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EX-32.1 - EXHIBIT 32.1 - PROCERA NETWORKS, INC.ex32_1.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-Q
 
(Mark one)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2011
 
or

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

For the transition period from   to   .

Commission File Number: 000-49862
 

 PROCERA NETWORKS, INC.
(Exact name of registrant as specified in its charter)
 

 
Nevada
 
33-0974674
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. employer identification number)

4121 Clipper Court, Fremont, California
 
94538
(Address of principal executive offices)
 
(Zip code)

(510) 230-2777
 (Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ   No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ   No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  o
Accelerated filer  þ
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 Act).  Yes o   No þ
 
As of November 3, 2011, the registrant had 14,453,935 shares of its common stock, par value $0.001, outstanding.
 


 
1

 
 
PROCERA NETWORKS, INC.

 
     
Page
PART I. FINANCIAL INFORMATION
 
       
 
Item 1.
3
       
   
3
       
   
4
       
   
5
       
   
6
       
 
Item 2.
16
       
 
Item 3.
24
       
 
Item 4.
24
       
PART II. OTHER INFORMATION
 
       
 
Item 1.
24
       
 
Item 1A.
25
       
 
Item 2.
36
       
 
Item 3.
36
       
 
Item 4.
36
       
 
Item 5.
36
       
 
Item 6.
37
       
38
 
 
2


PART I. FINANCIAL INFORMATION

Item 1.            Consolidated Financial Statements

Procera Networks, Inc.
CONDENSED CONSOLIDATED BALANCE SHEETS
 
   
September 30,
2011
   
December 31,
2010
 
   
(Unaudited)
       
ASSETS
           
Current assets:
           
Cash and cash equivalents
 
$
18,915,278
   
$
7,875,798
 
Short-term investments
   
15,424,138
     
 
Accounts receivable, less allowance of $97,784 and $321,823 at September 30, 2011 and December 31, 2010, respectively
   
12,410,011
     
11,407,220
 
Inventories, net
   
3,978,899
     
2,549,695
 
Prepaid expenses and other
   
1,783,371
     
831,737
 
Total current assets
   
52,511,697
     
22,664,450
 
                 
Property and equipment, net
   
1,283,088
     
873,173
 
Goodwill
   
960,209
     
960,209
 
Other non-current assets
   
10,791
     
19,150
 
Total assets
 
$
54,765,785
   
$
24,516,982
 
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Line of credit
 
$
   
$
1,718,732
 
Accounts payable
   
2,452,888
     
1,943,799
 
Deferred revenue
   
5,045,951
     
3,732,756
 
Accrued liabilities
   
3,158,917
     
2,662,564
 
Total current liabilities
   
10,657,756
     
10,057,851
 
                 
Non-current liabilities:
               
Deferred revenue
   
868,124
     
704,735
 
Total liabilities
   
11,525, 880
     
10,762,586
 
                 
Commitments and contingencies (Note 14)
   
     
 
                 
                 
Stockholders’ equity:
               
Common stock, $0.001 par value; 32,500,000 shares authorized; 14,449,310 and 11,314,965 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively
   
14,449
     
11,315
 
Additional paid-in capital
   
103,925,381
     
76,093,272
 
Accumulated other comprehensive loss
   
(677,392
)
   
(331,883
)
Accumulated deficit
   
(60,022,533
)
   
(62,018,308
)
Total stockholders’ equity
   
43,239,905
     
13,754,396
 
Total liabilities and stockholders’ equity
 
$
54,765,785
   
$
24,516,982
 

See accompanying notes to condensed consolidated financial statements.
 
 
3

 
Procera Networks, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
2011
   
September 30,
2010
   
September 30,
2011
   
September 30,
2010
 
Sales:
                       
Product sales
 
$
10,128,362
   
$
3,491,821
   
$
24,006,619
   
$
9,588,376
 
Support sales
   
2,064,841
     
1,242,956
     
4,765,451
     
3,216,768
 
Total net sales
   
12,193,203
     
4,734,777
     
28,772,070
     
12,805,144
 
Cost of sales:
                               
Product cost of sales
   
4,472,928
     
1,891,090
     
10,619,984
     
5,266,405
 
Support cost of sales
   
255,822
     
131,884
     
516,492
     
392,809
 
Total cost of sales
   
4,728,750
     
2,022,974
     
11,136,476
     
5,659,214
 
                                 
Gross profit
   
7,464.453
     
2,711,803
     
17,635,594
     
7,145,930
 
                                 
Operating expenses:
                               
Research and development
   
1,024,304
     
859,987
     
3,303,546
     
2,271,108
 
Sales and marketing
   
2,975,840
     
1,614,384
     
8,183,785
     
4,831,885
 
General and administrative
   
1,393,413
     
934,243
     
3,982,432
     
3,000,102
 
Total operating expenses
   
5,393,557
     
3,408,614
     
15,469,763
     
10,103,095
 
                                 
Income (loss) from operations
   
2,070,896
     
(696,811
)
   
2,165,831
     
(2,957,165
)
Interest and other income (expense), net
   
(26,023
)
   
(40,438
)
   
(90,640
)
   
(115,889
)
                                 
Income (loss) before income taxes
   
2,044,873
     
(737,249
)
   
2,075,191
     
(3,073,054
)
Income tax provision
   
     
1,723
     
79,416
     
2,979
 
Net income (loss)
 
$
2,044,873
   
$
(738,972
)
 
$
1,995,775
   
$
(3,076,033
)
                                 
Net income (loss) per share – basic
 
$
0.14
   
$
(0.07
)
 
$
0.16
   
$
(0.29
)
Net income (loss) per share - diluted
 
$
0.14
   
$
(0.07
)
 
$
0.16
   
$
(0.29
)
                                 
Shares used in computing net income (loss) per share:
                               
Basic
   
14,357,639
     
11,208,272
     
12,488,852
     
10,792,888
 
Diluted
   
14,592,691
     
11,208,272
     
12,718,804
     
10,792,888
 
 
See accompanying notes to condensed consolidated financial statements.
 
 
4


Procera Networks, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
   
Nine Months Ended
September 30,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net income (loss)
 
$
1,995,775
   
$
(3,076,033
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
               
Depreciation
   
335,596
     
384,773
 
Compensation related to stock-based awards
   
1,214,641
     
996,511
 
Amortization of premium on investments
   
38,337
     
 
Provision for bad debts
   
     
33,861
 
Provision for excess and obsolete inventory
   
365,366
     
120,886
 
Changes in assets and liabilities:
               
Accounts receivable
   
(1,261,460
)
   
2,405,102
 
Inventories
   
(1,798,897
)
   
(1,094,931
)
Prepaid expenses and other current assets
   
(1,154,220
)
   
96,708
 
Accounts payable
   
511,424
     
103,972
 
Accrued liabilities and deferred rent
   
539,580
     
(191,547
)
Deferred revenue
   
1,566,085
     
1,185,434
 
Net cash provided by operating activities
   
2,352,227
     
964,736
 
                 
Cash flows from investing activities:
               
Purchase of property and equipment
   
(783,888
)
   
(626,235
)
Purchase of short-term investments
   
(15,479,081
)
   
 
Net cash used in investing activities
   
(16,262,969
)
   
(626,235
)
                 
Cash flows from financing activities:
               
Proceeds from issuance of common stock
   
26,456,626
     
6,471,203
 
Proceeds from issuance of common stock – exercise of options
   
305,178
     
 
Proceeds from issuance of common stock – exercise of warrants
   
67,364
     
 
Cash paid for fractional shares
   
(566
)
   
 
Proceeds from line of credit
   
716,656
     
1,022,386
 
Payments on line of credit
   
(2,435,388
)
   
(1,917,088
)
Payments on notes payable
   
     
(500,000
)
Other
   
     
45,266
 
Net cash provided by financing activities
   
25,109,870
     
5,121,767
 
                 
Effect of exchange rates on cash and cash equivalents
   
(159,648
)
   
(365,356
)
                 
Net increase in cash and cash equivalents
   
11,039,480
     
5,094,912
 
                 
Cash and cash equivalents, beginning of period
   
7,875,798
     
3,191,896
 
                 
Cash and cash equivalents, end of period
 
$
18,915,278
   
$
8,286,808
 

See accompanying notes to condensed consolidated financial statements.
 
 
5

 
 Procera Networks, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

1.        DESCRIPTION OF BUSINESS

Procera Networks, Inc. ("Procera" or the "Company") is a leading provider of Intelligent Policy Enforcement solutions based on Deep Packet Inspection technology, that enable mobile and broadband network operators and entities managing private networks including higher education institutions, businesses and government entities (collectively referred to as network operators) to gain enhanced visibility into, and control of, their networks and to create and deploy new services for their end user subscribers.  The Company sells its products through its direct sales force, resellers, distributors and system integrators in the Americas, Asia Pacific and Europe.
 
Procera was incorporated in 2002 and trades on the NYSE Amex Equities Market under the trading symbol “PKT”.

2.        SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation
 
Procera has prepared the consolidated financial statements included herein pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) applicable to interim financial information.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations.  However, Procera believes that the disclosures are adequate to ensure the information presented is not misleading. The consolidated balance sheet at December 31, 2010 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by United States generally accepted accounting principles (“U.S. GAAP”) for complete financial statements. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in Procera’s Annual Report on Form 10-K for the year ended December 31, 2010, filed with the SEC on March 16, 2011.
 
The consolidated financial statements present the accounts of Procera and its wholly-owned subsidiaries, Netintact AB and Netintact PTY.  All significant inter-company balances and transactions have been eliminated.
 
Reverse Stock Split
 
Effective February 4, 2011, Procera implemented a 1-for-10 reverse split of its common stock and reduced the number of authorized shares of common stock from 130,000,000 to 32,500,000 shares, as previously authorized and approved by the Company’s stockholders at the June 14, 2010 annual meeting.  The Company’s common stock began trading on the NYSE Amex Equities Market on a post-split basis on February 7, 2011. As a result, the Company’s issued and outstanding common stock as of February 4, 2011 was reduced from approximately 113.0 million to approximately 11.3 million shares.  The Company paid cash in lieu of any fractional shares to the holders of fractional shares of common stock. The par value of the common stock was not affected by the reverse stock split and remains at $0.001 per share. Consequently, the aggregate par value of the issued common stock was reduced by reclassifying the par value amount of the eliminated shares of common stock to “Additional paid-in capital” in the Company’s Consolidated Balance Sheets. The reverse split also effected a reduction in the number of shares of common stock issuable upon the exercise of stock options, restricted stock and warrants under the Company’s 2007 Equity Incentive Plan. All shares and per share amounts, including all common stock equivalents (stock options, restricted stock and warrants) in the Consolidated Financial Statements and Notes to the Consolidated Financial Statements have been retroactively adjusted, for all periods presented to reflect the reverse stock split.

Significant Accounting Policies

The accounting and reporting policies of the Company conform to U.S. GAAP and to the practices within the telecommunications industry.  There have been no significant changes in the Company's significant accounting policies during the nine months ended September 30, 2011 compared to what was previously disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2010, except for changes in the accounting for revenue recognition as a result of the new accounting standards and updates to the Company’s revenue recognition policy as described below.

 
6

 
Revenue Recognition
 
In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2009-13, “Multiple-Deliverable Revenue Arrangements” and ASU No. 2009-14, “Certain Revenue Arrangements that Include Software Elements.” The Company adopted the new guidance on a prospective basis for new or materially modified revenue arrangements as of January 1, 2011.  The adoption of this guidance did not have a material impact on the Company’s financial statements and is not expected to have a material impact in the future.

The Company’s most common sale involves the integration of software and a hardware appliance, where the hardware and software work together to deliver the essential functionality of the product.   The Company recognizes product revenue when all of the following have occurred: (1) the Company has entered into a legally binding arrangement with a customer resulting in the existence of persuasive evidence of an arrangement; (2) delivery has occurred, evidenced when product title transfers to the customer; (3) customer payment is deemed fixed or determinable and free of contingencies and significant uncertainties; and (4) collection is probable.
 
Product revenue consists of revenue from sales of appliances and software licenses. Product sales include a perpetual license to the Company’s software that is essential to the functionality of the hardware, and on occasion include licenses to additional software. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue.  Virtually all sales include post-contract support (“PCS”) services (included in support revenue) which consist of software updates and customer support. Software updates provide customers access to a constantly growing library of electronic internet traffic identifiers (signatures) and rights to non-specific software product upgrades, maintenance releases and patches released during the term of the support period. Support includes internet access to technical content, telephone and internet access to technical support personnel and hardware support.
 
Receipt of a customer purchase order is the primary method of determining that persuasive evidence of an arrangement exists.
 
Delivery generally occurs when a product is delivered to a common carrier F.O.B. shipping point.  However, product revenue based on channel partner purchase orders are recorded based on sell-through to the end user customers until such time as the Company has established significant experience with the channel partner’s ability to complete the sales process. Additionally, when the Company introduces new products for which there is no historical evidence of acceptance history, revenue is recognized on the basis of end-user acceptance until such history has been established.

Fees are typically considered to be fixed or determinable at the inception of an arrangement, generally based on specific products and quantities to be delivered. Substantially all of the Company’s contracts do not include rights of return or acceptance provisions. To the extent that agreements contain such terms, the Company recognizes revenue once the acceptance provisions or right of return lapses. Payment terms to customers generally range from net 30 to 90 days. In the event payment terms are provided that differ from the Company’s standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payments become due, provided the remaining criteria for revenue recognition have been met.
 
Procera assesses the ability to collect from its customers based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. If the customer is not deemed credit worthy, the Company defers all revenue from the arrangement until payment is received and all other revenue recognition criteria have been met.

Customer orders normally contain multiple items. The initial product delivery consists of the hardware and software elements, and these elements have standalone value to the customer. Through September 30, 2011, in virtually all of the Company’s contracts, the only elements that remained undelivered at the time of product delivery were PCS services. Prior to January 1, 2011, the majority of the Company’s transactions were within the scope of the software revenue recognition guidance. The Company accordingly recognized revenue for delivered items using the residual method, after allocating revenue to PCS services based on vendor specific objective evidence of fair value (“VSOE”).

Under the new guidance, the Company allocates revenue to each element in an arrangement based on relative selling price using a selling price hierarchy. The selling price for a deliverable is based on its VSOE if available, third party evidence ("TPE") if VSOE is not available, or the Company’s best estimate of selling price ("ESP") if neither VSOE nor TPE is available.  The maximum revenue recognized on a delivered element is limited to the amount that is not contingent upon the delivery of additional items. In arrangements that include non-essential software (“software deliverables”), revenue is allocated to each separate unit of accounting for the non-software deliverables and to the software deliverables as a group using the relative selling prices of each of the deliverables in the arrangement. Revenue allocated to the software deliverables as a group is then allocated first to the PCS services based on VSOE, and then to the software, using the residual method under the software revenue recognition guidance.

 
7

 
The Company determines VSOE for PCS based on the rate charged to customers based upon renewal pricing for PCS.  Each contract or purchase order entered into includes a stated rate for PCS. The renewal rate is generally equal to the stated rate in the original contract. The Company has a history of such renewals, the vast majority of which are at the stated renewal rate on a customer by customer basis. PCS revenue is recognized under a proportional performance method, ratably over the life of the contract.   A small portion of service revenue is derived from providing training on products and the Company uses the completed-contract method to recognize such revenue.
 
As the hardware and software products are rarely sold separately, the Company generally does not have VSOE for these products, and TPE is not available. The Company determines the ESP for hardware and software deliverables considering internal factors such as discounting and pricing policies, and external factors such as market conditions in different geographies and competitive positioning.

In certain contracts, billing terms may be agreed upon based on performance milestones such as the execution of a measurement test, a partial delivery or the completion of a specified service.  Payments received before the unconditional acceptance of a specific set of deliverables are recorded as deferred revenue until the conditional acceptance has been waived.

3.        RECENT ACCOUNTING PRONOUNCEMENTS

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 International Financial Reporting Standards (“IFRS”).” The amendments in this ASU generally represent clarification of Topic 820, but also include instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with GAAP and IFRS. The amendments are effective for interim and annual periods beginning after December 15, 2011 and are to be applied prospectively. Early application is not permitted. The Company does not expect that the adoption of ASU 2011-04 will have a material impact on its consolidated financial statements.

In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income.” Specifically, the new guidance allows an entity to present components of net income or other comprehensive income in one continuous statement, referred to as the statement of comprehensive income, or in two separate, but consecutive statements. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. While the new guidance changes the presentation of comprehensive income, there are no changes to the components that are recognized in net income or other comprehensive income under current accounting guidance. The new guidance is effective for fiscal years and interim periods beginning after December 15, 2011 and is to be applied retrospectively. The Company does not expect that the adoption of ASU 2011-05 will have a material impact on its consolidated financial statements.
 
4.        STOCK-BASED COMPENSATION

The Company has an equity incentive plan that provides for the grant of incentive stock options and restricted stock awards to eligible employees.  Stock-based employee compensation expense recognized pursuant to this plan on the Company’s condensed consolidated statements of operations for the three and nine-month periods ended September 30, 2011 and 2010 was as follows:

   
Three Months Ended
September 30,
   
Nine Months Ended
 September 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Cost of goods sold
 
$
25,847
   
$
19,948
   
$
77,058
   
$
43,850
 
Research and development
   
31,432
     
2,715
     
95,752
     
8,519
 
Sales and marketing
   
102,283
     
82,276
     
321,390
     
141,701
 
General and administrative
   
275,725
     
251,685
     
720,441
     
445,817
 
Total stock-based compensation expense
 
$
435,287
   
$
356,624
   
$
1,214,641
   
$
639,887
 

No income tax benefits were recognized in the three and nine months ended September 30, 2011 due to operating loss carry-forwards available to offset current income. No income tax benefits were recognized in the three and nine months ended September 30, 2010 due to losses incurred. No stock-based compensation has been capitalized in inventory due to the immateriality of such amounts.

As of September 30, 2011, total unrecognized compensation cost related to unvested stock options was $1,455,969, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average amortization period of 2.37 years. As of September 30, 2011, total unrecognized compensation cost related to unvested restricted stock awards  was $315,186, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average amortization period of 1.66 years.

 
8

 
General Share-Based Award Information
 
Stock Options
 
The following table summarizes the Company’s stock option activity for the nine months ended September 30, 2011:
 
   
Number of
Options
   
Weighted
Average
 Exercise Price
   
Weighted
Average
Remaining
 Contractual
Life
(in years)
 
Aggregate
 Intrinsic
Value
 
                       
Outstanding at December 31, 2010
   
975,153
   
$
8.93
           
Granted
   
161,100
   
$
9.82
           
Exercised
   
(18,407
)
 
$
5.92
           
Cancelled
   
(25,282
)
 
$
6.05
           
                           
Outstanding at September 30, 2011
   
1,092,564
   
$
9.24
     
6.87
   
$
2,251,236
 
Vested and expected to vest at September 30, 2011
   
1,063,192
   
$
9.29
     
6.82
   
$
2,178,090
 
Exercisable at September 30, 2011
   
737,302
   
$
10.06
     
6.10
   
$
1,342,467
 

The total intrinsic value of options exercised during the nine months ended September 30, 2011 was $84,450. The Company settles employee stock option exercises with newly issued common shares approved by stockholders for inclusion in its stock option plan.

Restricted Stock

The following is a summary of the Company’s restricted stock award activity for the nine months ended September 30, 2011:

   
Number of
Shares
   
Weighted Average Grant
Date Fair Value
 
Non-vested at December 31, 2010
   
60,000
   
$
5.30
 
Granted
   
23,289
   
$
8.62
 
Non-vested at September 30, 2011
   
83,289
   
$
6.23
 

No restricted stock awards vested during the nine months ended September 30, 2011.

Valuation Assumptions

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

The following assumptions were used in determining the fair value of stock options granted during the three and nine months ended September 30, 2011 and 2010:

   
Three Months Ended
 September 30,
   
Nine Months Ended
 September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Expected term (years)
   
4.86
     
4.30
     
4.79
     
4.55
 
Expected volatility
   
66.6
%
   
92.7
%
   
71.6
%
   
95.0
%
Risk-free interest rate
   
1.49
%
   
1.78
     
2.09
%
   
2.09
%
Expected dividend yield
   
0
%
   
0
%
   
0
%
   
0
%

 
9

 
The weighted average grant date fair value of options granted during the nine months ended September 30, 2011and  2010 was $4.74 and $3.30, respectively

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

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

The following table sets forth the computation of basic and diluted net income (loss) per share and potential shares of common stock that are not included in the diluted net income (loss) per share calculation because their effect is antidilutive:

   
Three Months Ended
 September 30,
   
Nine Months Ended
 September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Numerator:
                               
Net income (loss)
 
$
2,044,873
   
$
(738,972
)
 
$
1,995,775
   
$
(3,076,033
)
                                 
Denominator:
                               
Weighted average common shares - basic
   
14,357,639
     
11,208,272
     
12,488,852
     
10,792,888
 
Dilutive effect of employee equity incentive plans
   
184,002
     
     
164,958
     
 
Dilutive effect of warrants
   
51,050
     
     
64,994
     
 
Weighted average common shares - diluted
   
14,592,691
     
11,208,272
     
12,718,804
     
10,792,888
 
                                 
Net income (loss) per share:
                               
Basic
 
$
0.14
   
$
(0.07
)
 
$
0.16
   
$
(0.29
)
Diluted
 
$
0.14
   
$
(0.07
)
 
$
0.16
   
$
(0.29
)
                                 
Antidilutive securities:
                               
Options and restricted stock
   
487,079
     
965,777
     
492,030
     
965,777
 
Warrants
   
159.485
     
409,460
     
159,676
     
409,460
 
Total
   
646,564
     
1,375,237
     
651,706
     
1,375,237
 

6.        COMPREHENSIVE INCOME (LOSS)

The components of comprehensive income (loss) for the three and nine months ended September30, 2011 and 2010 are as follows:

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Net income (loss)
 
$
2,044,873
   
$
(738,972
)
 
$
1,995,775
   
$
(3,076,033
)
Foreign currency translation adjustments
   
(399,355
)
   
28,725
     
(328,904
)
   
(62,295
)
Unrealized loss on short-term investments
   
(16,606
)
   
     
(16,606
)
   
 
Comprehensive income (loss)
 
$
1,628,912
   
$
(710,247
)
 
$
1,650,265
   
$
(3,138,328
)

 
10


7.        CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

Investments are carried at fair value based upon quoted market prices at the end of the reporting period. As of September 30, 2011, all investments were classified as available-for-sale with unrealized gains and losses recorded as a separate component of accumulated other comprehensive income (loss) within stockholders’ equity.

The Company’s investments at September 30, 2011 are as follows:
 
                         
   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
 Money market funds
  $ 8,392,761     $ -     $ -     $ 8,392,761  
 Commercial paper
    4,796,833       161       -       4,796,995  
 U.S. agency securities
    8,083,491       904       (1,064 )     8,083,332  
 Corporate bonds
    5,160,041       201       (16,809 )     5,143,434  
 Total investments   $ 26,433,127     $ 1,267     $ (17,873 )   $ 26,416,521  
                                 
 Reported as:                                
 Cash equivalents
  $ 10,992,413     $ -     $ (30 )   $ 10,992,384  
 Short-term investments
    15,440,714       1,267       (17,843 )     15,424,138  
 Total   $ 26,443,127     $ 1,267     $ (17,873 )   $ 26,416,521  
 
Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase.  Short-term investments have a remaining maturity of greater than three months at the date of purchase and an effective maturity of less than one year.  At December 31, 2010, the Company had no investments.

The Company reviews its investments for impairment quarterly. For investments with an unrealized loss, the factors considered in the review include the credit quality of the issuer, the duration that the fair value has been less than the adjusted cost basis, severity of impairment, reason for the decline in value and potential recovery period, the financial condition and near-term prospects of the investees, and whether the Company would be required to sell an investment due to liquidity or contractual reasons before its anticipated recovery.  Based on its review, the Company did not identify any investments that were other-than-temporarily impaired during the three and nine months ended September 30, 2011.

The Company did not incur any realized gains or losses in the three and nine months ended September 30, 2011.

8.        FAIR VALUE MEASUREMENTS

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

Fair Value Hierarchy

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

 
·
Level 1. Quoted prices in active markets for identical assets or liabilities.

 
·
Level 2. Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets with insufficient volume or infrequent transactions (less active markets), or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities.

 
·
Level 3. Unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of assets or liabilities.

 
11

 
The following tables represent the Company’s fair value hierarchy for its financial assets as of September 30, 2011 measured at fair value on a recurring basis:
 
    Level 1     Level 2     Level 3     Total  
Money market funds
  $ 8,392,761     $ -     $ -     $ 8,392,761  
Commercial paper
    -       4,796,995       -       4,796,995  
U.S. agency securities
    -       8,083,332       -       8,083,332  
Corporate bonds
    -       5,143,434       -       5,143,434  
Total assets measured at fair value   $ 8,392,761     $ 18,023,760     $ -     $ 26,416,521  
 
In general, and where applicable, the Company uses quoted market prices in active markets for identical assets to determine fair value.  This pricing methodology applies to Level 1 investments which are comprised of money market funds. If quoted prices in active markets for identical assets are not available, then the Company uses quoted prices for similar assets or inputs other than quoted prices that are observable, either directly or indirectly.  These investments are included in Level 2 and consist of commercial paper, U.S. agency securities and corporate bonds. U.S. agency securities and corporate bonds are valued at  a consensus price, which is a weighted average price based on market prices from a variety of industry standard data providers used as inputs to a distribution-curve based algorithm. Commercial paper is valued using market prices where available, adjusting for accretion of the purchase price to face value at maturity.
 
During the nine months ended September 30, 2011, the Company did not have any transfers between Level 1 and Level 2 fair value instruments.

9.        INVENTORIES

Inventories are stated at the lower of cost, which approximates actual costs on a first in, first out basis, or market. Inventories at September 30, 2011 and December 31, 2010 consisted of the following:

   
September 30,
2011
   
December 31,
2010
 
Finished goods
 
$
3,024,468
   
$
2,429,846
 
Raw materials
   
427,544
     
119,849
 
Inventories, net
 
$
3,452,012
   
$
2,549,695
 

10.      ACCRUED LIABILITIES

Accrued liabilities at September 30, 2011 and December 31, 2010 consisted of the following:

   
September 30,
2011
   
December 31,
2010
 
Payroll and related
 
$
1,117,243
   
$
973,970
 
Audit and legal services
   
148,483
     
92,946
 
Sales, VAT and income taxes
   
126,679
     
175,462
 
Sales commissions
   
659,483
     
461,407
 
Warranty
   
615,035
     
530,758
 
Other
   
491,994
     
428,021
 
Total
 
$
3,158,917
   
$
2,662,564
 

Warranty Accrual

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

Changes in the warranty accrual during the nine months ended September 30, 2011 were as follows:
 
Warranty accrual at December 31, 2010
 
$
530,758
 
Provision for current period sales
   
84,277
 
Deductions for warranty claims processed during the period
   
 
Warranty accrual at September 30, 2011
 
$
615,035
 

 
12

 
11.      RELATED PARTY TRANSACTIONS

On July 19, 2010, the Company entered into a Master OEM Purchase and Sales Agreement with GENBAND US LLC and GENBAND Ireland Ltd. (collectively, “GENBAND”) pursuant to which GENBAND may purchase any of the Company’s existing software and hardware products, as well as procure licenses and services related to such products from Procera.  Pursuant to this agreement, the Company’s Board of Directors supported the election of Mark Pugerude, Chief Strategy Officer of GENBAND, as a director of the Company.

During the three and nine months ended September 30, 2011, the Company recognized revenue of approximately $0.1 million and $0.8 million, respectively, on sales to GENBAND.  At September 30, 2011 and December 31, 2010, the Company had accounts receivable of approximately $0.1 million and $1.2 million, respectively, from GENBAND.

12.      STOCKHOLDERS’ EQUITY
 
On June 24, 2011, the Company completed a registered offering of 3.0 million shares of common stock, which includes the exercise in full of the underwriters’ overallotment option to purchase 0.4 million shares of common stock.  The shares were sold at $9.50 per share for a gross sales price of $28.8 million.  The Company received net proceeds of approximately $26.5 million after deducting underwriting commissions and other offering expenses.  The Company intends to use the net proceeds for general working capital purposes.

On March 4, 2010, the Company closed a registered placement of its common stock primarily to institutional investors. The offering price of the Company’s common stock was $4.00 per share. The Company sold 1.8 million shares of common stock at a gross sales price of $7.2 million, and received net proceeds of approximately $6.5 million after deducting the placement agent’s commission and legal and other offering costs. The placement agent also received a warrant to purchase 18,000 shares of the Company’s common stock at an exercise price of $4.00 per share which expires on March 4, 2013. The warrant had an estimated fair value of $44,547 calculated using the Black-Scholes option pricing model.
 
Warrants

A summary of warrant activity for the nine months ended September 30, 2011 is as follows:
 
   
Warrants
 
   
Number of
Shares
   
Weighted Average Purchase
Price
 
Outstanding December 31, 2010
   
409,462
   
$
8.39
 
Issued
   
     
 —
 
Exercised
   
(143,437
)
   
4.49
 
Cancelled/expired
   
(24,763
)
   
6.73
 
Outstanding September 30, 2011
   
241,262
   
$
10.87
 

The chart below shows the outstanding warrants as of September 30, 2011 by exercise price and the average contractual life before expiration.

Exercise Price
   
Number Outstanding
   
Weighted Average
Remaining Contractual
Life (Years)
   
Number Exercisable
 
$
4.00
     
83,263
     
3.55
     
83,263
 
 
10.00
     
36,000
     
0.17
     
36,000
 
 
15.00
     
102,000
     
0.17
     
102,000
 
 
20.00
     
19,999
     
0.80
     
19,999
 
                             
$
10.87
     
241,262
     
1.39
     
241,262
 

 
13

 
13.      INCOME TAXES

At September 30, 2011 and December 31, 2010, the Company had $238,338 of unrecognized tax benefits, a total of $204,975 which would affect the Company’s effective tax rate if recognized.
 
The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. As of September 30, 2011, the Company had no accrued interest or penalties related to uncertain tax positions. The federal returns for the years ended 2007 through the current period and most state returns for the years ended 2006 through the current period remain open to examination.  In addition, all of the net operating losses and research and development credit carry-forwards that may be used in future years are still subject to adjustment.  The Company's Australian and Swedish income tax returns for the years ended 2005 and 2004, respectively, through the current period are still open to examination.

 The Company does not anticipate that the total unrecognized tax benefits will significantly change due to the settlement of audits and the expiration of statutes of limitations prior to September 30, 2012.

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

14.      COMMITMENTS AND CONTINGENCIES

Legal

The Company is periodically involved in legal actions and claims that arise as a result of events that occur in the normal course of operations. The Company does not believe that any of its legal actions and claims will have, individually or in the aggregate, a material adverse effect on the Company's financial position or results of operations.

Operating Leases

The Company leases its operating and office facilities for various terms under long-term, non-cancelable operating lease agreements. The leases expire at various dates through 2016 and provide for renewal options ranging from month-to-month to 3 year terms. In the normal course of business, it is expected that these leases will be renewed or replaced by leases on other properties. The leases provide for increases in future minimum annual rental payments based on defined increases which are generally meant to correlate with the Consumer Price Index, subject to certain minimum increases. Also, the agreements generally require the Company to pay executory costs (real estate taxes, insurance and repairs).
 
The Company and its subsidiaries have entered into office lease agreements for its headquarters in Fremont, California; Netintact AB offices in Varberg, Sweden; and Netintact PTY offices in Melbourne, Australia.

As of September 30, 2011, future minimum lease payments under operating leases are as follows:

Three months ending December 31, 2011
 
$
81,362
 
Years ending December 31,
       
2012
   
304,273
 
2013
   
166,954
 
2014
   
98,757
 
2015
   
98,757
 
Thereafter
   
74,068
 
Total minimum lease payments
 
$
824,171
 

Secured Line of Credit

The Company has a secured line of credit facility (the “Secured Credit Facility”) for short-term working capital purposes with Silicon Valley Bank. The Secured Credit Facility provides borrowings of up to $2.0 million through December 10, 2011. Borrowings under the facility bear interest at the prime rate plus 1%, but not less than 5% per annum. If the Company’s cash balance falls below $2,000,000, outstanding borrowings will bear an additional interest charge of 0.6875% per month, or 8.25% per annum. Under the terms of the Secured Credit Facility, the Company will pay Silicon Valley Bank a $17,000 fee in each of the two years of the agreement and will pay a minimum monthly interest charge of $3,000 per month.  The Company also issued a warrant to Silicon Valley Bank for the purchase of 50,000 shares of the Company’s common stock with an exercise price of $4.00 per share and a fair value of $166,302, which is being amortized to interest expense over the two-year term of the Secured Credit Facility. The Secured Credit Facility is secured by substantially all of the Company’s assets. The terms of the Secured Credit Facility include financial covenants requiring minimum quarterly revenue and restrictions on the Company’s ability to incur certain additional indebtedness, pay dividends, create or permit liens on assets or engage in mergers, consolidations or dispositions.   At September 30, 2011, the Company had no outstanding balance on its Secured Credit Facility.

 
14

 
15.      SEGMENT INFORMATION

The Company operates in one segment, using one measure of profitability to manage its business. Sales for geographic regions were based upon the customer’s location. The location of long-lived assets is based on the physical location of the Company’s regional offices. The following are summaries of sales and long-lived assets by geographical region:

   
Three Months Ended
 September 30,
   
Nine Months Ended
 September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Sales:
                       
United States
 
$
7,032,580
   
$
2,935,724
   
$
14,562,933
   
$
7,467,013
 
Europe, Middle East and Africa
   
3,643,336
     
741,160
     
8,986,913
     
2,322,088
 
Asia Pacific
   
1,517,287
     
1,057,893
     
5,222,224
     
3,016,043
 
Total
 
$
12,193,203
   
$
4,734,777
   
$
28,772,070
   
$
12,805,144
 

   
September 30,
2011
   
December 31,
2010
 
Long-lived assets:
           
United States
 
$
368,536
   
$
416,791
 
Europe
   
911,046
     
458,580
 
Australia
   
14,297
     
16,952
 
Total
 
$
1,293,879
   
$
892,323
 

Sales made to customers located outside the United States as a percentage of total net revenues were 42% and 49% for the three and nine months ended September 30, 2011, respectively, and 38% and 42% for the three and nine months ended September 30, 2010, respectively.

For the three months ended September 30, 2011, revenue from two customers represented 41% and 22% of net revenues, respectively, and for the nine months ended September 30, 2011, revenue from one customer represented 28% of net revenues, with no other single customer representing more than 10% of net revenues. For the three months ended September 30, 2010, revenue from two customers represented 19% and 12% of net revenues, respectively, and for the nine months ended September 30, 2010, revenue from one other customer (Cox Communications, Inc.) represented 15% of net revenues, with no other single customer representing more than 10% of net revenues.
 
At September 30, 2011, accounts receivable from two customers represented 31% and 21% of total accounts receivable, respectively, with no other single customer accounting for more than 10% of the accounts receivable balance. At December 31, 2010, accounts receivable from two customers represented 23% and 11%, respectively, of total accounts receivable with no other single customer accounting for more than 10% of the accounts receivable balance.  As of September 30, 2011 and December 31, 2010, approximately 49% and 51%, respectively, of the Company’s total accounts receivable were due from customers outside the United States.
 
 
15

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

The following is a discussion of our results of operations and current financial position. This discussion should be read in conjunction with our unaudited consolidated financial statements and related notes included elsewhere in this report and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2010, filed with the SEC on March 16, 2011.

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

Cautionary Note Regarding Forward-Looking Statements

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

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

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

 
our liquidity and financial resources, including anticipated capital expenditures, funding of capital expenditures and anticipated levels of indebtedness and the ability to raise capital through financing activities;

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

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

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

We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. We also provide the following cautionary discussion of risks and uncertainties related to our businesses. These are factors that we believe, individually or in the aggregate, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties.

Our forward-looking statements are subject to a variety of factors that could cause actual results to differ significantly from current beliefs and expectations, identified under the caption "Risk Factors" and elsewhere in this quarterly report on Form 10-Q, as well as general risks and uncertainties such as those relating to general economic conditions and demand for our products and services.

Overview

We are a leading provider of Intelligent Policy Enforcement (“IPE”) solutions that enable mobile and broadband network operators and entities managing private networks including higher education institutions, businesses and government entities (collectively referred to as network operators) to gain enhanced visibility into, and control of, their networks.  Our solutions provide granular network intelligence to enable network operators to improve the quality and longevity of their networks, better monetize their network infrastructure investments, control security hazards and create and deploy new services for their users.  The intelligence we provide about users and their usage enables qualified business decisions.  Our network operator customers include mobile service providers, broadband service providers, cable multiple system operators (“MSOs”), Internet Service Providers (“ISPs”), educational institutions, enterprises and government agencies.

 
16

 
Our IPE products are part of the market for mobile packet and broadband core products.  According to Infonetics Research, the market for IPE products is expected to grow from $249 million in 2009 to $1.5 billion in 2014, a compound annual growth rate of 44%.  Our bundled products deliver a solution that is a key element of the mobile packet and broadband core ecosystems.  Our solutions are often integrated with additional elements in the mobile packet and broadband core including Policy Management and Charging functions and are compliant with the widely adopted 3rd Generation Partnership Program (“3GPP”) standard.  In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, network operators are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers.  We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products.

Our products are marketed under the PacketLogic brand name.  We have a broad spectrum of products delivering IPE at the access, edge and core layers of the network.  Our products are designed to offer maximum flexibility to our customers and enable differentiated services and revenue-enhancing applications, all while delivering a high quality of service for subscribers.

We face competition from suppliers of standalone IPE and deep packet inspection (“DPI”) products including Allot Communications Ltd., Arbor Networks (acquired by Tektronix), Blue Coat Systems, Brocade Communications Systems, Cisco Systems, Inc., Cloudshield Technologies (acquired by SAIC), Ericsson, Huawei Technologies Company, Juniper Networks, and Sandvine Corporation. Some of our competitors supply platform products with different degrees of DPI functionality, such as switch/routers, routers, session border controllers and VoIP switches.
 
Most of our competitors are larger and more established enterprises with substantially greater financial and other resources.  Some competitors may be willing to reduce prices and accept lower profit margins to compete with us.  As a result of such competition, we could lose market share and sales, or be forced to reduce our prices to meet competition.  However, we do not believe there is a dominant supplier in our market.  Based on our belief in the superiority of our technology, we believe that we have an opportunity to capture meaningful market share and benefit from what we believe will be growth in the DPI market.

We were founded in 2002 and became a public company in October 2003 following our merger with Zowcom, Inc., a publicly-traded Nevada corporation. In 2006, we completed acquisitions of the Netintact entities. Our Company is headquartered in Fremont, California with regional headquarters in Varberg, Sweden and Singapore.  We sell our products through our direct sales force, resellers, distributors and systems integrators in the Americas, Asia Pacific and Europe.

Critical Accounting Estimates

Our discussion and analysis of our financial condition and results of operations are based upon financial statements which have been prepared in accordance with Generally Accepted Accounting Principles in the United States (“U.S. GAAP”).  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities.  On an ongoing basis, we evaluate these estimates.  We base our estimates on historical experience and on assumptions that are believed to be reasonable.  These estimates and assumptions provide a basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions, and these differences may be material.
 
We believe the following critical accounting policies reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements:

 
 ●
Revenue Recognition;
 
 ●
Valuation of Goodwill, Intangible and Long-Lived Assets;
 
 ●
Allowance for Doubtful Account;
 
 ●
Stock-Based Compensation; and
 
 ●
Accounting for Income Taxes.

These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2010, updated for changes in accounting for revenue recognition as a result of the new accounting standards as described below.
 
 
17

 
Revenue Recognition
 
In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2009-13, “Multiple-Deliverable Revenue Arrangements” and ASU No. 2009-14, “Certain Revenue Arrangements that Include Software Elements.” We adopted the new guidance on a prospective basis for new or materially modified revenue arrangements as of January 1, 2011.  The adoption of this guidance did not have a material impact on our financial statements and is not expected to have a material impact in the future.

Our most common sale involves the integration of software and a hardware appliance, where the hardware and software work together to deliver the essential functionality of the product.   We recognize product revenue when all of the following have occurred: (1) we have entered into a legally binding arrangement with a customer resulting in the existence of persuasive evidence of an arrangement; (2) delivery has occurred, evidenced when product title transfers to the customer; (3) customer payment is deemed fixed or determinable and free of contingencies and significant uncertainties; and (4) collection is probable.
 
Product revenue consists of revenue from sales of appliances and software licenses. Product sales include a perpetual license to our software that is essential to the functionality of the hardware, and on occasion include licenses to additional software. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue.  Virtually all sales include post-contract support (“PCS”) services (included in support revenue) which consist of software updates and customer support. Software updates provide customers access to a constantly growing library of electronic internet traffic identifiers (signatures) and rights to non-specific software product upgrades, maintenance releases and patches released during the term of the support period. Support includes internet access to technical content, telephone and internet access to technical support personnel and hardware support.
 
Receipt of a customer purchase order is the primary method of determining that persuasive evidence of an arrangement exists.

Delivery generally occurs when a product is delivered to a common carrier F.O.B. shipping point.  However, product revenue based on channel partner purchase orders are recorded based on sell-through to the end user customers until such time as we have established significant experience with the channel partner’s ability to complete the sales process. Additionally, when we introduce new products for which there is no historical evidence of acceptance history, revenue is recognized on the basis of end-user acceptance until such history has been established.

Fees are typically considered to be fixed or determinable at the inception of an arrangement, generally based on specific products and quantities to be delivered. Substantially all of our contracts do not include rights of return or acceptance provisions. To the extent that agreements contain such terms, we recognize revenue once the acceptance provisions or right of return lapses. Payment terms to customers generally range from net 30 to 90 days. In the event payment terms are provided that differ from our standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payments become due, provided the remaining criteria for revenue recognition have been met.
 
We assess the ability to collect from our customers based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. If the customer is not deemed credit worthy, we defer all revenue from the arrangement until payment is received and all other revenue recognition criteria have been met.

Customer orders normally contain multiple items. The initial product delivery consists of the hardware and software elements, and these elements have standalone value to the customer. Through September 30, 2011, in virtually all of our contracts, the only elements that remained undelivered at the time of product delivery were PCS services. Prior to January 1, 2011, the majority of our transactions were within the scope of the software revenue recognition guidance. We accordingly recognized revenue for delivered items using the residual method, after allocating revenue to PCS services based on vendor specific objective evidence of fair value (“VSOE”).

Under the new guidance, we allocate revenue to each element in an arrangement based on relative selling price using a selling price hierarchy. The selling price for a deliverable is based on its VSOE if available, third party evidence ("TPE") if VSOE is not available, or our best estimate of selling price ("ESP") if neither VSOE nor TPE is available.  The maximum revenue recognized on a delivered element is limited to the amount that is not contingent upon the delivery of additional items. In arrangements that include non-essential software (“software deliverables”), revenue is allocated to each separate unit of accounting for the non-software deliverables and to the software deliverables as a group using the relative selling prices of each of the deliverables in the arrangement. Revenue allocated to the software deliverables as a group is then allocated first to the PCS services based on VSOE, and then to the software, using the residual method under the software revenue recognition guidance.

We determine VSOE for PCS based on the rate charged to customers based upon renewal pricing for PCS.  Each contract or purchase order entered into includes a stated rate for PCS. The renewal rate is generally equal to the stated rate in the original contract. We have a history of such renewals, the vast majority of which are at the stated renewal rate on a customer by customer basis. PCS revenue is recognized under a proportional performance method, ratably over the life of the contract.   A small portion of service revenue is derived from providing training on products and we use the completed-contract method to recognize such revenue.

 
18

 
As the hardware and software products are rarely sold separately, we generally do not have VSOE for these products, and TPE is not available. We determine the ESP for hardware and software deliverables considering internal factors such as discounting and pricing policies, and external factors such as market conditions in different geographies and competitive positioning.

In certain contracts, billing terms may be agreed upon based on performance milestones such as the execution of measurement test, a partial delivery or the completion of a specified service.  Payments received before the unconditional acceptance of a specific set of deliverables are recorded as deferred revenue until the conditional acceptance has been waived.

Recent Accounting Pronouncements

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 International Financial Reporting Standards (“IFRS”).” The amendments in this ASU generally represent clarification of Topic 820, but also include instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with GAAP and IFRS. The amendments are effective for interim and annual periods beginning after December 15, 2011 and are to be applied prospectively. Early application is not permitted. We do not expect that the adoption of ASU 2011-04 will have a material impact on our consolidated financial statements.

In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income.” Specifically, the new guidance allows an entity to present components of net income or other comprehensive income in one continuous statement, referred to as the statement of comprehensive income, or in two separate, but consecutive statements. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. While the new guidance changes the presentation of comprehensive income, there are no changes to the components that are recognized in net income or other comprehensive income under current accounting guidance. The new guidance is effective for fiscal years and interim periods beginning after December 15, 2011 and is to be applied retrospectively. We do not expect that the adoption of ASU 2011-05 will have a material impact on our consolidated financial statements.
 
Results of Operations

Comparison of Three and Nine Months Ended September 30, 2011 and 2010

Revenue

   
Three Months Ended
 September 30,
         
Nine Months Ended
 September 30,
       
   
2011
   
2010
   
Increase
   
2011
   
2010
   
Increase
 
   
($ in thousands)
         
($ in thousands)
       
                         
Net product revenue
 
$
10,128
   
$
3,492
     
190
%
 
$
24,007
   
$
9,588
     
150
%
Net support revenue
   
2,065
     
1,243
     
66
%
   
4,765
     
3,217
     
48
%
Total revenue
 
$
12,193
   
$
4,735
     
158
%
 
$
28,772
   
$
12,805
     
125
%

Our revenue is derived from two sources: product revenue, which includes sales of our hardware appliances bundled with software licenses, and service revenue, which includes revenue from customer support, software maintenance and services.

The increase in product revenue of 190% and 150% for the three and nine months ended September 30, 2011, respectively, compared with the same periods in 2010, reflected revenue from recent service provider wins and follow-on orders from existing customers, and included increased sales of our high-end PL8000 and PL10000 series products.

The increase in support revenue of 66% and 48% for the three and nine months ended September 30, 2011, respectively, compared with the same periods in 2010, reflected the continued expansion of the installed base of our product to which we have sold ongoing support services.

We believe that our revenue will increase in the fourth quarter of the year ending December 31, 2011, as compared with the same period in 2010, although we expect the rate of growth in the fourth quarter to be less than the rate of growth experienced during the first nine months of 2011.

 
19

 
 Cost of Sales

Cost of sales includes: (i) direct labor and material costs for products sold, (ii) costs expected to be incurred for warranty, (iii) adjustments to inventory values, including the write-down of slow moving or obsolete inventory and (iv) costs for support personnel.

The following table presents the breakdown of cost of sales by category:

 
    Three Months Ended
 September 30,
          Nine Months Ended
 September 30,
       
    2011     2010     Change     2011     2010     Change  
   
($ in thousands)
         
($ in thousands)
       
                                     
Materials and per-use licenses
 
$
3,925
   
$
1,515
         
$
8,881
   
$
4,334
       
Percent of net product revenue
   
39
%
   
43
%
   
(4)
%
   
37
%
   
45
%
   
(8)
%
Applied labor and overhead
   
307
     
225
             
1,150
     
629
         
Percent of net product revenue
   
3
%
   
6
%
   
(3)
%
   
5
%
   
7
%
   
(2)
%
Other indirect costs
   
241
     
151
             
589
     
303
         
Percent of net product revenue
   
2
%
   
4
%
   
(2)
%
   
2
%
   
3
%
   
(1)
%
Product costs
   
4,473
     
1,891
             
10,620
     
5,266
         
Percent of net product revenue
   
44
%
   
54
%
   
(10)
%
   
44
%
   
55
%
   
(11)
%
                                                 
Support costs
   
256
     
132
             
516
     
393
         
Percent of net support revenue
   
12
%
   
11
%
   
1
%
   
11
%
   
12
%
   
(1)
%
                                                 
Total costs of sales
 
$
4,729
   
$
2,023
           
$
11,136
   
$
5,659
         
Percent of total net revenue
   
39
%
   
43
%
   
(4)
%
   
39
%
   
44
%
   
(5)
%

Total cost of sales during the three and nine months ended September 30, 2011 increased by approximately $2.7 million and $5.5 million, respectively, and decreased as a percentage of sales by 4 and 5 percentage points, respectively, compared to the same periods in 2010.  The increase in cost of sales primarily reflected higher material costs associated with increased product sales.  The decrease in cost of sales as a percentage of revenue primary reflected increased sales of our PL8000 series products, which have lower material costs compared with our other products,  and an increase in support revenue while corresponding support costs remained flat.

Gross Profit

Gross profit for the three and nine-month periods ended September 30, 2011 and 2010 was as follows:
 
    Three Months Ended
 September 30,
    Nine Months Ended
 September 30,
 
    2011       2010       Increase     2011       2010       Increase  
   
($ in thousands)
           
($ in thousands)
         
Gross profit
 
$
7,464
   
$
2,712
     
175
%
 
$
17,636
   
$
7,146
     
147
%
Percent of total net revenue
   
61
%
   
57
%
           
61
%
   
56
%
       

Gross profit margin for the three and nine months ended September 30, 2011 increased by 4 and 5 percentage points, respectively, to 61% from the comparable periods in the prior year.  This increase reflected the ramp in sales of our PL8000 series products, introduced in mid-2010, which have a higher margin compared with our other products.  We expect the gross margin rate to decrease in the fourth quarter ended December 31, 2011, as compared with the gross margin rate of 61% in the third quarter ended September 30, 2011.

 
20

 
Operating Expense

Operating expenses for the three and nine-month periods ended September 30, 2011 and 2010 were as follows:

   
Three Months Ended
 September 30,
   
Nine Months Ended
 September 30,
 
   
2011
   
2010
   
Change
   
2011
   
2010
   
Change
 
   
($ in thousands)
         
($ in thousands)
       
                                     
Research and development
 
$
1,024
   
$
860
     
19
%
 
$
3,304
   
$
2,271
     
45
%
Sales and marketing
   
2,976
     
1,614
     
84
%
   
8,184
     
4,832
     
69
%
General and administrative
   
1,393
     
934
     
49
%
   
3,982
     
3,000
     
33
%
Total
 
$
5,394
   
$
3,409
     
58
%
 
$
15,470
   
$
10,103
     
53
%

Research and Development

Research and development expenses include costs associated with personnel focused on the development or improvement of our products, prototype materials, initial product certifications and equipment costs.  Research and development costs include sustaining and enhancement efforts for products already released and development costs associated with planned new products.

 
    Three Months Ended
 September 30,
    Nine Months Ended
 September 30,
 
    2011     2010     Change     2011     2010     Change  
    ($ in thousands)           ($ in thousands)        
                                     
Research and development
 
$
1,024
   
$
860
     
19
%
 
$
3,304
   
$
2,271
     
45
%
As a percentage of net revenue
   
8
%
   
18
%
           
11
%
   
18
%
       

Research and development expenses for the three and nine months ended September 30, 2011 increased by $0.2 million and $1.0 million, respectively, compared to the same periods in 2010, as a result of increased hires of research and development personnel during 2010 and the corresponding additional employee compensation costs.  Additional personnel are expected to allow us to enhance our core product features and functionality in order to support new sales and to achieve follow-on sales to our current customers.  Stock-based compensation recorded to research and development expenses in the three and nine months ended September 30, 2011 was $31,432 and $95,752, respectively, compared to $2,715 and $11,234, respectively, in the corresponding periods in 2010.

Sales and Marketing

Sales and marketing expenses primarily include personnel costs, sales commissions and marketing expenses, such as trade shows, channel development and literature.
 
    Three Months Ended
 September 30,
    Nine Months Ended
 September 30,
 
    2011     2010     Change     2011     2010     Change  
    ($ in thousands)           ($ in thousands)        
                                     
Sales and marketing
 
$
2,976
   
$
1,614
     
84
%
 
$
8,184
   
$
4,832
     
69
%
As a percentage of net revenue
   
24
%
   
34
%
           
28
%
   
38
%
       

Sales and marketing expenses for the three and nine months ended September 30, 2011 increased by $1.4 million and $3.4 million, respectively, compared to the same periods in 2010.  The increase in sales and marketing expenses reflected increased commission costs as a result of the increase in revenue, and the cost of increased headcount, resulting from the hiring of additional sales personnel.  Stock-based compensation recorded to sales and marketing expense in the three and nine months ended September 30, 2011 was $102,284 and $321,392, respectively, compared to $82,275 and $223,976, respectively, in the corresponding periods in 2010.
 
General and Administrative

General and administrative expenses consist primarily of personnel and facilities costs related to our executive, finance function, service fees for professional services and amortization of intangible assets.  Professional services include costs for legal advice and services, independent auditors and investor relations.
 
21

 
    Three Months Ended
 September 30,
          Nine Months Ended
 September 30,
       
    2011     2010     Change     2011     2010     Change  
    ($ in thousands)           ($ in thousands)        
                                     
General and administrative
 
$
1,393
   
$
934
     
49
%
 
$
3,982
   
$
3,000
     
33
%
As a percentage of net revenue
   
11
%
   
20
%
           
14
%
   
23
%
       

General and administrative expenses for the three and nine months ended September 30, 2011 increased by $0.5 million and $1.0 million, respectively, compared to the same periods in 2010. The increase in general and administrative expenses reflected higher bonus costs associated with exceeding revenue targets that were established for 2011, as well as higher legal and audit fees.   Stock-based compensation recorded to general and administrative expense in the three and nine months ended September 30, 2011 was $275,724 and $720,440, respectively, compared to $251,685 and $697,501, respectively, in the corresponding periods in 2010.

Interest and Other Income (Expense), Net

   
Three Months Ended
 September 30,
   
Nine Months Ended
 September 30,
 
   
2011
   
2010
   
Change
   
2011
   
2010
   
Change
 
   
($ in thousands)
         
($ in thousands)
       
                                     
Interest and other income (expense), net
 
$
(26
)
 
$
(40
)
   
35
%
 
$
(91
)
 
$
(116
)
   
22
%

Interest and other income (expense), net was relatively flat for the three and nine months ended September 30, 2011 compared to the same periods in 2010.  Interest and other income (expense), net primarily reflected interest costs connected with our two-year secured credit facility with Silicon Valley Bank entered into on December 10, 2009.

Provision for Income Taxes

   
Three Months Ended
 September 30,
   
Nine Months Ended
 September 30,
 
   
2011
   
2010
   
Change
   
2011
   
2010
   
Change
 
   
($ in thousands)
         
($ in thousands)
       
                                     
Provision for income taxes
 
$
   
$
2
     
(100)