

Three Months Ended
July 31,

 

 

 

2010

 

2009

 

 

 

 

 

 

 

Balance as of April 30

 

$

301

 

$

389

 

Provision for warranties issued during fiscal period

 

12

 

29

 

Warranty costs incurred during fiscal period

 

(9

)

(55

)

Other adjustments to the liability (including changes in estimates for pre-existing warranties) during fiscal period

 

(50

)

 

 

 

 

 

 

 

Balance as of July 31

 

$

254

 

$

363

 

 

Reduction in force. In November 2009, the Company completed a reduction in force in an attempt to continue to reduce operating expenses.  As a result of this reduction in force, the Company reduced its workforce by approximately 10%.  In addition in December 2009, the Company completed the sublease of office space vacated in fiscal 2009 and identified additional impairments of fixed assets, which had become idle as a result of the reduction in force and are being held for sale. As a result of these activities, the Company recognized a charge in the third quarter of fiscal 2010 of approximately $0.7 million, including $0.5 million for severance and related benefits, $0.1 million related to incremental losses upon signing the sublease on vacated office space and $0.1 million associated with assets made idle by the reductions in force that are being held for sale.  All individuals impacted by the reduction in headcount were notified of the termination of their employment in November 2009.  As of July 31, 2010, approximately 90% of the remaining balance in the accrual for the reductions in force of $0.2 million relates to the estimated loss associated with subleasing vacated space in the Company’s Mountain View Headquarters and 10% relates to outplacement services and COBRA for the reduction in force completed in November 2009.

 

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Long-term Accrued Liabilities

 

Long-term accrued liabilities comprised (in thousands):

 

 

 

July 31,
2010

 

April 30,
2010

 

Convertible note issued in conjunction with exclusive distribution agreement

 

$

3,319

 

$

3,277

 

Other

 

40

 

228

 

Total

 

$

3,359

 

$

3,505

 

 

4.     GOODWILL AND PURCHASED INTANGIBLES

 

The carrying value of purchased intangible assets acquired in business combinations is as follows (in thousands):

 

 

 

July 31, 2010

 

 

 

Gross
Value

 

Accumulated
Amortization

 

Impairment

 

Net Value

 

Purchased Intangible Assets

 

 

 

 

 

 

 

 

 

Core technology

 

$

3,142

 

$

(2,177

)

$

(763

)

$

202

 

Customer relationships

 

1,100

 

(671

)

(429

)

 

Trade name and trademarks

 

200

 

(122

)

(78

)

 

URL

 

300

 

 

 

300

 

Total

 

$

4,742

 

$

(2,970

)

$

(1,270

)

$

502

 

 

 

 

April 30, 2010

 

 

 

Gross
Value

 

Accumulated
Amortization

 

Impairment

 

Net Value

 

Purchased Intangible Assets

 

 

 

 

 

 

 

 

 

Core technology

 

$

3,142

 

$

(2,157

)

$

(763

)

$

222

 

Customer relationships

 

1,100

 

(671

)

(429

)

 

Trade name and trademarks

 

200

 

(122

)

(78

)

 

URL

 

300

 

 

 

300

 

Total

 

$

4,742

 

$

(2,950

)

$

(1,270

)

$

522

 

 

In February 2010, the Company completed a small acquisition of 100% of the outstanding shares of Grid.com, a company with infrastructure to deliver services with simple credit card billing through the web. The purchase price, net of $0.1 million of cash received from Grid.com, totaled $0.5 million.  This purchase price, which included $35,000 of value attributable to a warrant issued for 100,000 shares of the Company’s common stock at an exercise price of $3.50 per share, based on a Black-Scholes valuation, was allocated to identified intangibles through established valuation techniques in the high-technology communications equipment industry.  The warrant expires in February 2013. As a result, the Company recorded an incremental $0.2 million in core technology intangible assets and $0.3 million related to the URL, the latter of which the Company has determined is an indefinite lived intangible asset.

 

In the three months ended July 31, 2010 and 2009, the Company recorded $20,000 and $18,000, respectively, of amortization of acquisition-related intangible assets.

 

Estimated future amortization expense for the core technology purchased intangible asset as of July 31, 2010 is as follows (in thousands):

 

 

 

Years ended April 30,

 

 

 

 

 

2011 (nine months)

 

$

61

 

2012

 

81

 

2013

 

60

 

 

 

$

202

 

 

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Table of Contents

 

5.             EXCLUSIVE DISTRIBUTION AGREEMENT

 

On September 10, 2009, the Company and Simulscribe, entered into a Reseller Agreement pursuant to which Simulscribe will provide, and the Company became the exclusive reseller of, Simulscribe’s voice to text (VTT) services to wholesale customers.  Pursuant to the agreement, the Company also assumed all of Simulscribe’s wholesale customers.  The Company (a) paid $3.5 million and issued a two-year promissory note for an additional $3.5 million for the assumption of the wholesale customer relationships and the exclusivity rights, (b) will pay a fee for the services provided by Simulscribe, and (c) will pay up to an additional $10 million if the revenues generated from the Simulscribe services meet certain performance milestones within the first three years of the agreement (the “Additional Payments”), subject to acceleration in certain events, such as the Company’s failure to use commercially reasonable efforts to market the services or a change of control of the Company at a time that revenues from these services are on track to result in the payment ultimately being made.

 

The note and the Additional Payments are convertible into the Company’s common stock at Simulscribe’s option.  The note is convertible into the Company’s common stock at maturity in two years at a conversion price of $3.50 per share, subject to adjustment for stock splits, stock dividends and the like. The note payable, which is due September 10, 2011, is non-interest bearing and includes an acceleration clause in the event of a change in control of the Company.  The note has been recorded at its fair value of $3.2 million based on an assumed interest rate of 5%, which represents the current market rate of interest at which the Company could borrow.  In the first quarter of fiscal 2011, the Company recognized $41,000 of interest expense associated with amortizing the $0.3 million discount on this note as a component of other expense, net in the Condensed Consolidated Statements of Operations.  There was no accretion of interest expense for the corresponding period in fiscal 2010. The remaining discount will be recognized over the remainder of the term of the note.  The Additional Payments may be converted into the Company’s common stock at a conversion price of $5.00 per share, provided that if a specified revenue target is met then up to $5.0 million of the Additional Payments can be converted at $4.00 per share.  The value of the additional payments has not been recorded as of the date of the transaction pursuant to the accounting guidance related to the issuance of equity-based instruments to non-employees for the purchase of goods or services, as it is not probable of incurrence.  In the event that payouts under the Additional Payments provisions of the agreement become probable of incurrence based on an assessment with know customer revenue streams and the remaining duration of agreement and/or the conditions of the payout are met, the Company will record the fair value of the Additional Payments at that time.

 

As a result of this agreement, the Company recorded the total consideration at a fair value of $6.7 million and recorded assets associated with the exclusive distribution rights and transfer of customers.  The value assigned to the intangible assets, which are recorded in other assets on the face of the Condensed Consolidated Balance Sheet, was determined by valuing the discounted potential cash flows associated with each asset over the four year term of the agreement.  The asset associated with the transferred customer relationships will be amortized, on a tax deductible basis, to sales and marketing expense ratably over the four year term of the agreement and the asset associated with the distribution rights will be amortized, on a tax deductible basis, to cost of goods sold on a unit of revenue basis, similar to a royalty payment, at the rate of 25% of revenue recognized based on the base level of revenue anticipated in the Agreement attributable to the $7 million of consideration issued to date.  The Company recorded amortization expense associated with the distribution rights of approximately $0.2 million for the three months ended July 31, 2010, and amortization expense associated with the customer relationships of approximately $0.2 million for the three months ended July 31, 2010.  There was no amortization expense for the corresponding period in fiscal 2010.

 

Subsequent to executing the Agreement, the Company hired one of the principle officers of Simulscribe to assume the position of Chief Strategy Officer at the Company.  His primary focus is on expansion of the wholesale market for voice transcription service.  This individual continues to hold a large ownership interest in Simulscribe.  As such, although he may have input into key decisions related to interaction between the Company and Simulscribe, the final decisions rest with the executive management team, of which he is not a member, and/or the Board of Directors.  This individual was also a major shareholder in Grid.com, which the Company acquired in February 2010.

 

In the fourth quarter of fiscal 2010, the Company and Simulscribe, entered into an Amendment No. 1 to Reseller Agreement (the “Amendment”), amending the Reseller Agreement previously entered into between the Company and Simulscribe on September 10, 2009. Primarily, the Amendment permits the Company to provide services to all voice to text customers, both retail and wholesale. Among other things, the Amendment also contains additional changes to the Reseller Agreement to conform to the new structure, and provides that both the retail and wholesale services will count as “Additional Payments” for purposes of determining what amount, if any, of the $10 million contingent consideration will be paid to Simulscribe.  In consideration for the amendment, the Company agreed to pay an additional $0.3 million in seven equal quarterly installments.  The first payment was made in the fourth quarter of fiscal 2010.  The Company recognized this consideration as an addition to the customer relationship intangible asset, which amount is being amortized over the remainder of the 4 year life assigned to the original customer relationship intangible asset in September 2009.

 

The carrying value of the related intangible assets acquired, which are included in other assets, was as follows (in thousands):

 

 

 

July 31, 2010

 

 

 

Gross

 

Accumulated

 

 

 

 

 

 

 

Value

 

Amortization

 

Impairment

 

Net Value

 

Distribution Agreement Intangible Assets:

 

 

 

 

 

 

 

 

 

Customer relationships

 

$

2,514

 

$

(552

)

$

 

$

1,962

 

Distribution rights

 

4,440

 

(465

)

 

3,975

 

Total

 

$

6,954

 

$

(1,017

)

$

 

$

5,937

 

 

 

 

 

 

 

April 30, 2010

 

 

 

Gross

 

Accumulated

 

 

 

 

 

 

 

Value

 

Amortization

 

Impairment

 

Net Value

 

Distribution Agreement Intangible Assets:

 

 

 

 

 

 

 

 

 

Customer relationships

 

$

2,514

 

$

(389

)

$

 

$

2,125

 

Distribution rights

 

4,440

 

(249

)

 

4,191

 

Total

 

$

6,954

 

$

(638

)

$

 

$

6,316

 

 

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Table of Contents

 

Estimated future amortization expense for the customer relationship related intangible asset as of July 31, 2010 is as follows (in thousands):

 

 

 

Years ended April 30,

 

 

 

 

 

2011 (nine months)

 

$

493

 

2012

 

656

 

2013

 

606

 

2014

 

207

 

 

 

$

1,962

 

 

6.             STOCKHOLDERS’ EQUITY

 

Employee Equity Plans

 

The Company utilizes a combination of Employee Stock Purchase, Stock Option and Restricted Stock plans as a means to provide equity ownership in the Company for its employees. In the first quarter of fiscal 2011, 44,767 shares of common stock were issued under the Employee Stock Purchase Plan (“ESPP”) and 69,679 shares remain available for issuance under that plan as of July 31, 2010.

 

Activity under the stock option and restricted stock plans was as follows (in thousands, except exercise price amounts):

 

 

 

 

 

Outstanding Options

 

 

 

Shares Available
For Grant(1)

 

Number
of Shares

 

Weighted Average
Exercise Price

 

Balances, April 30, 2010

 

1,244

 

5,668

 

$

4.69

 

Restricted stock and restricted stock units issued

 

 

 

 

 

 

Restricted stock and restricted stock units forfeited

 

68

 

 

 

 

 

Options granted

 

(105

)

105

 

$

1.47

 

Options exercised

 

 

(1

)

$

0.91

 

Options forfeited

 

101

 

(101

)

$

2.20

 

Options expired

 

201

 

(201

)

$

6.56

 

Plan shares expired

 

(88

)

 

 

 

 

 

 

 

 

 

 

 

Balances, July 31, 2010

 

1,421

 

5,470

 

$

4.61

 

 


(1) Shares available for grant include shares from the 2005 New Recruit Stock Plan and the 2006 Equity Incentive Plan that may be issued as either stock options, restricted stock or restricted stock units. Shares issued under the 2006 Equity Incentive Plan as stock bonus awards, stock purchase awards, stock unit awards, or other stock awards in which the issue price is less than the fair market value on the date of grant of the award count as the issuance of 1.3 shares for each share of common stock issued pursuant to these awards for purposes of the share reserve.

 

The aggregate intrinsic value of stock options exercised in each of the first quarters of fiscal 2011 and 2010 was $0.

 

The summary of options vested and exercisable at July 31, 2010 comprised (in thousands, except term and exercise price):

 

 

 

Number of
Shares

 

Weighted
Average
Exercise Price

 

Aggregate
Intrinsic
Value

 

Weighted
Average
Remaining
Contractual
Term

 

Fully vested and expected to vest options

 

5,192

 

$

4.78

 

$

185

 

5.61

 

Options exercisable

 

3,541

 

$

6.16

 

$

102

 

4.21

 

 

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Table of Contents

 

The summary of unvested restricted stock awards for the first quarter of fiscal 2011 comprised (in thousands, except per share data):

 

 

 

Number of
Shares

 

Weighted Average
Grant Date Fair
Value

 

Nonvested restricted stock, April 30, 2010

 

44

 

$

4.29

 

Restricted stock issued

 

 

$

 

Restricted stock vested

 

(8

)

$

6.75

 

Restricted stock forfeited

 

(21

)

$

2.47

 

 

 

 

 

 

 

Nonvested restricted stock, July 31, 2010

 

15

 

$

5.56

 

 

The summary of unvested restricted stock units for the first quarter of fiscal 2011 comprised (in thousands):

 

 

 

Number of
Shares

 

Nonvested restricted stock units, April 30, 2010

 

318

 

Restricted stock units issued

 

 

Restricted stock units vested

 

(107

)

Restricted stock units forfeited

 

 

 

 

 

 

Nonvested restricted stock units, July 31, 2010

 

211

 

 

The aggregate intrinsic value of vested and expected to vest restricted stock awards and restricted stock units, which had a weighted average remaining contractual term of 1.7 years, was $211,000 at July 31, 2010. For the periods ended July 31, 2010 and 2009, the total fair value of restricted shares that vested was $0.1 million and $0.1 million, respectively.

 

As of July 31, 2010, there was approximately $1.5 million of total unrecognized compensation cost related to stock options and restricted stock/RSUs that is expected to be recognized over a weighted-average period of 2.2 years for options and 1.7 years for restricted stock and restricted stock units.

 

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The key assumptions used in the fair value model and the resulting estimates of weighted-average fair value per share used to record stock-based compensation in the first quarter of fiscal 2011 and 2010 for options granted and for employee stock purchases under the ESPP, during these periods are as follows:

 

 

 

Three months ended
July 31,

 

 

 

2010

 

2009

 

Stock options:

 

 

 

 

 

Dividend yield(1)

 

 

 

Volatility factor(2)

 

0.67

 

0.70

 

Risk-free interest rate(3)

 

2.0

%

2.7

%

Expected life (years)(4)

 

4.7

 

4.6

 

Weighted average fair value of options granted during the period

 

$

0.81

 

$

0.58

 

 

 

 

 

 

 

Employee stock purchase plan:(5)

 

 

 

 

 

 

 

 

 

 

 

Dividend yield(1)

 

 

 

Volatility factor(2)

 

0.56

 

1.03

 

Risk-free interest rate(3)

 

0.32

%

0.51

%

Expected life (years)(4)

 

0.99

 

0.99

 

Weighted average fair value of employee stock purchases during the period

 

$

0.49

 

$

0.59

 

 

 

 

 

 

 

Restricted stock and restricted stock units:

 

 

 

 

 

 

 

 

 

 

 

Weighted average fair value of restricted stock and RSUs granted during the period

 

$

 

$

1.05

 

 


(1) The Company has no history or expectation of paying dividends on its common stock.

 

(2) The Company estimates the volatility of its common stock at the date of grant based on the historic volatility of its common stock for a term consistent with the expected life of the awards affected at the time of grant.

 

(3) The risk-free interest rate is based on the U.S. Treasury yield for a term consistent with the expected life of the awards in affect at the time of grant.

 

(4) The expected life of stock options granted under the Stock Option Plans is based on historical exercise patterns, which the Company believes are representative of future behavior. The expected life of grants under the ESPP represents the amount of time remaining in the 12-month offering window.

 

(5) Assumptions for the Purchase Plan relate to the most recent enrollment period. Enrollment is currently permitted in May and November of each year.

 

7.             BORROWING AGREEMENT

 

In July 2010, the Company renewed its $2.0 million line of credit with its bank.  The renewed line of credit has substantially the same terms as the prior line of credit and expires on July 31, 2011. There were no borrowings outstanding under the line of credit as of July 31, 2010 and the Company was in compliance with its financial covenants.

 

8.             INCOME TAXES

 

The guidance on Accounting for Uncertainty in Income Taxes prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The liability for uncertain tax positions, if recognized, will decrease the Company’s tax expense. The Company does not anticipate that the amount of liability for uncertain tax positions existing at July 31, 2010 will change significantly within the next 12 months.  Interest and penalties related to the liability for uncertain tax positions are included in provision for income taxes.

 

The Company files income tax returns in the U.S. and various state and foreign jurisdictions. Most U.S. and foreign jurisdictions have 3 to10 years of open tax years. However, all the Company’s tax years since fiscal 1998 will be open to examination by the U.S. federal and certain state tax authorities due to the Company’s overall net operating loss and/or tax credit carryforward position. Based on the results of the most recent review of the impacts of ownership changes in our common stock on the future realizability of tax carryforwards, the Company put in place certain modifications to its Preferred Share Purchase Rights Plan.  The intent of these modifications is to reduce the risk of that future changes in the ownership interests will be sufficiently material as to require the Company to limit the amount of tax carryforward that can be realized in future periods. The Company is currently under audit by one state jurisdiction in which it operates for its fiscal 2005 filing but is not under examination by any other tax jurisdictions.

 

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The Company recorded a tax provision of $1,000 for the three months ended July 31, 2010 resulting in an effective tax rate of less than 1%.  The Company recorded a tax provision of $33,000 for the three months ended July 31, 2009 resulting in an effective tax rate of less than 1%. The effective tax rate for the three months ended July 31, 2010 and 2009 reflected the effects of a full valuation allowance against the federal and state net operating loss and tax credit carryforwards created during the quarter due to uncertainty as to the recoverability of those items due to the Company’s continuing operating losses. The tax provision for the quarter ended July 31, 2010 and 2009 is attributable to certain state and foreign jurisdictions in which the Company operates.

 

9.             COMMITMENTS AND CONTINGENCIES

 

Legal Proceedings

 

The Company is not a party to any material legal proceedings.  From time to time, the Company may be subject to legal proceedings and claims in the ordinary course of business.  These claims, even if not meritorious, could result in the expenditure of significant financial resources and diversion of management’s attention.

 

Lease Commitments

 

At July 31, 2010, future minimum payments and related sublease receipts under the Company’s current operating leases are as follows (in thousands):

 

Years ending April 30,

 

Minimum Lease
Payments

 

Sublease Payments

 

Net Lease
Payments

 

2011 (nine months)

 

$

828

 

$

(81

)

$

747

 

2012

 

276

 

(27

)

249

 

 

 

 

 

 

 

 

 

 

 

$

1,104

 

$

(108

)

$

996

 

 

Guarantees and Indemnifications

 

As is customary in the Company’s industry and as required by law in the U.S. and certain other jurisdictions, certain of the Company’s contracts provide remedies to its customers, such as defense, settlement, or payment of judgment for intellectual property claims related to the use of the Company’s products. From time to time, the Company indemnifies customers against combinations of losses, expenses, or liabilities arising from various trigger events related to the sale and the use of the Company’s products and services. In addition, from time to time the Company also provides protection to customers against claims related to undiscovered liabilities, additional product liability or environmental obligations. In the Company’s experience, claims made under such indemnifications are rare.

 

As permitted or required under Delaware law and to the maximum extent allowable under that law, the Company has certain obligations to indemnify its current and former officers and directors for certain events or occurrences while the officer or director is, or was serving at the Company’s request, in such capacity. These indemnification obligations are valid as long as the director or officer acted in good faith and in a manner that a person reasonably believed to be in or not opposed to the best interests of the Company, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his or her conduct was unlawful. The maximum potential amount of future payments the Company could be required to make under these indemnification obligations is unlimited; however, the Company has a director and officer insurance policy that limits the Company’s exposure and enables the Company to recover a portion of any future amounts paid. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnification obligations is minimal.

 

10.          REPORTABLE SEGMENTS AND GEOGRAPHIC INFORMATION

 

The Company is a global telecommunications equipment supplier for voice networks. The Company develops, produces and sells voice quality enhancement solutions as well as voice applications solutions to telecommunication service providers worldwide. The Company’s voice quality enhancement solutions enable service providers to deliver consistently clear, end-to-end communications to their subscribers. The Company’s revenues are organized along two main product categories: product and services, the latter of which is comprised of the Company’s new voice applications offerings as well as services in support of its voice quality enhancement solutions.  The Company currently operates in two business segments: the voice quality enhancement segment, which includes service revenues related to delivery of these solutions; and the voice applications segment.  The segments are determined in accordance with how management views and evaluates the Company’s business and based on the criteria as outlined in the authoritative guidance. A description of the types of products and services provided by each reportable segment is as follows:

 

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Voice Quality Enhancement Segment

 

The Company designs, develops, and markets stand-alone and system-based voice quality products for circuit-switched and VoIP mobile networks throughout the world. The Company’s products feature high-capacity, high-availability hardware systems coupled with a sophisticated array of voice optimization and measurement software to enhance the quality of voice communications.  In addition to the hardware systems that comprise this segment, the Company also includes services such as maintenance, training and installation which support the hardware system sales.

 

Voice Applications Segment

 

Voice services includes a range of applications and services with the common goal of utilizing the human voice to interface with various aspects of day to day life which have been historically limited to keyboard interface.  The products include voice-to-text transcription services, voice-based interface with the web and web-based applications, including social networking and calendar applications.

 

Segment Revenue and Contribution Margin

 

Segment contribution margin includes all product line segment revenues less the related cost of sales,  marketing and engineering expenses directly identifiable to each segment. Management allocates corporate manufacturing costs and some infrastructure costs such as facilities and information technology costs in determining segment contribution margin. Contribution margin is used, in part, to evaluate the performance of, and allocate resources to, each of the segments. Certain operating expenses are not allocated to segments because they are separately managed at the corporate level. These unallocated costs include sales costs, marketing costs other than direct marketing, general and administrative costs, such as legal and accounting, stock-based compensation expenses, acquisition-related integration costs, amortization and impairment of purchased intangible assets, restructuring costs, interest and other income (expense), net.

 

Segment Data

 

The results of the reportable segments are derived directly from the Company’s management reporting system. The results are based on the Company’s method of internal reporting and are not necessarily in conformity with accounting principles generally accepted in the United States. The Company measures the performance of each segment based on several metrics, including contribution margin.

 

Asset data, with the exception of inventory, is not reviewed by management at the segment level. All of the products and services within the respective segments are generally considered similar in nature, and therefore a separate disclosure of similar classes of products and services below the segment level is not presented.

 

Financial information for each reportable segment is as follows as of July 31, 2010 and April 30, 2010 and for the three months ended July 31, 2010 and 2009 (in thousands):

 

 

 

Voice Quality
Enhancement

 

Voice
Applications

 

Total

 

For the three months ended July 31, 2010:

 

 

 

 

 

 

 

Revenue

 

$

3,164

 

$

875

 

$

4,039

 

Contribution margin

 

992

 

(1,448

)

(456

)

As of July 31, 2010: Inventories

 

5,604

 

 

5,604

 

For the three months ended July 31, 2009:

 

 

 

 

 

 

 

Revenue

 

$

6,095

 

$

 

$

6,095

 

Contribution margin

 

2,240

 

(1,110

)

1,130

 

As of April 30, 2010: Inventories

 

5,985

 

 

5,985

 

 

The reconciliation of segment information to the Company’s condensed consolidated totals is as follows (in thousands):

 

 

 

Three Months Ended

 

 

 

July 31,
2010

 

July 31,
2009

 

Segment contribution margin

 

$

(456

)

$

1,130

 

Corporate and unallocated costs

 

(3,049

)

(3,773

)

Stock-based compensation

 

(348

)

(386

)

Amortization of purchased intangibles

 

(20

)

(18

)

Interest and other income (expense), net

 

(9

)

(693

)

 

 

 

 

 

 

Loss before provision for income taxes

 

$

(3,882

)

$

(3,740

)

 

Geographic Data

 

Geographic revenue information comprises (in thousands):

 

 

 

Three months ended July 31,

 

 

 

2010

 

2009

 

 

 

 

 

 

 

USA

 

$

2,674

 

$

4,652

 

Asia Pacific

 

1,222

 

316

 

Middle East/Africa

 

55

 

981

 

Rest of World

 

88

 

146

 

 

 

 

 

 

 

Total

 

$

4,039

 

$

6,095

 

 

Sales for the three months ended July 31, 2010 included three customers that represented greater than 10% of total revenue (29%, 17% and 13%). Sales for the three months ended July 31, 2009 included four customers that represented greater than 10% of total revenue (28%, 26%, 15% and 14%).    As of July 31, 2010, the Company had one customer that represented greater than 10% of accounts receivable (54%).  At April 30, 2010, two customers represented greater than 10% of accounts receivable (61% and 15%).

 

The Company maintained substantially all of its property and equipment in the United States at July 31, 2010 and April 30, 2010.

 

11.          SUBSEQUENT EVENT

 

The Company has performed an evaluation of subsequent events through the date on which these financial statements in this Form 10-Q Report were filed with the SEC.

 

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Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and Notes thereto for the year ended April 30, 2010 included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 14, 2010. The discussion in this Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, such as statements of our expected future financial operating results, plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed here. See “Future Growth and Operating Results Subject to Risk” at the end of this Item 2 for factors that could cause future results to differ materially.

 

Overview

 

We provide voice technologies for the telecommunications market.  We design, develop and market telecommunications equipment for use in enhancing voice quality and canceling echo in voice calls over wireline, wireless and internet protocol (IP) telecommunications networks. Our products monitor and enhance voice quality and provide transcoding in the delivery of voice services. Since entering the voice processing market, we have continued to refine our echo cancellation products to meet the needs of the ever-changing telecommunications marketplace. Our TDM-based product introductions have leveraged the processing capacity of our newer hardware platforms to offer not only echo cancellation but also enhanced Voice Quality Assurance (“VQA”) features including noise reduction, acoustic echo cancellation, voice level control and noise compensation through enhanced voice intelligibility.  We have also introduced products to support carriers that are deploying voice over internet protocol, or “VoIP,” technologies which offer all the voice capabilities of our TDM-based products along with codec transcoding to meet the new challenges faced by carriers deploying VoIP technologies.

 

We also design, develop and market telecommunications software and services. We have built a software-centric extension to our voice quality offerings, named mStage, which provides VQA as well as other voice technologies such as mixing and keyword spotting, enabling the next generation of voice application.  We have showcased an application called toktok which highlights the capabilities of mStage. We also market and develop voice-to-text applications, based on our exclusive reseller agreement with Simulscribe.  Voice-to-text utilizes much of the same core expertise in voice processing that underlies VQA.  The current primary market for voice-to-text is voicemail-to-text.  In the voicemail to text area we offer a broad spectrum of services, under the brand “PhoneTag”, including fully automated transcription services as well as transcription services that include human touch-up.  Using the same infrastructure we also offer transcription services for conference calls and other audio sources.

 

Since becoming a public company in June 1999, our financial success has been primarily predicated on the macroeconomic environment of U.S. wireline and, more recently, wireless carriers as well as our success in selling to the larger carriers. Over the years since becoming public, we have experienced ebbs and flows in the level of demand from these carriers due to their level of network expansion, adoption of new technologies in their networks and the impacts of merger and other consolidation in the industry.  Of late, the downturn in business volume we have experienced seems to have been driven by three main factors: technology transitions; budgetary constraints; and the global economic crisis.

 

The technology transition has impacted us on two fronts.  First and foremost, carriers have been extremely cautious to invest in legacy second generation (“2G”) technology, historically our primary source of revenue, for fear of stranding some or all of their investments by moving to newer third/fourth generation technology (“3G/4G”).  The hesitancy to invest in 2G equipment has resulted in protracted purchase cycles and smaller deployments to mitigate perceived risks, while still addressing needed improvements in voice quality in 2G networks.  The second impact has been felt on the 3G/4G investment, which has been far slower to develop than was first predicted by industry experts.  Instead of wholesale deployment of VoIP technologies, we have experienced a much more cautious entrance into this technology by many of the carriers with which we have historically done business, with the key by-product being that they are buying much smaller systems than would have been expected from their historical buying pattern and in some cases even deciding to limit investment in 3G technology in lieu of even newer fourth generation technologies that are currently in development.

 

On the budgetary side, even before the world-wide financial crisis became clear, we began to see tighter budgetary spending on capital equipment in many regions of the world, but most importantly with our large domestic customers.  Spending on capital equipment appears to have been primarily targeted at equipment that could show a direct correlation with revenue generation as opposed to our historical product offerings, which although not a direct source of revenue for carriers is critical to the overall call experience and therefore to customer satisfaction, which in our opinion can ultimately translate into call revenue. It is with this capital spending model in mind that we undertook development of our toktok and mStage products which, although leveraging off of our core knowledge of voice technology, we believe will be our first product offering to truly be tied to an identifiable revenue stream for our carriers.

 

Lastly, we believe that the current market conditions around the world have and could continue to create further delays in purchasing decisions both as carriers tighten their capital investment activity due to internal budget constraints and as tighter credit hampers their ability to borrow to facilitate network expansion and/or upgrades.

 

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Despite the previously mentioned delays due to budget and uncertainty around network architecture, we continue to believe that in the United States our continued focus on voice quality in the competitive wireless services landscape and the continued expansion of wireless networks, primarily using 3G/4G technologies and to a lesser degree 2G technologies, will be key factors in adding new customers and driving opportunities for revenue growth. We continue to believe that 2G technology will be the dominant technology in the international regions of the world where we have focused our sales efforts.  However, we are poised to support the deployment of our Packet Voice Processor (“PVP”) product in 3G/4G networks internationally, should demand for the 3G/4G technology grow internationally. The development of our VQA feature set, which was originally targeted at the international Global System for Mobile Communications (“GSM”) market, has seen growing importance in the domestic market as well. We continue to focus sales and marketing efforts on international and domestic mobile carriers that might best apply our VQA solution. We have continued to invest in customer trials domestically and internationally in an attempt to better avail ourselves of these opportunities as they arise. Despite these efforts, we have experienced mixed results as we remain dependant on the buying patterns of a small, yet more diverse, group of carriers.

 

We expect long-term opportunities for growth will occur in VoIP based network deployments as there appears to be a growing, albeit slow, trend of service providers transitioning from traditional circuit-switched network infrastructure to VoIP. As such, between fiscal 2005 and early fiscal 2009 we directed the majority of our research and development spending towards the development of our PVP, a platform targeting VoIP-based network deployments.  The Packet Voice Processor introduces cost-effective voice format transcoding capabilities combined with our VQA technology to improve call quality and clarity by eliminating acoustic echo and voice level imbalances and reducing packet loss and jitter. Although fiscal 2008 marked the first period in which revenue from the PVP exceeded 10% of total revenue and the first quarter of fiscal 2010 marked the first quarter in which revenue from the PVP exceeded 25% of total revenue, ordering patterns are still volatile leading to spikes in the timing and amount of revenue from this product.

 

Beginning in fiscal 2009, we began shifting our development efforts to other product offerings that leverage off our expertise in voice technology.  The first effort was tied to the creation of licensed versions of our core technology for use in other elements within communications networks, such as Bluetooth headsets.  More recently we have shifted the majority of our development efforts to our mStage and toktok products, which are nearing the end of their initial development efforts and beginning to be deployed for evaluation at potential customer locations.  While the licensing initiative is typically focused on moving our expertise in voice quality to communication interface devices, mStage and toktok are designed to enable mobile subscribers to use their voice as well as their thumbs to interact with web applications like social networking and IM on-demand, even during a phone call.

 

In fiscal 2010, we entered into an exclusive worldwide distribution agreement with Simulscribe.  In conjunction with this agreement we obtained the exclusive right to market Simulscribe’s voice-to-text transcription services to customers around the world.  We believe that this voice-to-text transcription service provides a meaningful complement to the other voice technologies being developed under our mStage and toktok product initiatives. We are undertaking these new opportunities in an effort to not only diversify our product offerings but also our customer base.  We believe that these products could help generate a more predictable revenue base, which we believe is less susceptible to our customer’s decisions on the timing and nature of the network expansions than our legacy product offerings have experienced on a stand alone basis.

 

Due to softened demand for our products over the last three years, we have undertaken a number of cost cutting measures in an attempt to better align our spending with our revenue levels while still investing in the future of the company by means of development projects, like our voice services products which leverage our core strengths in the voice technology and will hopefully provide for more stable revenue streams in the future.  The focus of our cost cutting efforts has not only been on reducing headcount, which has declined by well over 50% since the end of fiscal 2007, but also on targeted spending reductions on discretionary spending areas such as travel, marketing campaigns and trade shows.  We intend to continue to monitor our spending and intend to take further steps if needed to balance our spending with the revenue opportunities we see ahead of us.

 

Reseller Agreement.   In September 2009, we entered into a Reseller Agreement with Simulscribe pursuant to which we became the exclusive reseller of Simulscribe’s voice-to-text services to wholesale customers.  Pursuant to the agreement, we also assumed all of Simulscribe’s wholesale customers.  We (a) paid $3.5 million and issued a two-year promissory note for an additional $3.5 million for the assumption of the wholesale customer contracts and the exclusivity rights, (b) will pay a fee for the services provided by Simulscribe, and (c) will pay up to an additional $10 million if the revenues generated from the Simulscribe services meet certain performance milestones within the first three years of the agreement (the “Additional Payments”), subject to acceleration in certain events, such as our failure to use commercially reasonable efforts to market the services or a change of control of our company at a time that revenues from these services are on track to result in the payment ultimately being made.  The note and the Additional Payments are convertible into our common stock at Simulscribe’s option.  The note is convertible into our common stock at maturity in two years at a conversion price of $3.50 per share, subject to adjustment for stock splits, stock dividends and the like. The Additional Payments may be converted into our common stock at a conversion price of $5.00 per share, provided that if a specified revenue target is met then up to $5.0 million of the Additional Payments can be converted at $4.00 per share. In the fourth quarter of fiscal 2010, we amended our agreement with Simulscribe that extended our exclusive distribution rights to all customers, not just wholesale customers.  The agreement, and the related amendment, were accounted for as an asset acquisition and the value of the consideration given was allocated to the assets received as part of the transaction.

 

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Our Customer Base.    Historically, with the exception of fiscal 2009, the majority of our sales have been to customers in the United States. Domestic customers accounted for approximately 66% of our revenue in the first three months fiscal 2011, and 72% and 46% of our revenue in fiscal 2010 and 2009, respectively.  The geographic mix of revenue reflects domestic demand for our legacy TDM business and our VoIP business, as well as the vast majority of our voice service product revenue being generated from domestic customers.  Our international business for the quarter ended July 31, 2010 was primarily concentrated in South East Asia. However, sales to some of our U.S. customers may result in our products purchased by these customers eventually being deployed internationally, especially in the case of any original equipment manufacturer that distributes overseas. To date, the vast majority of our international sales have been export sales and denominated in U.S. dollars. Our international revenue has been largely driven by demand from customers in South East Asia, the Middle East and Latin America. We expect our international demand to continue to be heavily influenced by these markets as they are experiencing the highest level of growth and commonly have the most need for cost effective solutions to address voice quality in their growing networks.

 

Our revenue historically has come from a small number of customers. Our largest customer in the first three months of fiscal 2011, a wireless carrier in South East Asia, accounted for approximately 29% of our revenue.  In fiscal 2010, our largest customer was a domestic wireline and wireless carrier, which accounted for 30% of revenue.  Our largest customer in fiscal 2009 was a domestic wireless provider which accounted for 22% of revenue. Our five largest customers accounted for approximately 64% of our revenue in the first three months of fiscal 2011 and 75% and 60% of our revenue in fiscal 2010 and 2009, respectively. Consequently, the loss of, or significant decline in purchases by, any one of our largest customers, without an offsetting increase in revenue from existing or new customers, would have a negative and substantial effect on our business. This customer concentration risk was evidenced in fiscal 2006 and again over the last few fiscal years as sudden delays and/or declines in purchases by our large customers resulted in significant declines in our overall revenues and ultimately resulted in net losses for those periods.

 

Critical Accounting Policies and Estimates.    The preparation of our financial statements requires us to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosures. We evaluate these estimates on an ongoing basis, including those related to our revenue recognition, investments, inventory valuation allowances, cost of warranty, impairment of long-lived assets, accounting for stock-based compensation and accounting for income taxes. Estimates are based on our historical experience and other assumptions that we consider reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual future results may differ from these estimates in the event that facts and circumstances vary from our expectations. If and when adjustments are required to reflect material differences arising between our ongoing estimates and the ultimate actual results, our future results of operations will be affected. We believe that the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our consolidated financial statements.

 

Revenue Recognition—In applying our revenue recognition and allowance for doubtful accounts policies the level of judgment is generally relatively limited, as the vast majority of our revenue has been generated by a handful of relatively long-standing customer relationships. These customers are some of the largest wire-line and wireless carriers in the world and our relationships with them are documented in contracts, which clearly highlight potential revenue recognition issues, such as passage of title and risk of loss. As of July 31, 2010, we had deferred $0.9 million of revenue. However, only to the extent that we have received cash for a given deferred revenue transaction is the deferred revenue recorded on the Condensed Consolidated Balance Sheet. Of the $0.9 million of total deferred revenue transactions at July 31, 2010, substantially all of it had been collected from customers and therefore $0.9 million was reported as deferred revenue on the Condensed Consolidated Balance Sheet.

 

Of the $0.9 million of revenue deferred as of July 31, 2010, substantially all of it was associated with maintenance contracts, which are recognized ratably over the term of the contract, typically twelve months. In dealing with the remaining smaller customers, we closely evaluate the credit risk of these customers. In those cases where credit risk is deemed to be high, we either mitigate the risk by having the customer post a letter of credit, which we can draw against on a specified date, to effectively provide reasonable assurance of collection, or we defer the revenue until customer payment is received.

 

Investments—We consider investment securities that have maturities of more than three months at the date of purchase but remaining maturities of less than one year, and auction rate securities, which we have historically settled on 7, 28 or 35 day auction cycles, as short-term investments. However, when auction rate securities fail to settle at auction, which has been occurring since the middle of fiscal 2008, and conditions leading to their failure to auction create uncertainty as to whether they will settle in the near-term, we classify them as long-term consistent with the contractual term of the underlying security. Long-term investment securities include any investments with remaining maturities of one year or more and auction rate securities for which we are unable to estimate when they will settle. Short-term and long-term investments consist primarily of certificates of deposit and asset backed securities. We have classified our investments as available-for-sale securities in the accompanying condensed consolidated financial statements. We carry available-for-sale securities at fair value, and report unrealized gains and losses as a separate component of stockholders’ equity. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities, if any, are included in other income, net based on specific identification. We include interest on securities classified as available-for-sale in total other income. See also the discussion in “Liquidity and Capital Resources” and Item 3 of Part I below for additional information on auction rate securities.

 

Inventory Valuation Allowances—In conjunction with our ongoing analysis of inventory valuation, we constantly monitor projected demand on a product by product basis. Based on these projections we evaluate the levels of write-downs required for inventory on hand and inventory on order from our contract manufacturers. Although we believe we have been reasonably successful in identifying write-downs in a timely manner, sudden changes in buying patterns from our customers, either due to a shift in product interest and/or a complete pull back from their expected order levels has resulted in the recognition of larger than anticipated write-downs. For example, we recorded inventory write-downs for excess levels of inventory, due to wholesale shifts in demand, of $2.4 million and $5.1 million in fiscal 2009 and 2008, respectively. There were no sales of previously written-down inventory during the first quarter of fiscal 2011, or in fiscal 2010 or 2009.

 

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Cost of Warranty—At the time that we recognize revenue, we accrue for the estimated costs of the warranty we offer on our products. We currently offer warranties on the hardware elements of our products ranging from one to five years and warranties on the software elements of our products ranging from 90 days to one year. The warranty generally provides that we will repair or replace any defective product and provide software bug fixes within the term of the warranty. Our accrual for the estimated warranty is based on our historical experience and expectations of future conditions. To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, we may revise our estimated warranty accrual to reflect these additional exposures. This would result in a decrease in gross profits. As of July 31, 2010 and April 30, 2010, we had $0.3 million accrued related to estimated future warranty costs. See Note 3 of the Notes to the condensed consolidated financial statements.

 

Impairment of Long-lived Assets—We continually monitor events and changes in circumstances that could indicate that carrying amounts of long-lived assets, including intangible assets, may not be recoverable. When such events or changes in circumstances arise, we assess the recoverability of our long-lived assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. If the total of the undiscounted future cash flows is less than the carry amount of the assets in question, we recognize an impairment loss based on the excess of the carrying amount over the fair value of the assets. We evaluate the recoverability of our amortizable purchased intangible assets based on an estimate of the undiscounted cash flows resulting from the use of the related asset group and its eventual disposition. The asset group represents the lowest level for which cash flows are largely independent of cash flows of other assets and liabilities. We report long-lived assets to be disposed of at the lower of carrying amount or fair value less costs to sell. During fiscal 2010 and 2009, we recorded impairment charges of approximately $0.1 million and $0.3 million, respectively, associated with certain identifiable assets that were abandoned as a result of the cumulative affects of the reductions in force that had been implemented over the last two fiscal years.  There was no impairment of long-lived assets in the first quarter of fiscal 2011.

 

Accounting for Stock-based Compensation—Stock-based compensation cost is estimated at the grant date based on the award’s fair value as calculated by the Black-Scholes-Merton (“Black-Scholes”) option-pricing model and is recognized as expense, net of estimated forfeitures, ratably over the requisite service period. Given our employee stock options have certain characteristics that are significantly different from traded options and, because changes in the subjective assumptions can materially affect the estimated value, in our opinion the existing valuation models may not provide an accurate measure of the fair value of our employee stock options. Although we determine the fair value of employee stock options using the Black-Scholes option-pricing model, that value may not be indicative of the fair value observed between a willing buyer and a willing seller in a market transaction.

 

The Black-Scholes model requires various highly judgmental assumptions including expected option life and volatility. If any of the assumptions used in the Black-Scholes model or the estimated forfeiture rate changes significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

 

Accounting for Income Taxes—Amounts recorded for income taxes, both current and deferred, are based on estimates of the tax consequences of our operations in the various tax jurisdictions in which we operate. Our deferred taxes are the result of temporary differences resulting from differing treatment of items such as valuation allowances for bad debts and inventory, for tax and accounting purposes. As part of our ongoing assessment of the recoverability of our deferred tax assets, on a quarterly basis we review the expiration dates of our net operating loss and research credit carry forwards. In addition, we complete a study on the impact of Section 382 of the Internal Revenue Code on at least a semi-annual basis to determine whether a change in ownership may limit the value of our net operating loss carry forwards. We determined that a full valuation allowance against all of our deferred tax assets beginning as of April 30, 2008 was required. We have considered all evidence, positive and negative, and believe that based on our recent operating losses and uncertainty about the magnitude and timing of future operating profits, it is no longer more likely than not that our deferred tax assets will be realized.

 

Effective May 1, 2007, we adopted the accounting guidance relative to accounting for uncertainties in income. This guidance prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This guidance also provides guidance on derecognition of tax benefits, classification on the balance sheet, interest and penalties, accounting in interim periods, disclosure, and transition. We have classified interest and penalties as a component of tax expense. As a result of the implementation of this guidance effective May 1, 2007, we recognized a $0.4 million decrease in the liability for unrecognized tax benefits, which was accounted for as a decrease in the May 1, 2007 balance of accumulated deficit. We do not expect a significant change to the liability for uncertain tax positions over the next 12 months.

 

We are currently not under audit for any years or in any jurisdictions. We regularly assess the likelihood of adverse outcomes resulting from these types of examinations to determine the adequacy of our provision for income taxes.

 

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Recent Accounting Guidance Not Yet Effective

 

In October 2009, the FASB issued authoritative guidance on revenue recognition that will become effective for the Company beginning May 1, 2011, with earlier adoption permitted. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue recognition guidance. Additionally, the FASB issued authoritative guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. We are currently assessing the potential effect, if any, on our financial statements.

 

In April 2010, the Financial Accounting Standards Board (FASB) issued new authoritative guidance on the milestone method of revenue recognition. The milestone method applies to research and development arrangements in which one or more payments are contingent upon achieving uncertain future events or circumstances. This guidance defines a milestone and provides criteria for determining whether the milestone method is appropriate. This standard is effective for milestones achieved in fiscal years beginning on or after June 15, 2010, on a prospective basis, with earlier application permitted. As we are typically not a party to research and development arrangements, we believe this standard will not have a material impact on our financial statements.

 

RESULTS OF OPERATIONS

 

The following table sets forth, for the periods indicated, the components of the results of operations, as reflected in our statement of operations, as a percentage of sales.

 

 

 

Three Months Ended

 

 

 

July 31,

 

 

 

2010

 

2009

 

Revenue

 

100.0

%

100.0

%

Cost of goods sold

 

55.4

 

43.0

 

Gross Profit

 

44.6

 

57.0

 

Operating expenses:

 

 

 

 

 

Sales and marketing

 

50.3

 

36.5

 

Research and development

 

54.2

 

46.1

 

General and administrative

 

35.5

 

24.1

 

Amortization of purchased intangibles

 

0.5

 

0.3

 

Total operating expenses

 

140.5

 

107.0

 

Loss from operations

 

(95.9

)

(50.0

)

Other income (loss), net

 

(0.2

)

(11.4

)

Loss before provision for (benefit from) income taxes

 

(96.1

)

(61.4

)

Provision for (benefit from) for income taxes

 

0.0

 

0.5

 

Net loss

 

(96.1

)%

(61.9

)%

 

THREE MONTHS ENDED JULY 31, 2010 AND 2009.

 

Revenue.

 

 

 

Three months ended

 

 

 

 

 

July 31,

 

Increase/(Decrease)

 

$’s in thousands

 

2010

 

2009

 

from Prior Year

 

Revenue

 

$

4,039

 

$

6,095

 

$

(2,056

)

 

The decrease in revenue during the first quarter of fiscal 2011 compared to the first quarter of fiscal 2010 was largely due to a decrease in product revenue from our top five customers.   In the aggregate, our top five customers in the first quarter of fiscal 2011 accounted for $2.6 million of product revenue as compared to the top five customers in the first quarter of fiscal 2010, which accounted for $5.3 million.  This decline in product revenue was largely due to volatility in the timing of closing transactions with several domestic and international customers for legacy TDM and VoIP products.  The decline in product revenue from our top five customers was partially offset by an increase in revenue from our voice services business, which began generating revenue in the latter part of the second quarter of fiscal 2010.  For the three months ended July 2010, three customers accounted for more than 10% of total revenue (29%, 17% and 13%), with our largest customer being an international wireless provider.   The second and third greater than 10% customers have been our largest two customers for the last two years.  Although our Broadband Voice Processor Flex (“BVP-Flex”) continues to be the primary voice quality product purchased by our domestic customers and has begun to experience a growing interest from international customers, our PVP product and service contracts have grown as a percentage of revenue during over the last two years due in large part to growing deployment of the PVP in conferencing providers’ VoIP networks.

 

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Table of Contents

 

Geographically, our first quarter fiscal 2011 revenue was primarily domestic at 66% of total worldwide revenue, which was a decrease from 76% of revenue reported in the first quarter of fiscal 2010.  The decrease in the domestic portion of our revenue was primarily driven by a delay in closing transactions with one of our larger domestic customers.  Following the success of our BVP-Flex, revenue over the last three fiscal years and the first quarter of fiscal 2011 has been generated largely from domestic sales.  Our international growth has primarily been dependent on our success in selling VQA. Although we continue to believe that there are meaningful international revenue opportunities, we continue to experience volatility in the purchasing cycles from our existing and prospective international customers, which has resulted in volatility in the level of international revenue from quarter to quarter.  Most recently potential changes in India’s import regulations related to technology-based products contributed to delays in our ability to close orders in that region, as we worked to understand the implication of the potential rule changes on our products and to ensure that our intellectual property was adequately protected.  We intend to continue to work to understand the implications of these potential changes in India’s import regulations, which could continue to cause delays in our ability to close orders in that region.  We plan to continue to invest in customer trials to attempt to capture the international revenue opportunities that exist for us.

 

Cost of Goods Sold and Gross Profit.

 

 

 

Three months ended

 

 

 

 

 

July 31,

 

Increase/(Decrease)

 

$’s in thousands

 

2010

 

2009

 

from Prior Year

 

Cost of goods sold

 

$

2,239

 

$

2,622

 

$

(383

)

Gross profit

 

$

1,800

 

$

3,473

 

$

(1,673

)

Gross margin %

 

44.6

%

57.0

%

(12.4

)pts

 

Cost of goods sold consists of direct material costs, personnel costs for test, configuration and quality assurance, costs of licensed technology incorporated into our products, post-sales installation costs, provisions for inventory and warranty expenses and other indirect costs. The decrease in cost of goods sold was primarily driven by the decrease in business volume during the first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010.  Our analysis of gross profit below discusses the other factors, which are impacting cost of goods sold and resulting in the net decline in the gross margin percentage.

 

Our gross margin percentage decreased in the first quarter of fiscal 2011 as a result of our product mix for the first quarter of fiscal 2011 being more heavily weighted to lower margin voice service revenue, which we began recognizing in the latter part of the second quarter of fiscal 2010, and fixed manufacturing costs representing a larger percentage of revenue.  Although we have reduced our fixed manufacturing costs in real terms, they have increased as a percentage of revenue due to the decline in revenue experienced in the first quarter of fiscal 2011.  Partially offsetting these declines in margin was a reduction in the level of write-downs of excess inventory.

 

Sales and Marketing.

 

 

 

Three months ended
July 31,

 

Increase/(Decrease)

 

$’s in thousands

 

2010

 

2009

 

from Prior Year

 

Sales and marketing

 

$

2,030

 

$

2,224

 

$

(194

)

% of revenue

 

50.3

%

36.5

%

13.8

pts

 

Sales and marketing expenses primarily consist of personnel costs, including commissions and costs associated with customer service, travel, trade shows and outside consulting services.  The decrease in sales and marketing expense in the first quarter of fiscal 2011 was largely due to the impacts of the reduction in force that occurred in second quarter of fiscal 2010, as well as subsequent attrition.   The resulting reduction in headcount had a direct impact on both base pay and variable compensation, which experienced a combined reduction of $0.4 million.  The reduction in headcount also impacted travel and related expenses which experienced a $0.1 million decrease from the first quarter of 2010.  Partially offsetting this decline in spending was a $0.2 million increase in outside service costs primarily due to increased costs associated with our voice service product marketing, primarily for our PhoneTag product.

 

Research and Development.

 

 

 

Three months ended
July 31,

 

Increase/(Decrease)

 

$’s in thousands

 

2010

 

2009

 

from Prior Year

 

Research and development

 

$

2,188

 

$

2,808

 

$

(620

)

% of revenue

 

54.2

%

46.1

%

8.1

pts

 

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Table of Contents

 

Research and development expenses primarily consist of personnel costs, contract consultants, materials and supplies used in the development of voice processing products. The decrease in expense in the first quarter of fiscal of 2011 as compared to the first quarter of fiscal 2010 was also largely driven by the reduction in force that occurred in the second quarter of fiscal 2010 and subsequent attrition.  As a result of the reduction in headcount, we experienced a decline in payroll and related expenses totaling $0.4 million. In addition, we experienced a $0.3 million reduction in depreciation due to a significant amount of assets becoming fully depreciated late in the fourth quarter of fiscal 2010.

 

General and Administrative.

 

 

 

Three months ended
July 31,

 

Increase/(Decrease)

 

$’s in thousands

 

2010

 

2009

 

from Prior Year

 

General and administrative

 

$

1,435

 

$

1,470

 

$

(35

)

% of revenue

 

35.5

%

24.1

%

11.4

pts

 

General and administrative expenses primarily consist of personnel costs for corporate officers, finance and human resources personnel, as well as insurance, legal, accounting and consulting costs.  The minor decline in general and administrative expenses was primarily due to decline in payroll and related expense due to attrition during the latter part of fiscal 2010.

 

We expect operating expenses in the second quarter of fiscal 2011 to decline compared to the first quarter of fiscal 2011 primarily due to our continued emphasis on controlling costs and seasonality of professional fees related to audit and tax services.

 

Stock-based Compensation.

 

Stock-based compensation expense recognized in the first quarters of fiscal 2011 and 2010 was as follows:

 

 

 

Three months ended
July 31,

 

$’s in thousands

 

2010

 

2009

 

Cost of good sold

 

$

21

 

$

42

 

Sales and marketing