UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

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

Commission File Number: 001-33041

ACME PACKET, INC.

(Exact name of registrant as specified in its charter)

Delaware		04-3526641
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

100 Crosby Drive
Bedford, MA 01730
(Address of principal executive offices) (zip code)

(781) 328-4400
(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o No

     Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). þ Yes o No

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

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

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

     The number of shares outstanding of each of the issuer’s classes of common stock, as of October 21, 2011: 67,124,891

 

 

ACME PACKET, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2011

Table of Contents

Item		Page No.
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements:			3
Condensed Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010 (unaudited)			3
Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2011 and 2010 (unaudited)			4
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2011 and 2010 (unaudited)			5
Notes to Condensed Consolidated Financial Statements			6
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			16
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk			30
ITEM 4. Controls and Procedures			32
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings			33
ITEM 1A. Risk Factors			33
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds			35
ITEM 3. Defaults Upon Senior Securities			36
ITEM 4. (Removed and Reserved)			36
ITEM 5. Other Information			36
ITEM 6. Exhibits			36
EX-10.3
EX-31.1
EX-31.2
EX-32.1
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT

PART I — FINANCIAL INFORMATION

ITEM 1 — Financial Statements

ACME PACKET, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(in thousands, except share and per share data)

		September 30,				December 31,
		2011				2010
ASSETS
Current assets:
Cash and cash equivalents		$	156,962			$	91,669
Short-term investments			181,660				179,024
Accounts receivable, net of allowance of $1,616 and $1,463, respectively			51,246				34,797
Inventory			11,779				6,662
Deferred product costs			1,074				3,572
Deferred tax asset, net			3,814				3,814
Income taxes receivable			13,404				9,979
Other current assets			6,953				3,231
Total current assets			426,892				332,748
Long-term investments			—				5,030
Property and equipment, net			24,514				17,156
Intangible assets, net of accumulated amortization of $4,079 and $2,466, respectively			9,095				9,468
Goodwill			3,269				—
Deferred tax asset, net			14,802				14,802
Other assets			425				940
Total assets		$	478,997			$	380,144
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	7,056			$	7,161
Accrued expenses and other current liabilities			13,494				14,629
Deferred revenue			28,838				31,998
Total current liabilities			49,388				53,788
Deferred rent, net of current portion			3,471				4,265
Deferred revenue, net of current portion			1,820				1,546
Commitments and contingencies (Note 12)
Stockholders’ equity:
Undesignated preferred stock, $0.001 par value:
Authorized — 5,000,000 shares; Issued and outstanding — 0 shares			—				—
Common stock, $0.001 par value:
Authorized — 150,000,000 shares; Issued 73,889,327 and 71,157,422 shares, respectively			74				71
Additional paid-in capital			334,254				266,114
Treasury stock, at cost — 6,780,061 and 6,756,687 shares, respectively			(37,522	)			(37,522	)
Accumulated other comprehensive income			21				34
Retained earnings			127,491				91,848
Total stockholders’ equity			424,318				320,545
Total liabilities and stockholders’ equity		$	478,997			$	380,144

See accompanying Notes to Condensed Consolidated Financial Statements.

ACME PACKET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
(in thousands, except share and per share data)

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2011				2010				2011				2010
Revenue:
Product		$	53,077			$	45,328			$	177,507			$	129,452
Maintenance, support and service			17,544				11,286				46,814				31,548
Total revenue			70,621				56,614				224,321				161,000
Cost of revenue (1):
Product			8,778				7,903				30,090				22,886
Maintenance, support and service			3,042				2,556				8,573				6,964
Total cost of revenue			11,820				10,459				38,663				29,850
Gross profit			58,801				46,155				185,658				131,150
Operating expenses (1):
Sales and marketing			27,201				17,012				75,640				50,062
Research and development			13,249				8,896				37,262				26,235
General and administrative			5,406				3,906				15,771				10,785
Merger and integration-related costs			120				—				300				—
Total operating expenses			45,976				29,814				128,973				87,082
Income from operations			12,825				16,341				56,685				44,068
Other (expense) income:
Interest income			141				157				454				397
Other (expense) income, net			(194	)			32				(601	)			(43	)
Total other (expense) income, net			(53	)			189				(147	)			354
Income before provision for income taxes			12,772				16,530				56,538				44,422
Provision for income taxes			4,846				6,065				20,895				15,895
Net income		$	7,926			$	10,465			$	35,643			$	28,527
Net income per share (Note 10):
Basic		$	0.12			$	0.17			$	0.54			$	0.46
Diluted		$	0.11			$	0.15			$	0.50			$	0.43
Weighted average number of common shares used in the calculation of net income per share:
Basic			66,752,669				62,772,466				66,011,761				61,371,085
Diluted			70,908,590				68,426,272				70,887,241				67,114,486

Cost of product revenue		$	318			$	202			$	846			$	557
Cost of maintenance, support and service revenue			563				279				1,436				737
Sales and marketing			4,433				2,006				11,671				5,339
Research and development			2,850				1,254				7,350				3,551
General and administrative			1,563				847				3,707				1,761

See accompanying Notes to Condensed Consolidated Financial Statements.

ACME PACKET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)

		Nine Months Ended
		September 30,
		2011				2010
Operating activities
Net income		$	35,643			$	28,527
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			7,087				5,826
Provision for bad debts			153				54
Amortization of premium/discount on investments			697				1,419
Stock-based compensation expense			25,010				11,945
Excess tax benefit related to exercise of stock options			(23,357	)			(20,429	)
Change in operating assets and liabilities, net of acquisition:
Accounts receivable			(16,530	)			(4,739	)
Inventory			(5,117	)			(1,907	)
Deferred product costs			2,498				899
Other current assets			(3,347	)			339
Accounts payable			(120	)			76
Accrued expenses, other current liabilities and deferred rent			16,973				12,848
Deferred revenue			(2,944	)			(2,109	)
Net cash provided by operating activities			36,646				32,749
Investing activities
Purchases of property and equipment			(12,812	)			(10,546	)
Purchases of marketable securities			(269,435	)			(151,003	)
Proceeds from sale and maturities of marketable securities			271,119				107,777
Increase in other assets			837				—
Cash paid for acquisition, net			(4,195	)			—
Net cash used in investing activities			(14,486	)			(53,772	)
Financing activities
Proceeds from exercise of stock options			19,776				20,765
Excess tax benefit related to exercise of stock options			23,357				20,429
Net cash provided by financing activities			43,133				41,194
Net increase in cash and cash equivalents			65,293				20,171
Cash and cash equivalents at beginning of period			91,669				90,471
Cash and cash equivalents at end of period		$	156,962			$	110,642
Supplemental disclosure of noncash investing and operating activities:
Capital additions as a result of lease incentives		$	—			$	3,199
Supplemental disclosure of cash flow related to acquisition:
In connection with the acquisition of Newfound Communications, Inc. on January 20, 2011, the following transactions occurred:
Fair value of assets acquired		$	4,784			$	—
Liabilities assumed related to acquisition			(423	)			—
Total purchase price			4,361				—
Less cash and cash equivalents acquired			(166	)			—
Cash paid for acquisition, net of cash acquired		$	4,195			$	—

See accompanying Notes to Condensed Consolidated Financial Statements.

ACME PACKET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
(in thousands, except share and per share data)

1. Business Description and Basis of Presentation

Business Description

     Acme Packet, Inc. (the Company) is the leader in session delivery network solutions which enable the trusted, first class delivery of next-generation voice, data and unified communication services and applications across internet protocol (IP) networks.

     The Company’s Net-Net product family fulfills demanding security, service assurance and regulatory requirements in service provider, enterprise and contact center networks. Based in Bedford, Massachusetts, the Company designs and manufactures its products in the United States, selling them through over 200 reseller partners worldwide. More than 1,525 end user customers in 107 countries have deployed over 14,000 of the Company’s systems, including 90 of the top 100 service providers and 36 of the Fortune 100.

Basis of Presentation

     The accompanying interim condensed consolidated financial statements are unaudited. These financial statements and notes should be read in conjunction with the audited consolidated financial statements and related notes, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations, contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

     The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with United States generally accepted accounting principles (U.S. GAAP) have been condensed or omitted pursuant to such SEC rules and regulations. In the opinion of management, the unaudited condensed consolidated financial statements and notes have been prepared on the same basis as the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, and include all adjustments (consisting of normal, recurring adjustments) necessary for the fair presentation of the Company’s financial position at September 30, 2011, statements of income for the three and nine months ended September 30, 2011 and 2010 and statements of cash flows for the nine months ended September 30, 2011 and 2010. These interim periods are not necessarily indicative of the results to be expected for any other interim period or the full year.

     The Company has evaluated all subsequent events and determined that there are no material recognized or unrecognized subsequent events requiring disclosure.

     As of September 30, 2011, except as described below under “Revenue Recognition,” the Company’s significant accounting policies and estimates, which are detailed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, have not changed.

Revenue Recognition

     The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the consideration is fixed or determinable, and collection of the related accounts receivable is deemed probable. In making these judgments, management evaluates these criteria as follows:

	•		Persuasive evidence of an arrangement exists. The Company considers a non-cancellable agreement signed by the customer and the Company to be representative of persuasive evidence of an arrangement.
	•		Delivery has occurred. The Company considers delivery to have occurred when product has been delivered to the customer and no significant post-delivery obligations exist. In instances where customer acceptance is required, delivery is deemed to have occurred when customer acceptance has been achieved.

	•		Consideration is fixed or determinable. The Company considers the consideration to be fixed or determinable unless the consideration is subject to refund or adjustment, or is not payable within normal payment terms. If the consideration is subject to refund or adjustment, the Company recognizes revenue when the right to a refund or adjustment lapses. If offered payment terms exceed the Company’s normal terms, then revenue is recognized upon the receipt of cash.
	•		Collection is deemed probable. The Company conducts a credit review for all transactions at the inception of an arrangement and then routinely on an ongoing basis to determine the creditworthiness of the customer. Collection is deemed probable if, based upon the Company’s evaluation, the Company expects that the customer will be able to pay amounts under the arrangement as payments become due. If the Company determines that collection is not probable, revenue is deferred and recognized upon the receipt of cash.

     The Company’s revenue arrangements regularly include the sale of hardware, licensing of software and provision of maintenance, professional services and training. Revenue arrangements may include one of these single elements, or may incorporate one or more elements in a single transaction or some combination of related transactions. During the first quarter of 2011, the Company prospectively adopted the guidance of Accounting Standards Update (ASU) No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements (ASU No. 2009-13) and ASU No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements (ASU No. 2009-14), which were ratified by the Financial Accounting Standards Board (FASB) Emerging Issues Task Force on September 23, 2009. ASU No. 2009-13 affects accounting and reporting for all multiple-deliverable arrangements. It also applies to companies that are affected by the amendments of ASU No. 2009-14.

     The amendments in ASU No. 2009-14 provide that tangible products containing software components and non-software components that function together to deliver the tangible product’s essential functionality are no longer within the scope of the software revenue recognition guidance in Accounting Standards Codification (ASC) Topic 985-605, Software Revenue Recognition (ASC 985-605) and should follow the guidance in ASU No. 2009-13 for multiple-element arrangements. All non-essential and standalone software components will continue to be accounted for under the guidance of ASC 985-605.

     ASU No. 2009-13 establishes a selling price hierarchy for determining the selling price of a deliverable in a revenue arrangement. The selling price for each deliverable is based on vendor-specific objective evidence (VSOE), if available, third-party evidence (TPE) if VSOE is not available, or the Company’s best estimated selling price (BESP) if neither VSOE nor TPE are available. The amendments in ASU No. 2009-13 eliminate the residual method of allocating arrangement consideration and require that it be allocated at the inception of the arrangement to all deliverables using the relative selling price method. The relative selling price method allocates any discount in the arrangement proportionately to each deliverable on the basis of the deliverable’s estimated selling price.

     For all transactions entered into prior to January 1, 2011 and for those transactions which include the licensing of stand-alone or non-essential software as an element after January 1, 2011, the Company allocates revenue among the multiple elements associated with the stand-alone and non-essential software based on the software revenue recognition guidance of ASC 985-605. Under this guidance, when arrangements include multiple elements, the Company allocates the total fee among the various elements using the residual method. Under the residual method, revenue is recognized when VSOE of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements of the arrangement. Each arrangement requires the Company to analyze the individual elements in the transaction and to estimate the fair value of each undelivered element, which typically represents maintenance and services. Revenue is allocated to each of the undelivered elements based on its respective fair value, with the fair value determined by the price charged when that element is sold or licensed separately. If VSOE of fair value for any undelivered element does not exist, revenue from the entire arrangement is deferred and recognized at the earlier of (a) delivery of those elements for which VSOE of fair value does not exist or (b) when VSOE is established. However, in instances where maintenance services are the only undelivered element without VSOE of fair value, the entire arrangement is recognized ratably as a single unit of accounting over the contractual service period.

     For transactions entered into subsequent to the adoption of ASU No. 2009-13 that include multiple elements, arrangement consideration is allocated to each element based on the relative selling prices of all of the elements in the arrangement using the fair value hierarchy as required by ASU No. 2009-13. The Company limits the amount of revenue recognized for delivered elements to the amount that is not contingent on the future delivery of products or services, future performance obligations, or subject to customer-specific return or refund privileges.

     Consistent with the methodology used under the previous accounting guidance, the Company establishes VSOE for its training services, post sale customer support and installation services based on the sales price charged for each element when it is sold or licensed separately. Because the Company generally does not sell any of its products on a standalone basis, it has yet to establish VSOE for these offerings.

     The Company is typically not able to determine TPE for its products or services. TPE is determined based on competitor prices for similar elements when sold or licensed separately. Generally, the Company’s offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, the Company is unable to reliably determine the selling prices on a stand-alone basis of similar products offered by its competitors.

     When the Company is unable to establish the selling price of its products or certain services using VSOE or TPE, the Company uses BESP in its allocation of arrangement consideration. The objective of BESP is to determine the price at which the Company would transact a sale if the product or service were sold or licensed on a stand-alone basis. The Company determines BESP for a product or service by considering multiple factors including, but not limited to, pricing practices, geographies, customer classes and distribution channels.

     The Company plans to analyze the selling prices used in its allocation of arrangement consideration, at a minimum, on an annual basis. Selling prices will be analyzed on a more frequent basis if a significant change in the Company’s business necessitates a more frequent analysis, or if the Company experiences significant variances in its selling prices.

     The following table presents the effects to the Company’s previously reported Condensed Consolidated Statements of Income for the three months ended September 30, 2010 as if the Company had adopted the standards effective January 1, 2010 (in thousands):

		As Reported				Adjustments				As Amended
Total revenue		$	56,614			$	1,457			$	58,071
Gross profit			46,155				1,140				47,295
Net income			10,465				718				11,183
Net income per share:
Basic		$	0.17			$	0.01			$	0.18
Diluted		$	0.15			$	0.01			$	0.16

     The following table presents the effects to the Company’s previously reported Condensed Consolidated Statements of Income for the nine months ended September 30, 2010 as if the Company had adopted the standards effective January 1, 2010 (in thousands):

		As Reported				Adjustments				As Amended
Total revenue		$	161,000			$	3,019			$	164,019
Gross profit			131,150				2,415				133,565
Net income			28,527				1,546				30,073
Net income per share:
Basic		$	0.46			$	0.03			$	0.49
Diluted		$	0.43			$	0.02			$	0.45

     The following table presents the effects to the Company’s previously reported Condensed Consolidated Balance Sheet as of September 30, 2010 as if the Company had adopted the standards effective January 1, 2010 (in thousands):

		As Reported				Adjustments				As Amended
Deferred product costs		$	2,501			$	(317	)		$	2,184
Deferred revenue			29,708				(1,457	)			28,251

2. Business Combination

     On January 20, 2011, the Company acquired Newfound Communications, Inc. (Newfound Communications), an emerging, innovative provider of call recording solutions for the IP communications industry. The aggregate purchase price was $4,195 in cash payments to the stockholders of Newfound Communications. In allocating the total preliminary purchase price for Newfound Communications based on estimated fair values, the Company recorded $3,269 of goodwill, $1,240 of identifiable intangible assets and $423 of net tangible liabilities. In connection with the acquisition of Newfound Communications, the Company incurred $180 of merger and integration related costs during 2011, which the Company recorded as an expense in the condensed consolidated statements of income for the three months ended March 31, 2011 and the nine months ended September 30, 2011.

     This transaction was accounted for under the acquisition method of accounting. Accordingly, pro forma information reflecting the acquisition of Newfound Communications has not been provided because the impact on revenues, net income and net income per common share attributable to Acme Packet, Inc. shareholders in not material. All of the assets acquired and liabilities assumed in the transaction have been recognized at their acquisition date fair values, which remain preliminary at September 30, 2011.

3. Cash, Cash Equivalents, Short and Long-Term Investments

     Cash, cash equivalents, short and long-term investments as of September 30, 2011 and December 31, 2010 consist of the following:

		As of September 30, 2011
		Contracted				Amortized				Fair Market				Carrying
		Maturity				Cost				Value				Value
Cash		Demand				$	141,629			$	141,629			$	141,629
Money market funds		Demand					134				134				134
U.S. agency notes—held-to-maturity		52 - 74 days					15,199				15,199				15,199
Total cash and cash equivalents						$	156,962			$	156,962			$	156,962
U.S. agency notes—available-for-sale		28 - 390 days				$	76,632			$	76,653			$	76,653
U.S. agency notes—held-to-maturity		20 - 358 days					105,007				105,009				105,007
Total short-term marketable securities						$	181,639			$	181,662			$	181,660

		As of December 31, 2010
		Contracted				Amortized				Fair Market				Carrying
		Maturity				Cost				Value				Value
Cash		Demand				$	35,580			$	35,580			$	35,580
Money market funds		Demand					56,089				56,089				56,089
Total cash and cash equivalents						$	91,669			$	91,669			$	91,669
U.S. agency notes—available-for-sale		4 - 419 days				$	69,575			$	69,606			$	69,606
U.S. agency notes—held-to-maturity		15 - 329 days					109,418				114,451				109,418
Total short-term marketable securities						$	178,993			$	184,057			$	179,024
U.S. agency notes—held-to-maturity		419 days				$	5,030			$	5,029			$	5,030
Total long-term marketable securities						$	5,030			$	5,029			$	5,030

     To date, realized gains and losses from the sales of cash equivalents or short or long-term investments have been immaterial.

4. Inventory

     Inventory is stated at the lower of cost, determined on a first in, first out basis, or market, and consists primarily of raw material and finished products. Inventory is comprised of the following:

		September 30, 2011				December 30, 2010
Raw Materials		$	4,557			$	1,355
Finished Goods			7,222				5,307
Total Inventory		$	11,779			$	6,662

5. Concentrations of Credit Risk and Off-Balance-Sheet Risks

     The Company has no significant off-balance-sheet risks such as foreign exchange or option contracts, or other international hedging arrangements. Financial instruments that potentially expose the Company to concentrations of credit risk consist primarily of cash, cash equivalents, short and long-term investments and accounts receivable. The Company maintains its cash, cash equivalents, and short and long-term investments principally in accredited financial institutions of high credit standing. The Company assesses the creditworthiness of its customers both at the inception of the business relationship and then routinely on an ongoing basis. The Company generally does not require collateral from its customers. Due to these factors, no additional credit risk beyond amounts provided for collection losses is believed by management to be probable in the Company’s accounts receivable.

     The Company had certain customers whose revenue individually represented 10% or more of the Company’s total revenue, as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2011				2010				2011				2010
Customer A			14	%			*				11	%			*
Customer B			*				15	%			*				12	%
Customer C			*				13				*				*

     The Company had certain customers whose accounts receivable balances individually represented 10% or more of the Company’s accounts receivable, as follows:

		September 30, 2011				December 31, 2010
Customer A			18	%			*
Customer D			10				*
Customer C			*				20	%
Customer B			*				10

6. Product Warranties

     Substantially all of the Company’s products are covered by a standard warranty of ninety days for software and one year for hardware. In the event of a failure of hardware or software products covered by these warranties, the Company must repair or replace such hardware or software product, or, if those remedies are insufficient, and at the discretion of the Company, provide a refund. The Company’s customers typically purchase maintenance and support contracts, which supersede its warranty obligations. The Company’s warranty reserve reflects estimated material and labor costs for potential product issues in its installed base that are not covered under maintenance contracts but for which the Company expects to incur an obligation. The Company’s estimates of anticipated rates of warranty claims and costs are primarily based on historical information and future forecasts. The Company assesses the adequacy of the warranty allowance on a quarterly basis and adjusts the amount as necessary. If the historical data used to calculate the adequacy of the warranty allowance are not indicative of future requirements, additional or reduced warranty reserves may be required.

     The following is a summary of changes in the amount reserved for warranty costs for the nine months ended September 30, 2011:

Balance at December 31, 2010		$	89
Provision for warranty costs			389
Uses/Reductions			(380	)
Balance at September 30, 2011		$	98

7. Stock-Based Compensation

     The Company recorded stock-based compensation expense of $9,727 and $4,588 for the three months ended September 30, 2011 and 2010, respectively, and $25,010 and $11,945 for the nine months ended September 30, 2011 and 2010, respectively. As of September 30, 2011, there was $84,144 of unrecognized stock-based compensation expense related to stock-based awards that is expected to be recognized over a weighted average period of 2.41 years.

     Through the second quarter of 2011, the Company’s assumptions about the expected term had been based on that of companies that had option vesting and contractual terms and employee demographics that were similar to the Company’s because there was limited relevant historical information to support the expected sale and exercise behavior of the Company’s employees who had been granted options recently. Commencing in the third quarter of 2011, the Company began to estimate the expected term based upon the historical exercise behavior of the Company’s employees. The risk-free interest rate for periods within the contractual life of the award is based on the U.S. Treasury yield curve in effect at the time of grant. The following table presents the weighted-average assumptions used to estimate the fair values of the stock options granted (excluding options granted in connection with the Exchange, see below) in the periods presented:

		Three months ended								Nine months ended
		September 30,								September 30,
		2011				2010				2011				2010
Employee Stock Options
Expected life in years			4.75				4.75				4.79				4.77
Risk-free interest rate			1.1	%			1.6	%			2.0	%			2.2	%
Volatility			73	%			60	%			61	%			59	%
Weighted average fair value of grants		$	30.61			$	15.34			$	34.74			$	8.67

     The following is a summary of the status of the Company’s stock options as of September 30, 2011 and the stock option activity for all stock option plans during the nine months ended September 30, 2011:

										Weighted				Weighted
										Average				Average
										Exercise				Remaining				Aggregate
		Number of				Exercise Price				Price Per				Contractual				Intrinsic
		Shares				Per Share				Share				Life (Years)				Value(1)
Outstanding at December 31, 2010			10,211,039			$	0.20 — 53.45			$	10.47
Granted			2,162,173				45.78 — 82.02				66.96
Canceled			(101,436	)			0.20 — 82.02				40.50
Exercised			(2,548,038	)			0.20 — 38.83				7.88							$	172,586
Outstanding at September 30, 2011			9,723,738			$	0.20 — 82.02			$	23.53				5.13			$	237,536
Exercisable at September 30, 2011			3,076,077			$	0.20 — 76.35			$	8.58				4.39			$	105,199
Vested or expected to vest at September 30, 2011 (2)			9,331,390			$	0.20 — 82.02			$	22.63				5.10			$	233,226

     The Company has entered into restricted stock unit (RSU) agreements with certain of its employees relating to RSUs granted to those employees pursuant to the Acme Packet, Inc. 2006 Equity Incentive Plan. Vesting occurs periodically at specified time intervals, ranging from one to four years, and in specified percentages. Upon vesting, the holder will receive one share of the Company’s common stock for each unit vested. A summary of the Company’s unvested RSUs outstanding at September 30, 2011 and the changes during the nine months then ended, is presented below:

						Weighted
						Average
		Number of				Grant Date
		RSUs				Fair Value
Unvested at December 31, 2010			412,833			$	6.22
Granted			92,750				61.51
Vested			(187,851	)			8.71
Forfeited			—				—
Unvested at September 30, 2011			317,732				20.89

8. Employee Stock Purchase Plan

     On May 5, 2011 the Company’s shareholders approved the 2011 Employee Stock Purchase Plan (the ESPP), under which 2,500,000 shares of the Company’s common stock have been reserved for issuance. Effective June 1, 2011, eligible employees may purchase shares of the Company’s common stock through regular payroll deductions of up to 15% of their eligible compensation, to a maximum number of shares with a fair market value of $25 per calendar year, through a six month purchase period. Employees may purchase shares of the Company’s common stock at a discount of 15% of the lesser of the fair market value of a share of the Company’s common stock on the first or the last day of each six month offering period. The ESPP is scheduled to terminate on January 3, 2020. During the three and nine months ended September 30, 2011, no shares were issued under the ESPP.

9. Comprehensive Income

     Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Accumulated other comprehensive income is presented separately on the balance sheet as required.

     The following table displays the computation of comprehensive income:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2011				2010				2011				2010
Net income		$	7,926			$	10,465			$	35,643			$	28,527
Unrealized (loss) gain on available-for-sale securities			(11	)			18				21				55
Comprehensive income		$	7,915			$	10,483			$	35,664			$	28,582

     Accumulated other comprehensive income consists entirely of unrealized gains and losses on available-for-sale securities at September 30, 2011.

10. Net Income Per Share

     A reconciliation of the number of shares used in the calculation of basic and diluted net income per share is as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2011				2010				2011				2010
Weighted average number of common shares used in calculating basic net income per share			66,752,669				62,772,466				66,011,761				61,371,085
Weighted average number of common shares issuable upon exercise of outstanding stock options, based on treasury stock method			4,023,050				5,441,418				4,716,555				5,533,717
Weighted average number of common shares issuable upon vesting of outstanding restricted stock units			132,871				212,388				158,925				209,684
Weighted average number of common shares used in calculating diluted net income per share			70,908,590				68,426,272				70,887,241				67,114,486

     In the computation of the diluted weighted average number of common shares outstanding, 2,102,268 and 638,685 weighted average common share equivalents underlying outstanding stock options have been excluded from the computation during the three months ended September 30, 2011 and 2010, respectively, and 1,606,374 and 402,176 stock options have been excluded from the computation during the nine months ended September 30, 2011 and 2010, respectively, as their effect would have been antidilutive.

11. Income Taxes

     For the three months ended September 30, 2011 and 2010, the Company’s effective income tax rate was approximately 38% and 37%, respectively. For the nine months ended September 30, 2011 and 2010, the Company’s effective income tax rate was approximately 37% and 36%, respectively. As of September 30, 2011, the Company expects to realize recorded net deferred tax assets of $18,616. The Company’s conclusion that these assets will be recovered is based upon its expectation that current and future earnings will provide sufficient taxable income to realize the recorded net deferred tax asset. The realization of the Company’s net deferred tax assets cannot be assured, and to the extent that future taxable income against which these tax assets may be applied is not sufficient, some or all of the Company’s recorded net deferred tax assets would not be realizable. Approximately $10,588 of the deferred tax assets recorded as of September 30, 2011 was attributable to benefits associated with stock-based compensation charges. In accordance with the provision of ASC 718, Compensation-Stock Compensation, no valuation allowance has been recorded against this amount. However, in the future, if the underlying amounts expire with an intrinsic value less than the fair value of the awards on the date of grant, some or all of the benefits may not be realizable.

12. Commitments and Contingencies

Litigation

     From time to time, and in the ordinary course of business, the Company may be subject to various claims, charges and litigation.

     On January 5, 2011, Nortel Networks, Inc. (Nortel), a customer of the Company, filed a claim against Covergence Inc. (Covergence) in the United States Bankruptcy Court in the District of Delaware alleging that prior to the Company’s acquisition of Covergence in April 2009, Covergence received a preferential payment of approximately $1,200 prior to Nortel’s bankruptcy petition in January 2009. The Company has reached an agreement and has recorded a liability of $120 which is included in merger and integration related costs in the condensed consolidated statements of income for the three and nine months ended September 30, 2011.

     At September 30, 2011 and 2010, the Company did not have any pending claims, charges or litigation that it expects would have a material adverse effect on its condensed consolidated financial position, results of operations or cash flows that have not been disclosed.

Operating Leases

     The Company is party to a lease with MSCP Crosby, LLC, dated as of November 23, 2009 (the Lease), as amended by the First Amendment to Lease dated as of July 12, 2010, amended by the Second Amendment to Lease dated as of June 10, 2011, and further amended by the Third Amendment to Lease dated as of June 10, 2011.

     The premises leased pursuant to the Lease, as amended, consist of 261,961 rentable square feet of space in the building located at 100 Crosby Drive, Bedford, Massachusetts.

     The term of the Lease expires on March 31, 2022. The Company has two options to extend the term of the lease each for an additional period of five years, with the first extension term commencing, if at all, immediately following the expiration of the term of the Lease, as amended, and the second extension term commencing, if at all, immediately following the expiration of the first extension term.

     Pursuant to the Lease, as amended, the monthly base rent as of April 1, 2012 will be $245,292 and the Company is required to pay additional monthly rent in an amount equal to its proportionate share of certain taxes and operating expenses, as further set forth in the second amendment to the Lease. Commencing on July 1, 2012, the monthly base rent will be $448,814. The Company’s monthly base rent shall be increased from time to time, as further set forth in Section 4.3 of the second amendment to the Lease.

Other

     Certain of the Company’s arrangements with customers include clauses whereby the Company may be subject to penalties for failure to meet certain performance obligations. The Company has not incurred any such penalties to date.

13. Segment Information

Geographic Data

     Total revenue to unaffiliated customers by geographic area was as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2011				2010				2011				2010
United States and Canada		$	36,842			$	32,915			$	127,394			$	97,587
International			33,779				23,699				96,927				63,413
Total		$	70,621			$	56,614			$	224,321			$	161,000

     During the three and nine months ended September 30, 2011 and 2010, no one international country contributed more than 10% of the Company’s total revenue.

     As of September 30, 2011 and 2010, property and equipment at locations outside the United States were not material.

14. Fair Value Measurements

     Fair value is defined as an exit price, representing the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants based on the highest and best use of the asset or liability. 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. The Company uses valuation techniques to measure fair value that maximize the use of observable inputs and minimize the use of unobservable inputs. These inputs are prioritized as follows:

•

Level 1: Observable inputs such as quoted prices for identical assets or liabilities in active markets;

•

Level 2: Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly such as quoted prices for similar assets or liabilities or market corroborated inputs; and

•

Level 3: Unobservable inputs for which there is little or no market data, which require the reporting entity to develop its own assumptions about how market participants would price the assets or liabilities.

     The valuation techniques that may be used to measure fair value are as follows:

•

Market approach — Uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities;

•

Income approach — Uses valuation techniques to convert future amounts to a single present amount based on current market expectations about those future amounts, including present value techniques, option pricing models and excess earnings method; and

•

Cost approach — Based on the amount that currently would be required to replace the service capacity of an asset (replacement cost).

     The following table sets forth the Company’s financial instruments carried at fair value within the accounting standard hierarchy and using the lowest level of input as of September 30, 2011:

						Significant
		Quoted Prices in				Other				Significant
		Active Markets for				Observable				Unobservable
		Identical Items				Inputs				Inputs
		(Level 1)				(Level 2)				(Level 3)				Total
Assets:
Money market funds		$	134			$	—			$	—			$	134
Total cash equivalents			134				—				—				134
Short-term U.S. agency notes			—				196,859				—				196,859
Total assets		$	134			$	196,859			$	—			$	196,993

     Realized gains and losses from sales of the Company’s investments are included in other income (expense) and unrealized gains and losses from available-for-sale securities are included as a separate component of stockholders’ equity unless the loss is determined to be other-than-temporary. The Company has not incurred any other-than-temporary losses to date.

     The Company measures eligible assets and liabilities at fair value with changes in fair value recognized in earnings. Fair value treatment may be elected either upon initial recognition of an eligible asset or liability or, for an existing asset or liability, if an event triggers a new basis of accounting. The Company did not elect to remeasure any of its existing financial assets or liabilities, and did not elect the fair value option for any financial assets and liabilities transacted in the three and nine months ended September 30, 2011.

15. Recent Accounting Pronouncements

     In September 2011, the FASB amended ASC 350, Intangibles — Goodwill and Other. This amendment is intended to reduce the cost and complexity of the annual goodwill impairment test by providing entities an option to perform a qualitative assessment to determine whether further impairment testing is necessary. The amended provisions are effective for reporting periods beginning on or after December 15, 2011. However, early adoption is permitted if an entity’s financial statements for the most recent annual or interim period have not yet been issued. This amendment impacts testing steps only and, therefore, adoption will not have an impact on the Company’s consolidated financial position, results of operations or cash flows.

     In June 2011, the FASB amended ASC 220, Comprehensive Income. This amendment was issued to enhance comparability between entities that report under GAAP and International Financial Reporting Standards (IFRS) and to provide a more consistent method of presenting non-owner transactions that affect an entity’s equity. The amendment requires companies to present the components of net income and other comprehensive income either as one continuous statement or as two separate but consecutive statements. It eliminates the option to report other comprehensive income and its components as part of the statement of changes in shareholders’ equity. The amended provisions are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted, and full retrospective application is required. This amendment impacts presentation and disclosure only, and therefore adoption will not have an impact on the Company’s consolidated financial position, results of operations or cash flows.

     In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820) Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (ASU No. 2011-04). The amendments in this update apply to all reporting entities that are required or permitted to measure or disclose the fair value of an asset, a liability, or an instrument classified in a reporting entity’s shareholders’ equity in the financial statements. ASU No. 2011-04 does not extend the use of fair value accounting, but provides guidance on how it should be applied where its use is already required or permitted by other standards within U.S. GAAP or IFRS. ASU No. 2011-04 changes the wording used to describe many requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. Additionally, ASU No. 2011-04 clarifies the FASB’s intent about the application of existing fair value measurements. The amendments in this update are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. Early application by public entities is not permitted. The Company does not expect the provisions of ASU No. 2011-04 to have a material effect on its financial position, results of operations or cash flows.

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

Cautionary Statement

     This Quarterly Report on Form 10-Q, including the information incorporated by reference herein, contains, in addition to historical information, forward-looking statements. We may, in some cases, use words such as “project,” “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “continue,” “should,” “would,” “could,” “potentially,” “will,” “may” or similar words and expressions that convey uncertainty of future events or outcomes to identify these forward-looking statements. Forward-looking statements in this Quarterly Report on Form 10-Q may include statements about:

	•		our ability to attract and retain customers;
	•		our ability to retain and hire necessary employees and appropriately staff our operations;
	•		our financial performance;
	•		our expectations regarding our revenue, cost of revenue and our related gross profit and gross margin;
	•		our development activities, expansion of our product offerings and the emerging opportunities for our solutions;
	•		our position in the session delivery network solutions market and our competitors;
	•		the effect of the worldwide economy on purchases of our products;
	•		the expectations about our growth and acquisitions of new technologies;
	•		the demand for and the growth of worldwide revenues for session delivery network solutions;
	•		the benefits of our products, services, or programs;
	•		our ability to establish and maintain relationships with key partners and contract manufacturers;
	•		potential natural disasters in locations where we, our customers, or our suppliers operate;
	•		the advantages of our technology as compared to that of our competitors;
	•		our expectations regarding the realization of recorded deferred tax assets; and
	•		our cash needs.

     The outcome of the events described in these forward-looking statements is subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from the results anticipated by these forward-looking statements. These important factors include our financial performance, our ability to attract and retain customers, our development activities and those factors we discuss in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K under the caption “Risk Factors.” You should read these factors and the other cautionary statements made in this Quarterly Report on Form 10-Q as being applicable to all related forward-looking statements wherever they appear in this Quarterly Report on Form 10-Q. These risk factors are not exhaustive and other sections of this Quarterly Report on Form 10-Q may include additional factors which could adversely impact our business and financial performance.

Company Background

     Acme Packet, Inc. is the leader in session delivery network solutions which enable the trusted, first class delivery of next-generation voice, data and unified communication services and applications across internet protocol, or IP, networks.

     Our Net-Net product family fulfills demanding security, service assurance and regulatory requirements in service provider, enterprise and contact center networks. We design and manufacture our products in the United States, selling them through over 200

reseller partners worldwide. More than 1,525 customers in 107 countries have deployed over 14,000 of our systems, including 90 of the top 100 service providers and 36 of the Fortune 100.

     Our headquarters are located in Bedford, Massachusetts. We maintain sales offices in Beijing, China; Tokyo, Japan; Madrid, Spain; Seoul, South Korea; and Ipswich, United Kingdom. We also have sales and support personnel in Argentina, Australia, Belgium, Brazil, Canada, Columbia, Croatia, Czech Republic, France, Germany, Hong Kong, India, Indonesia, Israel, Italy, Malaysia, Mexico, the Netherlands, New Zealand, Peru, Poland, Russia, Saudi Arabia, Singapore, South Africa, Sweden, Taiwan, Thailand, United Arab Emirates and throughout the United States. We expect to selectively add personnel to provide additional geographic sales and technical support coverage.

Industry Background

     Service providers traditionally have delivered voice and data services over two separate networks: the public switched telephone network, or PSTN, and the internet. The PSTN provides high reliability and security but is costly to operate and is limited in its ability to support high bandwidth video and other interactive multimedia services. The internet is capable of cost effectively transmitting any form of traffic that is IP-based, including interactive voice, video and data, but it transmits traffic only on a best efforts basis, because all forms of traffic have the same priority. Therefore, the internet attempts to deliver all traffic without distinction, which can result in significantly varying degrees of service quality for the same or similar types of traffic transmissions. Internet-based services are also subject to disruptive and fraudulent behavior, including identity theft, viruses, unwanted and excessively large input data, known as SPAM, and the unauthorized use and attempts to circumvent or bypass security mechanisms associated with those services, known as hacking.

     Service providers are migrating to a single IP network architecture to serve as the foundation for their next generation voice, video, multimedia and data service offerings. Recently, an increasing number of enterprises, including contact centers and government agencies have begun to migrate to a single IP network architecture as well. In order to provide secure and high quality interactive communications on a converged IP network, service providers and enterprises must be able to control the communications flows that comprise communication sessions.

Evolution to a Converged IP Network

     IP networks can be designed and operated more cost effectively than the PSTN. In addition, IP networks are capable of delivering converged voice, video and data service packages to businesses and consumers. Service providers are seeking to provide these next-generation services to enhance their profitability by generating incremental revenue and by reducing subscriber turnover. Enterprises are searching for ways to unify their communications by seamlessly integrating voice, video, instant messaging and collaboration while reducing costs. Managing two distinct networks—the PSTN and an IP network—is not a viable economic alternative. As a result, service providers and enterprises have begun to migrate to a single IP network architecture to serve as the foundation for their next-generation services and applications. In order to successfully transition to a single IP network, however, they must maintain the same reliability, quality and security that have for decades exemplified their delivery of voice services.

Challenges of IP Networks in Delivering Session Based Communications

     IP networks were designed initially to provide reliable delivery of data services such as file downloads and website traffic that are not sensitive to latency or time delay. If data packets are lost or misdirected, an IP network exhibits tremendous resiliency in re-transmitting and eventually executing the desired user request, which generally is an acceptable result for these types of data services. However, IP networks historically have not been capable of guaranteeing real time, secure delivery of high quality sessions-based communications such as interactive voice and video.

     A session is a communications interaction that has a defined beginning and end, and is effective only when transmitted in real time without latency or delays. In order to enable a session-based communication, control of the session from its origination point to its defined end point is required. No single IP network extends far enough to enable that level of control, however, the internet lacks the fundamental quality of service and security mechanisms necessary to consistently deliver the security and quality of real time multimedia communications that consumers and businesses require. In order to gain the trust of users, service providers and enterprises must be able to assure secure and high quality interactive communications across multiple networks.

Key Financial Highlights

     Some of our key financial highlights for the three months ended September 30, 2011, as compared to the same metrics for the three months ended September 30, 2010, include the following:

	•		Total revenue was $70.6 million compared to $56.6 million.
	•		Net income was $7.9 million compared to $10.5 million.
	•		Earnings per share was $0.11 per share on a diluted basis compared to $0.15 per share on a diluted basis.
	•		Cash provided by operating activities was $16.4 million compared to $9.7 million.

The Acme Packet Strategy

     Principal elements of our strategy include:

	•		Continuing to satisfy the evolving border requirements of enterprises and fixed-line, mobile and over-the-top service providers. Our product deployments position us to gain valuable knowledge that we can use to expand and enhance our products’ features and functionality. We may develop new products organically or through selective acquisitions.
	•		Implementing new technologies to enhance product performance and scalability. We will seek to leverage new technologies as they become available to increase the performance, capacity and functionality of our product family, as well as to reduce our costs.
	•		Investing in quality and responsive support. As we broaden our product platform and increase our product capabilities, we will continue to provide comprehensive service and support targeted at maximizing customer satisfaction and retention.
	•		Facilitating and promoting service interconnects and federations among our customers. We intend to drive increased demand for our products by helping our customers to extend the reach of their services and applications and, consequently, to increase the value of their services to their customers.
	•		Leveraging distribution partnerships to enhance market penetration. We will continue to invest in training and tools for our distribution partners’ sales, systems engineering and support organizations, in order to improve the overall efficiency and effectiveness of these partnerships.
	•		Actively contributing to architecture and standards definition processes. We will utilize our breadth and depth of experience with SBC deployments to contribute significantly to organizations developing standards and architectures for next generation IP networks.

Factors That May Affect Future Performance

	•		Global Macroeconomic Conditions. We believe that the capital budgets and spending initiatives of some of our core customers—service providers, enterprises, government agencies and contact centers—may be affected by current worldwide economic conditions. Our ability to generate revenue from these core customers is dependent on the status of such budgets and initiatives.
	•		Gross Margin. Our gross margin has been, and will continue to be, affected by many factors, including (a) the demand for our products and services, (b) the average selling price of our products, which in turn depends, in part, on the mix of product and product configurations sold, (c) the level of software license upgrades, (d) new product introductions, (e) the mix of sales channels through which our products are sold, and (f) the costs of manufacturing our hardware products and providing our related support services. Customers license our software in various configurations depending on each customer’s requirements for session capacity, feature groups and protocols. The product software configuration mix will have a direct impact on the average selling price of the system sold. Systems with higher software content (higher session capacity, support for higher number of security protocols and a larger number of feature groups) will generally have a

			higher average selling price than those systems sold with lower software content. If customers begin to purchase systems with lower software content, this may have a negative impact on our revenue and gross margins.
	•		Competition. Competition in our product categories is strong and constantly evolving. While we believe we are currently the market leader in the service provider and enterprise markets for session delivery network solutions, we expect competition to persist and intensify in the future as the market grows. Our primary competitors for session delivery network solutions generally consist of specialty vendors, such as GENBAND Inc., and more established network and component companies such as Cisco Systems, Inc. and Huawei Technologies Co., Ltd. We also compete with some of the companies with which we have distribution partnerships, such as Alcatel-Lucent, Nokia Siemens Networks B.V. and Telefonaktiebolaget LM Ericsson. We believe we compete successfully with all of these companies based upon our experience in interactive communications networks, the breadth of our applications and standards support, the depth of our border control features, the demonstrated ability of our products to interoperate with key communications infrastructure elements and our comprehensive service and support. We also believe our products are priced competitively with our competitors’ offerings. As the session delivery network solutions market opportunity grows, we expect competition from additional networking and IP communications equipment suppliers, including our distribution partners.
	•		Evolution of the Session Delivery Network Solutions Market. The market for our products is in its early stages and is still evolving, and it is uncertain whether these products will continue to achieve and sustain high levels of demand and market acceptance. Our success will depend, to a substantial extent, on the willingness of interactive communications service providers and enterprises to continue to implement our solutions.
	•		Research and Development. To continue to achieve market acceptance for our products, we must effectively anticipate and adapt, in a timely manner, to customer requirements and must offer products that meet changing customer demands. Prospective customers may require product features and capabilities that our current products do not have. The market for session delivery network solutions is characterized by rapid technological change, frequent new product introductions, and evolving industry requirements. We intend to continue to invest in our research and development efforts, which we believe are essential to maintaining our competitive position.
	•		Managing Growth. We significantly expanded our operations in 2010 and the first nine months of 2011. During the period from January 1, 2010 through September 30, 2011 we increased the number of our employees and full time independent contractors by 65%, from 450 to 741. We anticipate that further expansion of our infrastructure and headcount will be required to achieve planned expansion of our product offerings, projected increases in our customer base and anticipated growth in the number of product deployments. In the future, we expect to continue to carefully manage the increase of our operating expenses based on our ability to expand our revenues, the expansion of which could occur organically or through future acquisitions.

Revenue

     We derive product revenue from the sale of our Net-Net hardware and the licensing of our Net-Net software. We generally recognize product revenue at the time of product delivery, provided all other revenue recognition criteria have been met. For arrangements that include customer acceptance or other material non-standard terms, we defer revenue recognition until after delivery, assuming all other criteria for revenue recognition have been met.

     We generate maintenance, support and service revenue from (a) maintenance associated with software licenses, (b) technical support services for our software product, (c) hardware repair and maintenance services, (d) implementation, training and consulting services and (e) reimbursable travel and other out-of-pocket expenses.

     We offer our products and services indirectly through distribution partners and directly through our sales force. Our distribution partners include networking and telecommunications equipment vendors throughout the world. Our distribution partners generally purchase our products after they have received a purchase order from their customers and, generally, do not maintain an inventory of our products in anticipation of sales to their customers. Generally, the pricing offered to our distribution partners will be lower than to our direct customers.

     The product configuration, which reflects the mix of session capacity, signaling protocol support and requested features, determines the price for each product sold and licensed. Customers can purchase our products in either a standalone or high availability configuration and can license our software in various configurations, depending on the customers’ requirements for

session capacity, functionality and protocols. The product software configuration mix will have a direct impact on the average selling price of the system sold. As the market continues to develop and grow, we expect to experience increased price pressure on our products and services.

     We believe that our revenue and results of operations may vary significantly from quarter to quarter as a result of long sales and deployment cycles, variations in customer ordering patterns, and the application of complex revenue recognition rules to certain transactions. Some of our arrangements with customers include clauses under which we may be subject to penalties for failure to meet specified performance obligations. We have not incurred any such penalties to date.

Cost of Revenue

     Cost of product revenue consists primarily of (a) third party manufacturers’ fees for purchased materials and services, combined with our expenses for (b) salaries, wages and related benefits for our manufacturing personnel, (c) related overhead, (d) provision for inventory obsolescence, (e) amortization of intangible assets and (f) stock-based compensation. Amortization of intangible assets represents the amortization of developed technologies from our acquisitions of Covergence Inc. and Newfound Communications, Inc.

     Cost of maintenance, support and service revenue consists primarily of (a) salaries, wages and related benefits for our support and service personnel, (b) related overhead, (c) billable and non-billable travel, lodging, and other out-of-pocket expenses, (d) material costs consumed in the provision of services and (e) stock-based compensation.

Gross Profit

     Our gross profit has been, and will be, affected by many factors, including (a) the demand for our products and services, (b) the average selling price of our products, which in turn depends, in part, on the mix of product and product configurations sold or licensed, (c) the mix between product and service revenue, (d) new product introductions, (e) the mix of sales channels through which our products are sold, (f) the volume and costs of manufacturing our hardware products, (g) the costs associated with fulfilling our maintenance and warranty obligations, and (h) personnel and related costs for manufacturing, support and services.

Operating Expenses

     Operating expenses consist of sales and marketing, research and development, general and administrative and merger and integration related expenses. Personnel related costs are the most significant component of each of these expense categories. During the period from January 1, 2010 through September 30, 2011, we increased the number of our employees and full time independent contractors related to our operating activities by 68%, from 381 to 640. We expect to continue to hire new employees to support our expected growth.

     Sales and marketing expense consists primarily of (a) salaries and related personnel costs, (b) commissions and bonuses, (c) travel, lodging and other out-of-pocket expenses, (d) marketing programs such as trade shows, (e) stock-based compensation and (f) other related overhead. Commissions are recorded as expense when earned by the employee. We expect sales and marketing expense to increase in absolute dollars and as a percentage of revenue as we expand our sales force to continue to increase our revenue and market share..

     Research and development expense consists primarily of (a) salaries and related personnel costs, (b) payments to suppliers for design and consulting services, (c) prototype and equipment costs relating to the design and development of new products and enhancement of existing products, (d) quality assurance and testing, (e) stock-based compensation and (f) other related overhead. To date, all of the costs related to our research and development efforts have been expensed as incurred as technological feasibility is determined at the same time as release. We intend to continue to invest in our research and development efforts, which we believe are essential to maintaining our competitive position. We expect research and development expense to increase in absolute dollars. However, we anticipate that research and development expense will remain relatively consistent as a percentage of total revenue in the future.

     General and administrative expense consists primarily of (a) salaries, wages and personnel costs related to our executive, finance, human resource and information technology organizations, (b) accounting and legal professional fees, (c) expenses associated with uncollectible accounts, (d) stock-based compensation and (e) other related overhead. We expect general and administrative expense to increase in absolute dollars as we invest in infrastructure to support continued growth and incur ongoing expenses related to being a

publicly-traded company. However, we anticipate that general and administrative expense will remain relatively consistent as a percentage of total revenue in the future.

     Merger and integration related costs primarily consist of legal fees.

Stock-Based Compensation

     Cost of revenue and operating expenses include stock-based compensation expense related to grants of stock options, awards and restricted stock units. In addition, in 2011 it includes the impact of our new Employee Stock Purchase Plan. We record stock-based compensation expense based on the fair value of the stock-based awards on the date of grant. For the three months ended September 30, 2011 and 2010, we recorded an expense of $9.7 million and $4.6 million, respectively, and for the nine months ended September 30, 2011 and 2010, we recorded an expense of $25.0 million and $11.9 million, respectively. As a result of stock-based awards granted from 2007 through 2011, a future expense of non-vested options of $84.1 million is expected to be recognized over a weighted average period of 2.41 years.

Other (Expense) Income

     Other (expense) income consists primarily of interest income earned on cash, cash equivalents and investments. We have invested cash in high quality securities and are not materially affected by fluctuations in interest rates. Other (expense) income also includes gains or losses from foreign currency translation adjustments of our international activities. The functional currency of our international operations in Europe and Asia is the U.S. dollar. Accordingly, all assets and liabilities of these international subsidiaries are re-measured into U.S. dollars using the exchange rates in effect at the balance sheet date, or historical rate, as appropriate. Revenue and expenses of these international subsidiaries are re-measured into U.S. dollars at the average rates in effect during the period. Any differences resulting from the re-measurement of assets, liabilities and operations of the European and Asian subsidiaries are recorded within other (expense) income.

Application of Critical Accounting Policies and Use of Estimates

     Our financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ significantly from these estimates under different assumptions or conditions. There have been no material changes to these estimates for the periods presented in this Quarterly Report on Form 10-Q. For a detailed explanation of the judgments made in these areas, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2010, which we filed with the Securities and Exchange Commission, or SEC, on February 18, 2011.

     We believe that our significant accounting policies, which are described in the notes to our unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q, have not materially changed from those described in the notes to our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2010, except as described below.

Revenue Recognition

     We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the consideration is fixed or determinable, and collection of the related accounts receivable is deemed probable. In making these judgments, management evaluates these criteria as follows:

•

Persuasive evidence of an arrangement exists. We consider a non-cancellable agreement signed by the customer and us to be representative of persuasive evidence of an arrangement.

•

Delivery has occurred. We consider delivery to have occurred when product has been delivered to the customer and no significant post-delivery obligations exist. In instances where customer acceptance is required, delivery is deemed to have occurred when customer acceptance has been achieved. Certain of our agreements contain products

that might not conform to published specifications or contain a requirement to deliver additional elements which are essential to the functionality of the delivered elements. Revenue associated with these agreements is recognized when the customer specifications have been met or delivery of the additional elements has occurred.

•

Consideration is fixed or determinable. We consider the consideration to be fixed or determinable unless the consideration is subject to refund or adjustment, or is not payable within normal payment terms. If the consideration is subject to refund or adjustment, we recognize revenue when the right to a refund or adjustment lapses. If offered payment terms exceed our normal terms, then revenue is recognized upon the receipt of cash.

•

Collection is deemed probable. We conduct a credit review for all transactions at the inception of an arrangement and then routinely on an ongoing basis to determine the creditworthiness of the customer. Collection is deemed probable if, based upon our evaluation, we expect that the customer will be able to pay amounts under the arrangement as payments become due. If we determine that collection is not probable, revenue is deferred and recognized upon the receipt of cash.

     Our revenue arrangements regularly include the sale of hardware, licensing of software, and provision of maintenance, professional services and training. Revenue arrangements may include one of these single elements, or may incorporate one or more elements in a single transaction or some combination of related transactions. During the first quarter of 2011, we prospectively adopted the guidance of Accounting Standards Update (ASU) No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements (ASU No. 2009-13) and ASU No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements (ASU No. 2009-14), which were ratified by the Financial Accounting Standards Board (FASB) Emerging Issues Task Force on September 23, 2009. ASU No. 2009-13 affects accounting and reporting for all multiple-deliverable arrangements. It also applies to companies that are affected by the amendments of ASU No. 2009-14.

     The amendments in ASU No. 2009-14 provide that tangible products containing software components and non-software components that function together to deliver the tangible product’s essential functionality are no longer within the scope of the software revenue guidance in Accounting Standards Codification (ASC) Topic 985-605, Software Revenue Recognition (ASC 985-605) and should follow the guidance in ASU No. 2009-13 for multiple-element arrangements. All non-essential and standalone software components will continue to be accounted for under the guidance of ASC 985-605.

     ASU No. 2009-13 establishes a selling price hierarchy for determining the selling price of a deliverable in a revenue arrangement. The selling price for each deliverable is based on vendor-specific objective evidence (VSOE), if available, third-party evidence (TPE) if VSOE is not available, or our best estimated selling price (BESP) if neither VSOE nor TPE are available. The amendments in ASU No. 2009-13 eliminate the residual method of allocating arrangement consideration and require that it be allocated at the inception of the arrangement to all deliverables using the relative selling price method. The relative selling price method allocates any discount in the arrangement proportionately to each deliverable on the basis of the deliverable’s estimated selling price.

     For all transactions entered into prior to January 1, 2011 and for those transactions which include the licensing of stand-alone or non-essential software as an element after January 1, 2011, we allocate revenue among the multiple elements associated with the stand-alone and non-essential software based on the software revenue recognition guidance. Under this guidance of ASC 985-605, when arrangements include multiple elements, we allocate the total fee among the various elements using the residual method. Under the residual method, revenue is recognized when VSOE of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements of the arrangement. Each arrangement requires us to analyze the individual elements in the transaction and to estimate the fair value of each undelivered element, which typically represents maintenance and services. Revenue is allocated to each of the undelivered elements based on its respective fair value, with the fair value determined by the price charged when that element is sold or licensed separately. If VSOE of fair value for any undelivered element does not exist, revenue from the entire arrangement is deferred and recognized at the earlier of (a) delivery of those elements for which VSOE of fair value does not exist or (b) when VSOE is established. However, in instances where maintenance services are the only undelivered element without VSOE of fair value, the entire arrangement is recognized ratably as a single unit of accounting over the contractual service period.

     For transactions entered into subsequent to the adoption of ASU No. 2009-13 that include multiple elements, arrangement consideration is allocated to each element based on the relative selling prices of all of the elements in the arrangement using the fair value hierarchy as required by ASU No. 2009-13. We limit the amount of revenue recognition for delivered elements to the amount that is not contingent on the future delivery of products or services, future performance obligation, or subject to customer-specific return or refund privileges.

     Consistent with the methodology used under the previous accounting guidance, we establish VSOE for our training services, post-sale customer support and installation services based on the sales price charged for each element when it is sold or licensed separately. Because we generally do not sell any of our products on a standalone basis, we have yet to establish VSOE for these offerings.

     We typically are not able to determine TPE for our products or certain of our services. TPE is determined based on competitor prices for similar elements when sold or licensed separately. Generally, our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, we are unable to reliably determine the selling prices on a stand-alone basis of similar products offered by our competitors.

     When we are unable to establish the selling price of our products or certain services using VSOE or TPE, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or service were sold or licensed on a stand-alone basis. We determine BESP for a product or service by considering multiple factors including, but not limited to, pricing practices, geographies, customer classes and distribution channels.

     We plan to analyze the selling prices used in our allocation of arrangement consideration, at a minimum, on an annual basis. Selling prices will be analyzed on a more frequent basis if a significant change in our business necessitates a more frequent analysis, or if we experience significant variances in our selling prices.

Results of Operations

Comparison of Three Months Ended September 30, 2011 and 2010

Revenue

		Three Months Ended September 30,
		2011								2010
						Percentage								Percentage
						of Total								of Total				Period-to-Period Change
		Amount				Revenue				Amount				Revenue				Amount				Percentage
										(dollars in thousands)
Revenue by Type:
Product		$	53,077				75	%		$	45,328				80	%		$	7,749				17	%
Maintenance, support and service			17,544				25				11,286				20				6,258				55
Total revenue		$	70,621				100	%		$	56,614				100	%		$	14,007				25	%
Revenue by Geography:
United States and Canada		$	36,842				52	%		$	32,915				58	%		$	3,927				12	%
International			33,779				48				23,699				42				10,080				43
Total revenue		$	70,621				100	%		$	56,614				100	%		$	14,007				25	%
Revenue by Sales Channel:
Direct		$	22,476				32	%		$	27,299				48	%		$	(4,823	)			(18	)%
Indirect			48,145				68				29,315				52				18,830				64
Total revenue		$	70,621				100	%		$	56,614				100	%		$	14,007				25	%

     The $7.7 million increase in product revenue was primarily due to an increase in the number of systems recognized as revenue, reflecting an increase in our customer base and customer demand. This increase was partially offset by a decrease in the average selling price of our systems due to changes in our product software configuration mix, including software upgrades, the mix of system platforms purchased by our customers and the sales channels through which they are sold. The product configuration, which reflects the mix of session capacity support for signaling protocols and requested features, determines the prices for each system sold. Customers can license our software in various configurations, depending on requirements for session capacity, feature groups and protocols. The product software configuration mix has a direct impact on the average selling price of a system sold or licensed. Systems with higher software content (higher session capacity support for higher number of signaling protocols and a higher number of feature groups) will generally have a higher average selling price than those systems sold or licensed with lower software content. Our indirect sales channels generally have higher discounts then our direct customers. The growth in product revenue was due to an increase in revenue from our indirect sales channel partially offset by a decrease in revenue from our direct sales channel. Indirect product revenues increased $14.4 million primarily due to an $8.6 million increase attributable to our customers in the United States and Canada, as well as an increase of $5.8 million related to our international customers. Direct product revenues decreased

$6.7 million, primarily due to a decrease of $8.1 million attributable to customers in the United States and Canada, partially offset by an increase of $1.4 million related to our international customers.

     Maintenance, support and service revenue increased by $6.3 million primarily due to increases in maintenance and support fees associated with the growth of our installed product base and to a lesser extent, fees associated with training and installation services.

Cost of Revenue and Gross Profit

		Three Months Ended September 30,
		2011								2010
						Percentage								Percentage
						of Related								of Related				Period-to-Period Change
		Amount				Revenue				Amount				Revenue				Amount				Percentage
										(dollars in thousands)
Cost of Revenue:
Product		$	8,778				17	%		$	7,903				17	%		$	875				11	%
Maintenance, support and service			3,042				17				2,556				23				486				19
Total cost of revenue		$	11,820				17	%		$	10,459				18	%		$	1,361				13	%
Gross Profit:
Product		$	44,299				83	%		$	37,425				83	%		$	6,874				18	%
Maintenance, support and service			14,502				83				8,730				77				5,772				66
Total gross profit		$	58,801				83	%		$	46,155				82	%		$	12,646				27	%

     The $875,000 increase in cost of product revenue was primarily due to (a) a $790,000 increase in direct product costs resulting from an increase in the number of systems recognized as revenue, (b) a $97,000 increase in salaries, wages and related benefits and (c) a $116,000 increase in stock-based compensation expense. These increases were partially offset by a decrease of $134,000 in other cost of sales.

     The $486,000 increase in cost of maintenance, support and service revenue was primarily due to (a) a $584,000 increase in salaries and related benefits corresponding to a 31% increase in employee headcount in our services organization to support our rapidly growing customer base, (b) a $284,000 increase in stock-based compensation expense, (c) an $80,000 increase in facility costs and related overhead, and (d) a $26,000 increase in travel and entertainment expenses reflecting the aforementioned increase in related headcount. These increases were partially offset by a $518,000 decrease in costs associated with performance of our maintenance and warranty obligations.

     Product gross margin remained consistent. The increase in product revenue corresponded with an increase in related costs.

     Gross margin on maintenance, support and service revenue increased by six percentage points, primarily due to an increase in maintenance revenues associated with the growth in our installed product base, and the timing of maintenance renewal orders received in the three months ended September 30, 2011, without a similar percentage increase in related costs.

     We expect cost of product, maintenance, support and service revenue each to increase at approximately the same rate as the related revenue for the foreseeable future. As a result, we expect that gross profit will increase, but that the related gross margin will remain relatively consistent with historical rates for the foreseeable future.

Operating Expenses

		Three Months Ended September 30,
		2011								2010
						Percentage								Percentage
						of Total								of Total				Period-to-Period Change
		Amount				Revenue				Amount				Revenue				Amount				Percentage
										(dollars in thousands)
Sales and marketing		$	27,201				38	%		$	17,012				30	%		$	10,189				60	%
Research and development			13,249				19				8,896				16				4,353				49
General and administrative			5,406				8				3,906				7				1,500				38
Merger and integration related costs			120				*				—				—				120				*
Total operating expenses		$	45,976				65	%		$	29,814				53	%		$	16,162				54	%

     The $10.2 million increase in sales and marketing expense was primarily due to (a) a $5.3 million increase in salaries, commissions, and other benefits associated with a 41% increase in the number of sales and marketing personnel, (b) a $2.4 million increase in stock-based compensation expense, (c) a $1.2 million increase in travel and entertainment expenses reflecting the aforementioned increase in related headcount, (d) a $266,000 increase in depreciation and amortization expense due to capital expenditures for evaluation systems, (e) a $245,000 increase in expenditures associated with marketing programs, including trade shows, (f) a $213,000 increase in facility costs and related overhead, and (g) a $107,000 increase in professional search related fees. The balance was due to increased overhead associated with increases in sales and marketing personnel. We expect sales and marketing expense to continue to increase in absolute dollars and as a percentage of revenue for the foreseeable future as we expand our sales force to continue to increase our revenue and market share.

     The $4.4 million increase in research and development expense was primarily due to (a) a $2.6 million increase in salaries and other benefits associated with a 43% increase in the number of employees working on the design and development of new products and the enhancement of existing products, quality assurance and testing, (b) a $1.6 million increase in stock-based compensation expense, (c) a $133,00 increase in depreciation and amortization expense, (d) a $98,000 increase in recruiting fees, (e) an $88,000 increase in facilities costs and related overhead, and (f) a $57,000 increase in software and other maintenance fees. These increases were partially offset by a decrease of $450,000 in bonuses. The addition of personnel and our continued investment in research and development were driven by our strategy of maintaining our competitive position by expanding our product offerings and enhancing our existing products to meet the requirements of our customers and market. We expect research and development expense to increase in absolute dollars and will remain relatively consistent as a percentage of total revenue, with historical rates, for the foreseeable future.

     The $1.5 million increase in general and administrative expense was primarily due to (a) a $716,000 increase in stock-based compensation expense, (b) a $513,000 increase in salaries and other benefits associated with a 48% increase in the number of employees, (c) a $123,000 increase in software and other maintenance fees, (d) a $102,000 increase in third party services, (e) a $94,000 increase in legal and professional fees, (f) a $90,000 increase in depreciation expense, and (g) an $86,000 increase in insurance premiums. These increases were partially offset by a decrease of $257,000 in bonuses. We expect general and administrative expense to continue to increase in absolute dollars as we invest in infrastructure to support continued growth and incur expenses related to being a publicly traded company. However, we expect general and administrative expense will remain relatively consistent as a percentage of total revenue, with historical rates, for the foreseeable future.

     During the three months ended September 30, 2011, we incurred $120,000 of merger and integration-related costs associated with our acquisition of Covergence Inc. which closed on April 30, 2009.

Other (Expense) Income

		Three Months Ended September 30,
		2011								2010
						Percentage								Percentage
						of Total								of Total				Period-to-Period Change
		Amount				Revenue				Amount				Revenue				Amount				Percentage
										(dollars in thousands)
Interest income		$	141				*	%		$	157				*	%		$	(16	)			(10	)%
Other (expense) income			(194	)			*				32				*				(226	)			(706	)
Total other (expense) income, net		$	(53	)			*	%		$	189				*	%		$	(242	)			(128	)%

     Interest income consisted of interest income generated from the investment of our cash balances. The decrease in interest income primarily reflected a decrease in the average interest rates in the three months ended September 30, 2011, partially offset by an increase in the average cash balance.

     Other expense primarily consisted of foreign currency translation adjustments of our international subsidiaries and sales consummated in foreign currencies. The increase in expense from 2010 to 2011 primarily reflects fluctuations in the value of the Euro and British Pound.

Provision for Income Taxes

		Three Months Ended September 30,
		2011								2010
						Percentage								Percentage
						of Total								of Total				Period-to-Period Change
		Amount				Revenue				Amount				Revenue				Amount				Percentage
										(dollars in thousands)
Provision for income taxes		$	4,846				7	%		$	6,065				11	%		$	(1,219	)			(20	)%

     For the three months ended September 30, 2011 and 2010, our effective tax rates were 38% and 37%, respectively The lower effective tax rate in 2010 was primarily attributable to higher state investment tax credits due to qualifying fixed asset additions associated with the build out of our corporate headquarters.

Comparison of Nine Months Ended September 30, 2011 and 2010

Revenue

		Nine Months Ended September 30,
		2011								2010
						Percentage								Percentage
						of Total								of Total				Period-to-Period Change
		Amount				Revenue				Amount				Revenue				Amount				Percentage
										(dollars in thousands)
Revenue by Type:
Product		$	177,507				79	%		$	129,452				80	%		$	48,055				37	%
Maintenance, support and service			46,814				21				31,548				20				15,266				48
Total revenue		$	224,321				100	%		$	161,000				100	%		$	63,321				39	%
Revenue by Geography:
United States and Canada		$	127,394				57	%		$	97,587				61	%		$	29,807				31	%
International			96,927				43				63,413				39				33,514				53
Total revenue		$	224,321				100	%		$	161,000				100	%		$	63,321				39	%
Revenue by Sales Channel:
Direct		$	92,206				41	%		$	78,989				49	%		$	13,217				17	%
Indirect			132,115				59				82,011				51				50,104				61
Total revenue		$	224,321				100	%		$	161,000				100	%		$	63,321				39	%