MRV COMMUNICATIONS INC - FORM 10-Q - November 5, 2014

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

________________________
FORM 10-Q
________________________
[x]
Quarterly report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 2014

[ ]
Transition report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from _______________ to ______________

Commission file number: 001-11174
 
MRV COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)
Delaware
06-1340090
(State or other jurisdiction of
(I.R.S. employer
incorporation or organization)
identification no.)

20415 Nordhoff Street, Chatsworth, CA 91311
(Address of principal executive offices, zip code)

(818) 773-0900
(Registrant's telephone number, including area code)

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

Indicate by check mark, whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.) Yes [x]  No [ ]

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

Large accelerated filer  [ ]
Accelerated filer  [x]
 
Non-accelerated filer [ ]
Smaller reporting company [ ]  
(Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ]   No [x]

As of November 4, 2014, 7,362,146 shares of Common Stock of MRV Communications, Inc. were outstanding.

1

MRV Communications, Inc.

Form 10-Q for the Quarter Ended September 30, 2014
 
Index


 
 
Page
Number
PART I
Financial Information
Item 1.
Unaudited Condensed Consolidated Financial Statements:
 
Condensed Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2014 and 2013
 
Condensed Consolidated Statements of Comprehensive (Loss) Income (unaudited) for the three and nine months ended September 30, 2014 and 2013
 
Condensed Consolidated Balance Sheets (unaudited) as of September 30, 2014 and December 31, 2013
 
Condensed Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2014 and 2013
 
Notes to Condensed Consolidated Financial Statements (unaudited)
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Item 4.
Controls and Procedures
PART II
Other Information
Item 1.
Legal Proceedings
Item 1A.
Risk Factors
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.
Defaults Upon Senior Securities
Item 4.
Mine Safety Disclosures
Item 6.
Exhibits
 
Signatures


2

PART I - FINANCIAL INFORMATION

Item 1.     Condensed Consolidated Financial Statements

MRV Communications, Inc.
Condensed Consolidated Statements of Operations
(In thousands, except per share data)
(unaudited)
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2014
 
2013
 
2014
 
2013
Revenue:
 
 
 
 
 
 
 
Product revenue
$
31,196

 
$
27,051

 
$
93,411

 
$
81,555

Service revenue
11,974

 
11,334

 
35,201

 
33,910

Total revenue
43,170

 
38,385

 
128,612

 
115,465

Cost of sales
28,454

 
23,411

 
85,863

 
74,092

Gross profit
14,716

 
14,974

 
42,749

 
41,373

Operating expenses:
 
 
 
 
 
 
 
Product development and engineering
5,060

 
4,627

 
16,030

 
13,729

Selling, general and administrative
10,080

 
10,308

 
32,118

 
32,153

Total operating expenses
15,140

 
14,935

 
48,148

 
45,882

Operating (loss) income
(424
)
 
39

 
(5,399
)
 
(4,509
)
Interest expense
(116
)
 
(41
)
 
(306
)
 
(414
)
Other expense, net
227

 
(132
)
 
(160
)
 
(217
)
Loss before provision for income taxes
(313
)
 
(134
)
 
(5,865
)
 
(5,140
)
Provision for income taxes
727

 
12

 
1,659

 
433

Net Loss
$
(1,040
)
 
$
(146
)
 
$
(7,524
)
 
$
(5,573
)
 
 
 
 
 
 
 
 
Net loss per share — basic
$
(0.14
)
 
$
(0.02
)
 
$
(1.03
)
 
$
(0.74
)
Net loss per share — diluted
$
(0.14
)
 
$
(0.02
)
 
$
(1.03
)
 
$
(0.74
)
Weighted average number of shares:
 
 
 
 
 
 
 
Basic
7,362

 
7,522

 
7,335

 
7,539

Diluted
7,362

 
7,522

 
7,335

 
7,539


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

3

MRV Communications, Inc.
Condensed Consolidated Statements of Comprehensive (Loss) Income
(In thousands)
(unaudited)

 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
 
2014
 
2013
 
2014
 
2013
Net Loss
 
$
(1,040
)
 
$
(146
)
 
$
(7,524
)
 
$
(5,573
)
Other comprehensive loss, net of tax
 
 
 
 
 
 
 
 
Foreign currency translation gain (loss)
 
(1,913
)
 
855

 
(2,078
)
 
460

Total comprehensive (loss) Income
 
$
(2,953
)
 
$
709

 
$
(9,602
)
 
$
(5,113
)

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

4

MRV Communications, Inc.
Condensed Consolidated Balance Sheets
(In thousands, except par values)
 
September 30,
2014
 
December 31,
2013
Assets
(unaudited)
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
24,533

 
$
27,591

Restricted time deposits
436

 
249

Accounts receivable, net
37,527

 
49,990

Other receivables
15,284

 
8,220

Inventories, net
23,071

 
22,981

Income taxes receivable
530

 
1,256

Deferred income taxes
1,139

 
1,219

Other current assets
5,372

 
5,664

Total current assets
107,892

 
117,170

Property and equipment, net
5,159

 
5,555

Deferred income taxes, net of current portion
3,806

 
3,694

Intangible asset, net
751

 
873

Other assets
1,275

 
655

Total assets
$
118,883

 
$
127,947

 
 
 
 
Liabilities and stockholders' equity
 
 
 
Current liabilities:
 
 
 
Short-term debt
$
5,175

 
$
4,320

Deferred consideration payable
233

 
233

Accounts payable
22,576

 
23,991

Accrued liabilities
14,728

 
19,463

Deferred revenue
13,024

 
10,557

Other current liabilities
639

 
357

Total current liabilities
56,375

 
58,921

Other long-term liabilities
5,883

 
5,236

Commitments and contingencies

 

 
 
 
 
Stockholders' equity:
 
 
 
Preferred Stock, $0.01 par value: Authorized — 1,000 shares; no shares issued or outstanding
—

 
—

Common Stock, $0.0017 par value:
 
 
 
Authorized — 16,000 shares
 
 
 
Issued — 8,219 shares in 2014 and 8,143 shares in 2013
 
 
 
Outstanding — 7,362 shares in 2014 and 7,286 in 2013
270

 
270

Additional paid-in capital
1,284,319

 
1,281,883

Accumulated deficit
(1,215,860
)
 
(1,208,337
)
Treasury stock — 856 shares in 2014 and 856 shares in 2013
(10,412
)
 
(10,412
)
Accumulated other comprehensive (loss) income
(1,692
)
 
386

Total stockholders' equity
56,625

 
63,790

Total liabilities and stockholders' equity
$
118,883

 
$
127,947


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

5

MRV Communications, Inc.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(unaudited)
 
Nine Months Ended 
 September 30,
 
2014
 
2013
Cash flows from operating activities:
 
 
 
Net loss
$
(7,524
)
 
$
(5,573
)
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
 
 
 
Depreciation and amortization
1,688

 
1,288

Share-based compensation expense
706

 
511

Provision for doubtful accounts
80

 
323

Deferred income taxes
346

 
(803
)
Loss on disposition of property and equipment
—

 
18

Changes in operating assets and liabilities:
 
 
 
Accounts and other receivables
10,205

 
(4,308
)
Inventories
(1,403
)
 
(2,536
)
Other assets
(7,253
)
 
2,498

Accounts payable
170

 
1,571

Accrued liabilities
(2,409
)
 
1,770

Income tax payable
88

 
(34
)
Deferred revenue
2,899

 
2,438

Other current liabilities
98

 
(162
)
Net cash used in operating activities
(2,309
)
 
(2,999
)
Cash flows from investing activities:
 
 
 
Purchases of property and equipment
(1,914
)
 
(2,738
)
Proceeds from sale of investments in unconsolidated entities
—

 
(53
)
Investment in restricted time deposits
(187
)
 
(4
)
Net cash used in investing activities
(2,101
)
 
(2,795
)
Cash flows from financing activities:
 
 
 
Shares repurchased for tax withholdings on vesting of restricted stock awards
(15
)
 
—

Purchase of treasury shares
—

 
(2,654
)
Borrowings on short-term debt
17,528

 
7,085

Payments on short-term debt
(15,802
)
 
(8,524
)
Net cash provided by (used in) financing activities
1,711

 
(4,093
)
Effect of exchange rate changes on cash and cash equivalents
(359
)
 
97

Net decrease in cash and cash equivalents
(3,058
)
 
(9,790
)
Cash and cash equivalents, beginning of period
27,591

 
40,609

Cash and cash equivalents, end of period
$
24,533

 
$
30,819

 
 
 
 
Supplemental disclosure of cash flow information:
 
 
 
Cash paid during period for interest
$
247

 
$
215

Cash paid during period for income taxes
$
638

 
$
656


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


6

MRV Communications, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)

1.
Organization and Summary of significant accounting policies

Organization and nature of operations

MRV Communications, Inc. ("MRV" or the "Company"), a Delaware corporation, is a global supplier of communications solutions to telecommunications service providers, enterprises and governments throughout the world. MRV's products enable customers to provide high-bandwidth data and video services and mobile communications services more efficiently and cost effectively. MRV markets and sells its products worldwide, through a variety of channels, which include a dedicated direct sales force, manufacturers' representatives, value-added-resellers, distributors and systems integrators. MRV conducts its business along two principal segments: the Network Equipment segment and the Network Integration segment. MRV's Network Equipment segment designs, manufactures, sells, and services equipment used by commercial customers, governments, and telecommunications service providers. Products include switches, optical transport platforms, physical layer products and out-of-band management products, and specialized networking products. The Italian Network Integration segment provides network system design, integration and distribution services that include products manufactured by third-party vendors.

Basis of Presentation

The consolidated financial statements include the accounts of MRV and its wholly-owned subsidiaries. All significant intercompany transactions and accounts have been eliminated. MRV consolidates the financial results of less than majority-owned subsidiaries when it has effective control, voting control, or has provided the entity's working capital. When investment by others in these enterprises reduces the Company's voting control below 50%, MRV discontinues consolidation and uses the cost or equity method of accounting for these investments, unless otherwise required.

The consolidated financial statements included herein have been prepared by MRV, and are unaudited, 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 accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted pursuant to such rules and regulations although management believes that the disclosures are adequate to make the information presented not misleading. The information included in this Quarterly Report on Form 10-Q for the quarter ended September 30, 2014, (this “Form 10-Q”) should be read in conjunction with the Financial Statements and Notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2013, (the “2013 Form 10-K”) filed with the SEC.

Restricted time deposits represent investments that are restricted as to withdrawal. Restricted time deposits generally secure standby letters of credit, bank lines of credit, or bank loans. Investments in and releases of restricted time deposits are included in investing activities on the Company's Statement of Cash Flows unless the time deposits relate to an underlying bank loan and will be used to repay the loan, in which case the related cash flows are treated as financing activities.

In the opinion of MRV's management, these unaudited statements contain all adjustments, which include normal recurring adjustments, necessary to present fairly the financial position of MRV as of September 30, 2014, and the results of its operations and comprehensive income (loss) for the three and nine months ended September 30, 2014 and 2013, and its cash flows for the nine months ended September 30, 2014 and 2013. The results reported in these financial statements should not be regarded as necessarily indicative of results that may be expected for the full year or any future periods.


7

Correction of an Immaterial Error

During the three months ended September 30, 2014, the Company recorded an out-of-period adjustment to eliminate intercompany profit in inventory of $0.2 million, which resulted in an increase to net loss of $0.2 million for the three and nine months ended September 30, 2014. The Company reduced inventory by $0.2 million, and increased cost of sales by $0.2 million related to prior periods to remove the effect of profit in inventory not previously eliminated. Management evaluated the effects of this adjustment on the Company’s consolidated financial statements and concluded that the error was not material to any prior periods, individually or in the aggregate. These out-of-period adjustments did not have a material impact on the Company’s consolidated financial statements for the three and nine months ended September 30, 2014.

During the three months ended June 30, 2014, the Company recorded an out-of-period adjustment to defer previously recognized revenue of $2.0 million, which resulted in an increase to after-tax net loss of $0.1 million for the nine months ended September 30, 2014. The Company reduced cost of sales by $1.8 million, gross profit by $0.2 million and the provision for income taxes by $0.1 million related to prior periods to remove the effect of the previously recognized revenue. These out of period adjustments also resulted in increases in Inventory of $1.9 million, deferred revenue of $2.0 million and deferred income taxes, net of current portion by $0.1 million. The impact on accumulated deficit and stockholder’s equity was a reduction by $0.1 million. Management evaluated the effects of this adjustment on the Company’s consolidated financial statements and concluded that the error was not material to any prior periods, individually or in the aggregate. These out-of-period adjustments did not have a material impact on the Company’s consolidated financial statements for the nine months ended September 30, 2014.

Recently Issued Accounting Standards

In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Stands Update ("ASU")No. 2014-09, "Revenue from Contracts with Customers (Topic 606)," ("ASU 2014-09"). ASU 2014-09 outlines a new, single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes current revenue recognition guidance, including industry-specific guidance. This new revenue recognition model provides a five-step analysis in determining when and how revenue is recognized. The new model will require revenue recognition to depict the transfer of promised goods or services to customers in an amount that reflects the consideration a company expects to receive in exchange for those goods or services. The pronouncement is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016, and early adoption is not permitted. The amendments may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of initial application. Management is currently evaluating the impact that adopting this new accounting guidance will have on its consolidated financial statements and footnote disclosures.

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

2.
Cash and Cash Equivalents and Restricted Time Deposits

MRV treats highly liquid investments with an original maturity of 90 days or less as cash equivalents. Investments with maturities of less than one year are considered short-term and are included on the balance sheet in restricted time deposits. MRV maintains cash balances and investments in qualified financial institutions, and at various times such amounts are in excess of federal insured limits.


8

3.
Fair Value Measurement

MRV's financial instruments, including cash and cash equivalents, restricted time deposits, accounts receivable, other receivables, other assets, accounts payable, accrued liabilities and short-term debt obligations, are carried at cost, which approximates their fair value due to their short term nature.

ASC 820-10 Fair Value Measurements defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. ASC 820-10 establishes a three-level hierarchy that prioritizes the use of observable inputs. The fair value hierarchy is divided into three levels based on the source of inputs as follows: Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access; Level 2 - Valuations for which all significant inputs are observable, either directly or indirectly, other than level 1 inputs for similar assets and liabilities; Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. Under this standard, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date.

As of September 30, 2014, and December 31, 2013, the Company had cash equivalents consisting of money market funds of $11.6 million and $14.0 million, respectively that were classified as Level 1 investments and were quoted at market price. Cash equivalents are included in the Condensed Consolidated Balance Sheets as follows (in thousands):
 
 
Cost
Fair Value
September 30, 2014
 
$
11,605

$
11,605

 
 
 
 
December 31, 2013
 
$
14,001

$
14,001


During 2014, the Company updated the estimated fair value as of the issuance date of 250,000 warrants that were issued to plaintiffs' counsel on February 18, 2014, in a litigation matter originally recorded as a liability in 2013. In calculating the fair value, the Company used the Black Scholes option pricing model with level 2 inputs, including a volatility of 41% based on the Company's historical quoted prices and peer company data, the risk free interest rate of 1.5% and the 5 years expected term of the warrants. Volatility based on both the Company's historical quoted prices and peer company data was used as the Company's stock is thinly traded. The resulting fair value was $6.59 per warrant. In relation to this revaluation, the Company recorded expense of $0.4 million for the three months ended March 31, 2014. No additional expense was recorded in the three months ended September 30, 2014. Upon issuance and revaluation, the warrants were removed from liabilities and recorded as a component of additional paid in capital.

4.
Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk primarily consist of cash and cash equivalents placed with high credit quality institutions and accounts receivable due from customers. Management evaluates the collectability of accounts receivable based on a combination of factors. If management becomes aware of a customer's inability to meet its financial obligations after a sale has occurred, the Company records an allowance to reduce the net receivable to the amount that it reasonably believes to be collectable from the customer. For all other customers, the Company records allowances for doubtful accounts based on the length of time the receivables are past due, the current business environment, and historical experience. If the financial conditions of MRV's customers were to deteriorate or if economic conditions worsen, additional allowances may be required in the future. Accounts receivable are charged off at the point they are considered uncollectible.

9

The following table summarizes the changes in the allowance for doubtful accounts during the nine months ended September 30, 2014 (in thousands):

 
Nine months ended
 
September 30, 2014
Balance at beginning of period
$
2,183

Charged (reversed) to expense
80

Write-offs, net of amounts recovered
(69
)
Foreign currency translation adjustment
(87
)
Balance at end of period
$
2,107


5.
Inventories

Inventories are stated at the lower of cost or market and consist of materials, labor and overhead. Cost is computed using standard cost, which approximates actual cost, on a first-in, first-out basis. Inventories, net of reserves, consisted of the following (in thousands):
 
September 30, 2014
 
December 31, 2013
Raw materials
$
4,119

 
$
5,723

Work-in process
985

 
1,121

Finished goods
17,967

 
16,137

Total
$
23,071

 
$
22,981

 
 
 
 

6.
Intangible Asset

The balance of the intangible asset was $0.8 million as of September 30, 2014 and $0.9 million as of December 31, 2013. A portion of this, which represents software license agreements, was placed in service as of September 30, 2014. Amortization of intangible assets was $0.01 million for the three and nine months ended September 30, 2014. There was no amortization recorded for the three and nine months ended September 30, 2013. The terms of the license agreements are definite, and once placed in service, the Company plans to amortize the cost over the estimated useful life, which is approximately 5 years.

The following table illustrates the estimated future amortization expense of intangible assets placed into service as of September 30, 2014 (in thousands):

Fiscal Years
Estimated Amortization Expense
2014
$
17

2015
68

2016
68

2017
68

2018
68

Thereafter
42

 
$
331



10

7.
Product Warranty

As of September 30, 2014, and December 31, 2013, MRV's product warranty liability recorded in accrued liabilities was $0.6 million. MRV accrues for warranty costs as part of cost of goods sold based on associated material product costs, technical support labor costs and associated overhead. The products sold are generally covered by a warranty for periods of 90 days to three years.

The following table summarizes the change in product warranty liability during the nine months ended September 30, 2014 (in thousands):

 
Nine months ended
 
September 30, 2014
Beginning balance
$
578

Cost of warranty claims
(18
)
Accruals for product warranties
52

Total
$
612


8.
Net Income (Loss) Per Share

Basic net income (loss) per share is computed using the weighted average number of shares of common stock ("Common Stock") outstanding, including restricted shares which, although they are legally outstanding and have voting rights, are subject to vesting and are treated as common stock equivalents in calculating basic income (loss) per share. Diluted net income (loss) per share is computed using the weighted average number of shares of Common Stock outstanding and dilutive potential shares of Common Stock from stock options outstanding during the period. Diluted shares outstanding include the dilutive effect of in-the-money options, which is calculated based on the average share price for each period using the treasury stock method.

Outstanding stock options to purchase 0.4 million shares were excluded from the computation of dilutive shares for the three months ended September 30, 2014, and 2013 as they were anti-dilutive because of the net loss. In addition, for the three months ended September 30, 2014, there were 10,907 potentially dilutive shares excluded from the calculation of diluted net loss per share because they were anti-dilutive, and there were no potentially dilutive shares to be excluded from the calculation of diluted net loss per share for the three months ended September 30, 2013. Treasury shares are excluded from the number of shares outstanding.

Outstanding stock options to purchase 0.3 million shares were excluded from the computation of dilutive shares for the nine months ended September 30, 2014, as they were anti-dilutive because of the net loss. Outstanding stock options to purchase 0.4 million shares were excluded in the computation of dilutive shares for the nine months ended September 30, 2013, as they were anti-dilutive because of the net loss. In addition, for the nine months ended September 30, 2014, there were 7,887 potentially dilutive shares excluded from the calculation of diluted net loss per share because they were anti-dilutive, and there were no potentially dilutive shares to be excluded from the calculation of diluted net loss per share for the nine months ended September 30, 2013. Treasury shares are excluded from the number of shares outstanding.


11

9.
Share-Based Compensation

MRV records share-based compensation expense at fair value. The following table summarizes the impact on MRV's results of operations of recording share-based compensation for the three and nine months ended September 30, 2014, and 2013 (in thousands):

 
Three months ended
 
Nine months ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Cost of goods sold
$
34

 
$
27

 
$
87

 
$
70

Product development and engineering
49

 
21

 
122

 
46

Selling, general and administrative
148

 
161

 
497

 
395

Total share-based compensation expense (1)
$
231

 
$
209

 
$
706

 
$
511

 
 
 
 
 
 
 
 

(1)
Income tax benefits realized from stock option exercises and similar awards were immaterial in both periods.

The Company granted 15,000 stock options during the three months ended September 30, 2014, and the related fair value was $6.06 per option. The Company granted 5,000 restricted shares during the three months ended September 30, 2014, and the related fair value was $13.46 per share. The Company granted no stock options and no restricted shares during the three months ended September 30, 2013. The Company granted 188,722 stock options during the nine months ended September 30, 2014 and the related weighted average fair value was $7.07 per share. The average fair value of 90,907 restricted shares granted during the nine months ended September 30, 2014, was $14.35 per share. The Company granted 80,242 stock options during the nine months ended September 30, 2013, and the related weighted average fair value was $4.89 per share. The average fair value of 91,388 restricted shares granted during the nine months ended September 30, 2013, was $9.98 per share. As of September 30, 2014, the total unrecognized share-based compensation balance for unvested securities, net of expected forfeitures, was $1.8 million, which is expected to be amortized over a weighted-average period of 2.3 years.

Valuation Assumptions

MRV uses the Black-Scholes option pricing model to estimate the fair value of stock option awards or related modifications. The Black-Scholes model requires the use of subjective and complex assumptions including the option's expected life and the underlying stock price volatility. MRV bases volatility on the Company's historical quoted prices and peer company data. The following weighted average assumptions were used for estimating the fair value of options granted during the nine months ended September 30, 2014 and the options modified during the nine months ended September 30, 2013, respectively.
 
 
 
Nine months ended September 30,
2014
2013
Risk-free interest rate
2.0
%
1.2
%
Dividend yield (1)
—

—

Volatility
51
%
52
%
Expected life (in years)
5.9

5.7

 
 
 

(1)
As the Company does not pay a dividend on a regular basis, and dividends paid in the past have been special in nature, a dividend rate of zero was used.

10.
Segment Reporting and Geographic Information

MRV operates its business in two segments: Network Equipment and Network Integration. Network Equipment designs, manufactures, distributes and services optical networking solutions and Internet infrastructure products, and Network Integration distributes network solutions and Internet infrastructure products and provides value-added integration and support services for customers' networks.


12

The accounting policies of the segments are the same as those described in the summary of significant accounting polices disclosed in MRV's 2013 Form 10-K. Management evaluates segment performance based on revenues, gross profit and operating income (loss) of each segment. As such, there are no separately identifiable Statements of Operations data below operating income (loss).

The following table summarizes revenues by segment, including intersegment revenues (in thousands):

 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2014
 
2013
 
2014
 
2013
Network Equipment
$
21,979

 
$
22,806

 
$
66,131

 
$
64,852

Network Integration
21,237

 
15,585

 
62,644

 
50,701

Before intersegment adjustments
43,216

 
38,391

 
128,775

 
115,553

Intersegment adjustments
(46
)
 
(6
)
 
(163
)
 
(88
)
Total
$
43,170

 
$
38,385

 
$
128,612

 
$
115,465

 
 
 
 
 
 
 
 

Network Equipment revenue primarily consists of optical communication systems that include Metro Ethernet equipment, optical transport equipment, lab automation equipment, out-of-band network equipment, and the related service revenue and fiber optic components sold as part of system solutions. Network Integration revenue primarily consists of value-added integration and support service revenue, related third-party product sales (including third-party product sales through distribution) and fiber optic components sold as part of system solutions. All Network Integration's sales are within Italy.

One customer accounted for $11.0 million and $10.4 million of revenue in Network Integration revenue, or 25% and 27% of total revenue, for the three months ended September 30, 2014, and 2013, respectively. Another customer accounted for $6.1 million and $4.0 million of Network Integration revenue, or 14% and 10% of total revenue, for the three months ended September 30, 2014, and 2013, respectively.

One customer accounted for $33.8 million and $32.5 million of revenue in Network Integration revenue, or 26% and 28% of total revenue, for the nine months ended September 30, 2014, and 2013, respectively. Another customer accounted for $20.2 million and $12.9 million of Network Integration revenue, or 16% and 11% of total revenue, for the nine months ended September 30, 2014, and 2013, respectively.

One customer in Network Integration accounted for 12% and 22% of total net accounts receivable as of September 30, 2014, and December 31, 2013, respectively. Another Network Integration customer accounted for 29% and 27% of total net accounts receivable as of September 30, 2014, and December 31, 2013, respectively.

The following table summarizes external revenue by geographic region (in thousands):

 
Three months ended
 
Nine months ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
United States
$
13,254

 
$
15,010

 
$
39,665

 
$
40,811

Americas (Excluding the U.S.)
197

 
972

 
879

 
3,452

Europe
25,553

 
21,275

 
78,653

 
66,565

Asia Pacific
4,166

 
1,128

 
9,415

 
4,637

Total
$
43,170

 
$
38,385

 
$
128,612

 
$
115,465

 
 
 
 
 
 
 
 

Revenue from external customers attributed to Italy totaled $21.2 million and $16.0 million for the three months ended September 30, 2014, and September 30, 2013 respectively. Revenue from external customers attributed to Italy totaled $63.0 million and $51.5 million for the nine months ended September 30, 2014, and September 30, 2013 respectively.


13

The following table summarizes long-lived assets, consisting of property and equipment, by geographic region (in thousands):
 
September 30, 2014
 
December 31, 2013
Americas
$
3,256

 
$
3,326

Europe
1,874

 
2,194

Asia Pacific
29

 
35

Total
$
5,159

 
$
5,555

 
 
 
 

The following table provides selected Statement of Operations information by business segment (in thousands):

 
Three months ended
 
Nine months ended
 
September 30,
 
September 30,
 
2014

2013
 
2014
 
2013
Gross profit
 
 
 
 
 
 
 
Network Equipment
$
11,062

 
$
12,041

 
$
33,007

 
$
33,990

Network Integration
3,654

 
2,934

 
9,742

 
7,378

Total before intersegment adjustments
14,716

 
14,975

 
42,749

 
41,368

Corporate unallocated and intersegment adjustments (1)
—

 
(1
)
 
—

 
5

Total
$
14,716

 
$
14,974

 
$
42,749

 
$
41,373

 
 
 
 
 
 
 
 
Depreciation expense
 
 
 
 
 
 
 
Network Equipment
$
459

 
$
406

 
$
1,428

 
$
988

Network Integration
50

 
54

 
149

 
159

Corporate
52

 
45

 
111

 
141

Total
$
561

 
$
505

 
$
1,688

 
$
1,288

 
 
 
 
 
 
 
 
Operating income (loss)
 
 
 
 
 
 
 
Network Equipment
$
(953
)
 
$
87

 
$
(5,296
)
 
$
(1,328
)
Network Integration
1,762

 
1,525

 
4,311

 
2,891

Total before intersegment adjustments
809

 
1,612

 
(985
)
 
1,563

Corporate unallocated operating loss and adjustments (1)
(1,233
)
 
(1,573
)
 
(4,414
)
 
(6,072
)
Total
$
(424
)
 
$
39

 
$
(5,399
)
 
$
(4,509
)
 
 
 
 
 
 
 
 

(1) Adjustments reflect the elimination of intersegment revenue and profit in inventory.

The following tables provide selected Balance Sheet and Statement of Cash Flow information by business segment (in thousands):

 
Nine months ended
 
September 30,
 
2014
 
2013
Additions to Fixed Assets
 
 
 
Network Equipment
$
1,736

 
$
2,679

Network Integration
95

 
53

Corporate
83

 
6

Total
$
1,914

 
$
2,738

 
 
 
 


14

 
September 30, 2014
 
December 31, 2013
Total Assets
 
 
 
Network Equipment
$
42,457

 
$
48,955

Network Integration
58,259

 
54,625

Corporate and intersegment eliminations
18,167

 
24,367

Total
$
118,883

 
$
127,947

 
 
 
 

11. Indemnification Obligations

Our agreements for the sale of our Source Photonics, CES, Interdata and Alcadon businesses include customary indemnification obligations running to the respective buyers.

We also have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we retain directors and officers insurance that reduces our exposure and enables us to recover portions of amounts paid. As a result of our insurance coverage, we believe the estimated fair value of these indemnification agreements is minimal. Accordingly, no liabilities have been recorded for these agreements as of September 30, 2014, and December 31, 2013.

12.
Litigation
    
We are subject to legal claims and litigation in the ordinary course of business, including but not limited to product liability, employment and intellectual property claims. The outcome of any such matters is currently not determinable. In addition, we were party to the litigation set forth below.

From June to August 2008, five purported stockholder derivative and securities class action lawsuits were filed in the U.S. District Court in the Central District of California and one derivative lawsuit was filed in the Superior Court of the State of California against the Company and certain of our former officers and directors. The five lawsuits filed in the Central District of California were consolidated. Claims were asserted under Section 10(b) and 20(a) of the Exchange Act, and Rule 10b-5 promulgated thereunder. In November 2010, the judge overseeing the securities class action lawsuits gave final approval to a stipulated $10.0 million settlement agreement, which was covered by our director and officer insurance policies. The federal and state derivative lawsuits were not settled.

As of January 4, 2013, all pending litigation in the federal and state derivative actions was stayed by agreement of the parties pending final Federal Court approval of a settlement between derivative plaintiffs, individual defendants and the Company. On April 8, 2013 the Federal Court preliminarily approved a Stipulation of Settlement (the "Settlement Stipulation"), which included, among other things, (a) a release of all claims relating to the derivative litigation for the Company, the individual defendants and the plaintiffs; (b) a provision that $2.5 million in cash be paid to the Company by the Company's insurance carriers; (c) payment of attorneys' fees to plaintiffs' counsel including $500,000 in cash and 250,000 warrants to purchase the Company's Common Stock, with a five-year term and strike price of the closing price of the Company's Common Stock on the date an order of the federal District Court approving the settlement becomes final; (d) the continued payment by the Company of applicable reasonable attorneys' fees for the individual defendants. On June 6, 2013, the Federal Court granted final approval of the Settlement Stipulation and on June 13, 2013 entered Judgment dismissing the federal derivative action with prejudice. On June 24, 2013, the State Court entered a dismissal with prejudice of the state derivative action. The Company was also required to undertake certain corporate governance reform actions, all of which are either in process of implementation or have been implemented.

A majority of the costs related to the Company's and defendants' defense of these actions was paid by the Company's insurance carriers under its director and officer insurance policies, including the securities class action settlement. Insurance proceeds paid to the Company upon settlement of the derivative litigation were $1.0 million. However, MRV paid $1.9 million in payment for services of defense counsel and other parties through December 31, 2013, above the insured amount.

15

In May 2014, a former customer of Tecnonet S.p.A.(Tecnonet), the Company's Italian subsidiary, filed a claim in an Italian civil court alleging that Tecnonet, and two of its third-party subcontractors, breached certain supply agreements with the customer, entered into between 2009 and 2011, by failing to have performed the contracted services. The plaintiff further alleges that Tecnonet was aware, at the time of entering into the supply agreements, that the customer’s managing director had a conflict of interest involving the subcontractors. The plaintiff is claiming damages and restitution from Tecnonet and the subcontractors, jointly and severally, of approximately $3.0 million in the aggregate, plus costs. While we believe that Tecnonet has valid defenses to the plaintiff's claims, we cannot provide assurance that such claims will not result in any liability to Tecnonet.

Nhan T. Vo, individually and on behalf of other aggrieved employees vs. the Company, Superior Court of California, County of Los Angeles. On June 27, 2013, the plaintiff in this matter filed a lawsuit against the Company alleging claims for failure to properly pay overtime or provide meal and rest breaks to its non-exempt employees in California, among other things. The complaint seeks an unspecified amount of damages and penalties under provisions of the Labor Code, including the Labor Code Private Attorneys General Act. The Company has filed an answer denying all allegations regarding the plaintiff’s claims and asserting various defenses. The Company is currently in the discovery phase of this case.  As the ultimate outcome of this matter is uncertain no amounts have been accrued by the Company as of the date of this report. Depending on the actual outcome of this case, provisions could be recorded in the future which may have a material adverse effect on the Company’s operating results.

From time to time, MRV has received notices from third parties alleging possible infringement of patents with respect to product features or manufacturing processes. Management believes such notices are common in the communications industry because of the large number of patents that have been filed on these subjects. The Company's policy is to discuss these notices with the parties in an effort to demonstrate that MRV's products and/or processes do not violate any patents. The Company has been involved in such discussions with Alcatel-Lucent SA, Apcon, Inc., Finisar Corporation, International Business Machines, Mediacom Broadband LLC, Ortel Communications, Ltd., Nortel Networks Corporation, Rockwell Automation, Inc. and The Lemelson Foundation in the past.
MRV and its subsidiaries have been named as a defendant in other lawsuits involving matters that management considers routine to the nature of its business. Management is of the opinion that the ultimate resolution of such matters will not have a material adverse effect on our business, operating results and financial condition.
13. Accounts Receivable Factoring
    
The Company's Italian subsidiary has agreements with unrelated third-parties for the factoring of specific accounts receivable in Italy in order to reduce the amount of working capital required to fund such receivables. At September 30, 2014, Tecnonet's factoring facility agreements permitted the factoring of up to €15.0 million, or $19.0 million, worth of receivables outside of the United States. The factoring of accounts receivable under these agreements is accounted for as a sale in accordance with ASC 860 Transfers and Servicing. The Company has no retained interests or servicing liabilities related to the accounts receivable that have been sold in Italy.
    
At September 30, 2014, and December 31, 2013, the face amount of total outstanding accounts receivable pursuant to these agreements was $18.2 million and $17.2 million, respectively. Receivables transferred to the factor are derecognized at the date of sale and the proceeds are recorded at fair value. Proceeds consist of a receivable due from the factor. Cash received from the factor is recorded as a reduction of the receivable due from the factor. The related outstanding balances due from the factor were $14.9 million and $7.7 million as of September 30, 2014, and December 31, 2013, respectively, and are included in other receivables on the accompanying balance sheets. The related losses on sale were $0.1 million and $0.1 million for the three months ended September 30, 2014, and September 30, 2013, respectively and $0.2 million and $0.2 million for the nine months ended September 30, 2014, and September 30, 2013, respectively and are included in interest expense on the accompanying consolidated statements of operations.

14. Share Repurchase

On December 3, 2012, the Company's Board of Directors approved a repurchase of shares of Common Stock of the Company in an amount up to $10.0 million under a stock repurchase program that expired on December 31, 2013. Under this program, the Company purchased 261,863 shares at a total cost of approximately $2.6 million during the nine months ended September 30, 2013. From December 3, 2012, through September 30, 2013, the Company purchased 302,178 shares at a total cost of approximately $3.0 million.


16

On August 15, 2013, the Company's Board of Directors terminated the existing stock repurchase plan and approved a replacement repurchase plan on substantially the same terms in an amount up to $7.0 million that expired on May 14, 2014. From August 15, 2013, through December 31, 2013, the Company purchased 127,510 shares at a total cost of approximately $1.3 million. No additional shares were repurchased during the three and nine months ended September 30, 2014, under this plan.

15. Income Taxes

The following table provides details of income taxes (in thousands, except percentages):
 
Three months ended
 
Nine months ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Loss before provision for income taxes
$
(313
)
 
$
(134
)
 
$
(5,865
)
 
$
(5,140
)
Provision for income taxes
727

 
12

 
1,659

 
433

Effective tax rate
(232
)%
 
(9
)%
 
(28
)%
 
(8
)%
 
 
 
 
 
 
 
 

The effective tax rate fluctuates based on the amount of pre-tax income or loss generated in the various jurisdictions where we conduct operations and pay income tax. The income tax expense of $0.7 million on an operating loss before provision for income taxes of $0.3 million for the three months ended September 30, 2014, is due to income tax associated with our foreign subsidiaries that do not benefit from our federal net operating loss carryforwards. The income tax expense of $1.7 million on an operating loss before provision for income taxes of $5.9 million for the nine months ended September 30, 2014, is due to income tax associated with our foreign subsidiaries that do not benefit from our federal net operating loss carryforwards and from the accrual of an income tax liability, including interest and penalties, of $0.3 million on a settlement of a tax audit of Tecnonet.
In 2013, the Italian Tax Authorities commenced an examination of Tecnonet and proposed a 100% disallowance of the deduction of certain sponsorship and advertising expenses for the years 2006 to 2011. The Company's management felt strongly that the deductions were fully supported by Italian tax law and that we would more-likely-than not prevail if we litigated the disallowance in the Italian tax courts. Therefore, there was no unrecognized benefit or income tax liability accrued in 2013 and the first quarter of 2014 related to the tax audit. During the three months ended June 30, 2014, the Italian tax authorities offered to reduce the 100% disallowance by 60%. Our local external tax advisers advised management that the 60% offer was a good result and that litigating the matter in Italian courts could be a protracted process despite the strong technical merits of our tax position. In consideration of our tax adviser’s assessment and management's desire to resolve this uncertainty, management accepted the 60% offer and settled with the Italian tax authorities in July 2014.

The Company recorded the interest and penalties of $0.1 million related to the accrued income tax expense of $0.2 million in income tax expense in the accompanying Condensed Consolidated Statement of Operations. Accrued interest and penalties are included in the related income tax liability in the Condensed Consolidated Balance Sheet. The interest and penalties of $0.1 million and accrued VAT expense of $0.1 million related to the settlement are recognized in other expenses in the accompanying Condensed Consolidated Statement of Operations. Accrued interest and penalties are included in the related current accrued liability in the Condensed Consolidated Balance Sheet in June 2014. The accrued income tax liability and accrued VAT liability including interest and penalties of $0.5 million were paid in full on October 3, 2014.
As of December 31, 2013, we had net operating losses ("NOLs") of $172.3 million, $93.1 million, and $95.8 million for federal, state, and foreign income tax purposes, respectively. Additionally, the Company has capital loss carryforwards of $110.5 million and $24.0 million for federal and state tax purposes, respectively. The capital loss carry forwards, which were generated by the sale of Source Photonics, expire in 2015. Under the Internal Revenue Code, if a corporation undergoes an "ownership change," the corporation's ability to use its pre-change NOLs, capital loss carry forwards and other pre-change tax attributes to offset its post-change income may be limited. An ownership change is generally defined as a greater than 50% change in its equity ownership by value over a three-year period. We may experience an ownership change in the future as a result of subsequent shifts in our stock ownership. If we were to trigger an ownership change in the future, our ability to use any NOLs and capital loss carry forwards existing at that time could be limited. As of September 30, 2014, the US federal and state NOLs had a full valuation allowance.

17

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the Financial Statements and Notes thereto included elsewhere in this Form 10-Q, and Items 6, 7 and 8 of our 2013 Form 10-K. The discussion in this Form 10-Q contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and may qualify for the safe harbor provided for in Section 21E of the Exchange Act. Forward-looking statements are statements other than statements of historical fact and may be identified by use of such terms as “expects,” “anticipates,” “intends,” “potential,” “estimates,” “believes,” “may,” “should,” “could,” “will,” “would,” and words of similar import.

Forward-looking statements involve known and unknown risks and uncertainties that could cause actual results to differ materially from those projected. In addition, the statements in this Form 10-Q may involve certain risks, uncertainties and assumptions, the likelihood of which are difficult to assess and may not occur, including risks that each of its business segments may not make the expected progress in its respective market, or that management's long-term strategy may not achieve the expected results. Other risks and uncertainties relate to delayed lead times in receiving components and delayed delivery times to customers due to short-term capacity constraints, potential changes in relationships with MRV's customers and suppliers and their financial condition, MRV's success in developing, introducing and shipping product enhancements and new products, competition in our market segments, market acceptance of new products and our ability to succeed in entering new markets, continued market acceptance of existing products and continued success in selling the products of other companies, product price discounts and general pricing pressure in certain of our markets, the timing and amount of significant orders from customers, obsolete inventory or product returns, warranty and other claims on products, the continued ability of MRV to protect its intellectual property rights and avoid onerous licensing fees, changes in product mix, maturing product life cycles, implementation of operating cost structures that align with revenue growth, political instability in areas of the world in which MRV operates or sells its products and services, currency fluctuations, changes in accounting rules, general economic conditions, as well as changes in such conditions specific to our market segments, maintenance of our inventory and production backlog, supply constraints directly or indirectly caused by natural disasters, litigation, including but not limited to patent infringement claims and litigation related to MRV's historical stock option granting practices.

In light of the risks and uncertainties inherent whenever matters or events expected to occur or not occur in the future are discussed, there can be no assurance that the forward-looking information contained in this Form 10-Q will in fact transpire or prove to be accurate.  All subsequent written and oral forward-looking statements attributable to the Company or persons acting on our behalf are expressly qualified in their entirety by this introduction. In light of the risks and uncertainties in all such projected operational matters, the inclusion of forward-looking statements in this Form 10-Q should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved or that any of the Company's operating expectations will be realized. Revenue and results of operations are difficult to forecast and could differ materially from those projected in the forward-looking statements contained in this Form 10-Q for the reasons detailed in Item 1A “Risk Factors” of Part I on the Company's 2013 Form 10-K and as set forth in item 1A of Part II of this Form 10-Q. Readers should not place undue reliance on forward-looking statements, which reflect management's view only as of the date of this Form 10-Q. The Company undertakes no obligation to amend this Form 10-Q or revise publicly these forward-looking statements (other than pursuant to requirements imposed on registrants pursuant to Item 1A under Part II of Form 10-Q) to reflect subsequent events or circumstances.  Readers should also carefully review the risk factors described in other documents the Company files from time to time with the SEC and the cautionary statements contained in our press releases when we provide forward-looking information.

18

Overview

We supply communications equipment and services to carriers, governments and enterprise customers worldwide. We conduct our business along two principal segments: Network Equipment and Network Integration. We evaluate segment performance based on the revenues, gross profit and operating expenses of each segment. We do not evaluate segment performance on additional financial information. As such, there are no separately identifiable Statements of Operations data below operating income. Our Network Equipment segment primarily provides communications equipment that facilitates access, transport, aggregation and management of voice, data and video traffic in communication networks and data centers used by telecommunications service providers, cable operators, enterprise customers and governments worldwide. Our Network Integration segment operates primarily in Italy, servicing Tier One service providers, regional carriers, large enterprises, and government institutions. Network Integration is a supplier of a wide range of communications equipment from leading global manufacturers, as well as telecommunications solutions and services, including network infrastructure, unified communications, mobility and wireless, network security, cloud computing services, managed call center services, network integration, and optimization. We market and sell our products worldwide, through a variety of channels, which include a dedicated direct sales force, manufacturers' representatives, value-added-resellers, distributors and systems integrators.

We continue to encounter a highly competitive global marketplace for our products and services.  Our recent introduction of the OptiDriver and OptiPacket product lines and the enhancement of existing products are positioning us to aggressively seek to retain current customers and capture additional market share. We expect the competitive landscape to remain dynamic. As technologies migrate toward being software-driven and the network layers converge, we expect to see competition for our products and services to increase.

As we seek opportunities for our OptiDriver and OptiPacket systems, additional investment in demonstration equipment, inventory, and deployment activities will be required. These investments may burden our results before we begin to see revenues as the sales cycle for these products can extend over several months.

In the Italian market, securing new opportunities on the Network Integration side of our business often requires less favorable pricing on the third party products that we sell to Tier One service providers. This less favorable pricing, combined with the protracted cash conversion cycle inherent in Italy, places working capital resources at risk. These market conditions can adversely affect our operations and cause fluctuations in our results.

Our business involves reliance on foreign-based offices. Some of our divisions, outside subcontractors and suppliers are located in foreign countries, including Argentina, Australia, Canada, Denmark, Germany, Israel, Italy, Netherlands, Philippines, Poland, Russia, Taiwan, Thailand, and the United Kingdom. For the nine months ended September 30, 2014 and 2013, foreign revenue constituted 62% and 59% of our total revenue, respectively. The majority of our foreign sales are to customers located in the European region, with the remaining foreign sales primarily to customers in the Asia Pacific region.

As of September 30, 2014, the Company had $24.5 million in cash and cash equivalents, $0.4 million in restricted time deposits, and $5.2 million in short-term debt.

Critical Accounting Policies

Our discussion and analysis of the Company's financial condition and results of operations are based upon the financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“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. We believe that the estimates, assumptions and judgments involved in the accounting policies described below have the greatest potential impact on our financial statements, so we consider these to be our critical accounting policies. Because of the uncertainty inherent in these matters, actual results could differ from the estimates we use in applying the critical accounting policies. Certain of these critical accounting policies affect working capital account balances, including the policies for revenue recognition, allowance for doubtful accounts, inventory reserves and income taxes. These policies require that we make estimates in the preparation of our financial statements as of a given date.

Within the context of these critical accounting policies, we are not currently aware of any reasonably likely events or circumstances that would result in materially different amounts being reported.

19


Revenue Recognition.    Our major revenue-generating products consist of switches and routers, console management, physical layer products, and fiber optic components. We recognize product revenue, net of sales discounts, returns and allowances, when persuasive evidence of an arrangement exists, delivery has occurred and all significant contractual obligations have been satisfied, the fee is fixed or determinable and collection is considered reasonably assured. Products are generally shipped "FOB shipping point," with no right of return and revenue is recognized upon shipment. If revenue is to be recognized upon delivery, such delivery date is tracked through information provided by the third party shipping company we use to deliver the product to the customer. Network Integration resells third party products. We recognize revenue on these sales on a gross basis, as a principal, because we are the primary obligor in the arrangement, we are exposed to inventory and credit risk, we negotiate the selling prices, and we sell the products as part of a solution in which we provide services. Sales of services and system support are deferred and recognized ratably over the contract period. Sales to end customers with contingencies, such as rights of return, rotation rights, conditional acceptance provisions and price protection, are infrequent and insignificant and are deferred until the contingencies have been satisfied or the contingent period has lapsed. For sales to distributors, we generally recognize revenue when product is sold to the distributor rather than when the product is sold by the distributor to the end user. In certain circumstances, distributors have limited rights of return, including stock rotation rights, and/or are entitled to price protection, where a rebate credit may be provided to the customer if we lower our price on products held in the distributor's inventory. We estimate and establish allowances for expected future product returns and credits. We record a reduction in revenue for estimated future product returns and future credits to be issued to the customer in the period in which revenue is recognized, and for future credits to be issued in relation to price protection at the time we make changes to our distributor price book. We monitor product returns and potential price adjustments on an ongoing basis and estimate future returns and credits based on historical sales returns, analysis of credit memo data, and other factors known at the time of revenue recognition.

We generally warrant our products against defects in materials and workmanship for 90 days to three year periods. The estimated cost of warranty obligations and sales returns and other allowances are recognized at the time of revenue recognition based on contract terms and prior claims experience.

Accounting for Multiple-Element Arrangements. We allocate arrangement consideration at the inception of the arrangement to all deliverables using the relative selling price method. The selling price we use for each deliverable is based on (a) vendor-specific objective evidence if available; (b) third-party evidence if vendor-specific objective evidence is not available; or (c) estimated selling price if neither vendor-specific objective evidence nor third-party evidence is available. We allocate discounts in the arrangement proportionally on the basis of the fair value of each deliverable.

Allowance for Doubtful Accounts. We make ongoing estimates relating to the collectability of our accounts receivable and maintain a reserve for estimated losses resulting from the inability of customers to meet their financial obligations to us. In determining the amount of the reserve, we consider our historical level of credit losses and make judgments about the creditworthiness of significant customers based on ongoing credit evaluations. Because we cannot precisely predict future changes in the financial stability of our customers, actual future losses from uncollectible accounts may differ from our estimates. If the financial condition of our customers deteriorates, resulting in their inability to make payments, a larger reserve may be required. In the event we determine that a change in the allowance is appropriate, we would record a credit or a charge to selling, general and administrative expense in the period in which we make such a determination.

Concentration of Credit Risk.    Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents placed with high credit quality institutions and accounts receivable due from customers. We perform ongoing credit evaluations of our customers and maintain reserves for potential credit losses.


20

Inventory.    We make ongoing estimates relating to the net realizable value of inventories, based upon our assumptions about future demand and market conditions. If we estimate that the net realizable value of our inventory is less than the cost of the inventory recorded on our books, we record an adjustment to the cost basis equal to the difference between the cost of the inventory and the estimated net realizable market value. This adjustment is recorded as a charge to cost of goods sold, and includes estimates for excess quantities and obsolete inventory. If changes in market conditions result in reductions in the estimated net realizable value of our inventory below previous estimates, we would make further adjustments in the period in which we make such a determination and record a charge to cost of goods sold. At the time of recording the adjustment, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration of, or increase in, that newly established cost basis.

Software Development Costs. Development costs related to software products are expensed as incurred until the technological feasibility of the product has been established. Technological feasibility occurs when a working model is completed or a detail program design exists. After technological feasibility is established, additional costs are capitalized. We believe that our process for internally developed software is essentially completed concurrent with the establishment of technological feasibility, and, accordingly, no software development costs for internally developed software have been capitalized to date.

Internal Use Software Development. Any software that we acquire, internally develop, or modify solely to meet our internal needs, and for which we have no substantive plan to market the software externally, is capitalized.

Income Taxes. As part of the process of preparing our interim financial statements, we estimate the income taxes in each of the jurisdictions in which we operate based on the estimated annual effective tax rate by jurisdiction. This process involves estimating the current income tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for income tax and accounting purposes. These differences result in deferred income tax assets and liabilities, which are included in our Condensed Consolidated Balance Sheets. We assess the likelihood that our deferred income tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we include an expense within the income tax provision in the Statements of Operations.

We utilize significant management judgment to determine the provision for income taxes, deferred income tax assets and liabilities, including uncertain tax positions, and any valuation allowance recorded against net deferred income tax assets. Management periodically evaluates the deferred income tax assets as to whether it is likely that the deferred income tax assets will be realized. We establish a valuation allowance on the deferred income tax asset at the time we determine the asset is not likely to be realized. If we later determine that it is more likely than not that a deferred tax asset will be realized, we release the valuation allowance and record a credit within the Statements of Operations.

Share-Based Compensation.    We determine the fair value of stock options using the Black-Scholes valuation model. The assumptions used in calculating the fair value of share-based payment awards represent our best estimates. Our estimates may be impacted by certain variables including stock price volatility, employee stock option exercise behaviors, additional stock option grants, estimates of forfeitures, and the related income tax impact. (See Note 9 “Share-Based Compensation” to the Financial Statements in Item 1, Part 1 of this Form 10-Q for further discussion.)

Correction of an Immaterial Error
 
During the three months ended September 30, 2014, the Company recorded an out-of-period adjustment to eliminate intercompany profit in inventory of $0.2 million, which resulted in an increase to net loss of $0.2 million for the three and nine months ended September 30, 2014. The Company reduced inventory by $0.2 million, and increased cost of sales by $0.2 million related to prior periods to remove the effect of profit in inventory not previously eliminated. Management evaluated the effects of this adjustment on the Company’s consolidated financial statements and concluded that the error was not material to any prior periods, individually or in the aggregate. These out-of-period adjustments did not have a material impact on the Company’s consolidated financial statements for the three and nine months ended September 30, 2014.


21

During the three months ended June 30, 2014, the Company recorded an out-of-period adjustment to defer previously recognized revenue of $2.0 million, which resulted in an increase to after-tax net loss of $0.1 million for the nine months ended September 30, 2014. The Company reduced cost of sales by $1.8 million, gross profit by $0.2 million and the provision for income taxes by $0.1 million related to prior periods to remove the effect of the previously recognized revenue. These out of period adjustments also resulted in an increase in Inventory of $1.9 million, deferred revenue of $2.0 million and deferred income taxes, net of current portion by $0.1 million. The impact on accumulated deficit and stockholder’s equity was a reduction by $0.1 million. Management evaluated the effects of this adjustment on the Company’s consolidated financial statements and concluded that the error was not material to any prior periods, individually or in the aggregate. These out-of-period adjustments did not have a material impact on the Company’s consolidated financial statements for the nine months ended September 30, 2014.

Currency Rate Fluctuations

Changes in the relative values of non-U.S. currencies to the U.S. dollar affect our results. We conduct a significant portion of our business in foreign currencies, including the Euro, the Taiwan dollar and the Israeli new shekel. For the nine months ended September 30, 2014 and 2013, 62% and 59% of revenue and 43% and 39% of operating expenses, respectively, were incurred at subsidiaries with a reporting currency other than the U.S. dollar. For the nine months ended September 30, 2014, these currencies strengthened against the U.S. dollar compared to the nine months ended September 30, 2013, so revenue and expenses in these currencies translated into slightly more dollars than they would have in the prior period. The Euro and Israeli new shekel strengthened 3% and 4% respectively against the U.S. dollar in nine months ended September 30, 2014, compared to nine months ended September 30, 2013. The Company's Taiwan subsidiary, Appointech, Inc., is included in Network Equipment that also includes our Optical Communications Systems ("OCS") division. Relative to OCS, the revenues and related operating gross profit and operating expenses are not material and the change in foreign currency did not have a material impact on the results for the three and nine months ended September 30, 2014, compared to the three and nine months ended September 30, 2013. Additional discussion of foreign currency risk and other market risk is included in Part I, Item 3 “Quantitative and Qualitative Disclosures About Market Risk” of this Form 10-Q.


22

Management Discussion Snapshot

The following table sets forth, for the periods indicated, certain consolidated Statements of Operations data (dollars in thousands):

 
Three months ended September 30,
 
Nine months ended September 30,
 
2014
 
2013
 
2014
 
2013
 
$
 
% (1)
 
$
 
% (1)
 
$
 
% (1)
 
$
 
% (1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenue (1) (2)
$
43,170

 
100
 %
 
$
38,385

 
100
%
 
$
128,612

 
100
 %
 
$
115,465

 
100
 %
Network Equipment
21,979

 
51

 
22,806

 
59

 
66,131

 
51

 
64,852

 
56

Network Integration
21,237

 
49

 
15,585

 
41

 
62,644

 
49

 
50,701

 
44

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Gross profit (3)
$
14,716

 
34

 
$
14,974

 
39

 
$
42,749

 
33

 
$
41,373

 
36

Network Equipment
11,062

 
50

 
12,041

 
53

 
33,007

 
50

 
33,990

 
52

Network Integration
3,654

 
17

 
2,934

 
19

 
9,742

 
16

 
7,378

 
15

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses (4)
$
15,140

 
35

 
$
14,935

 
39

 
$
48,148

 
37

 
$
45,882

 
40

Network Equipment
12,016

 
55

 
11,954

 
52

 
38,302

 
58

 
35,318

 
54

Network Integration
1,892

 
9

 
1,408

 
9

 
5,431

 
9

 
4,486

 
9

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating income (loss) (3) (4)
$
(424
)
 
(1
)
 
$
39

 
—

 
$
(5,399
)
 
(4
)
 
$
(4,509
)
 
(4
)
Network Equipment
(953
)
 
(4
)
 
87

 
—

 
(5,296
)
 
(8
)
 
(1,328
)
 
(2
)
Network Integration
1,762

 
8

 
1,525

 
10

 
4,311

 
7

 
2,891

 
6

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
___________________________________
(1)
Consolidated Statements of Operations data and segment revenue data express percentages as a percentage of consolidated revenue. Other Statements of Operations data by segment express percentages as a percentage of applicable segment revenue.
(2)
Revenue information by segment includes intersegment revenue reflecting sales of Network Equipment to Network Integration.
(3)
Consolidated gross profit data reflects adjustments for intersegment eliminations.
(4)
Consolidated operating expenses include corporate unallocated operating expenses.

Three months ended September 30, 2014 Compared to the Three months ended September 30, 2013

Revenue

The following table summarizes revenue by segment, including intersegment sales (dollars in thousands):

 
 
 
 
 
Favorable/(Unfavorable)
Three months ended September 30:
2014
 
2013
 
$
Change
 
%
Change
 
% Change constant
currency (1)
Network Equipment
$
21,979

 
$
22,806

 
$
(827
)
 
(4
)%
 
(4
)%
Network Integration
21,237

 
15,585

 
5,652

 
36

 
36

Before intersegment adjustments
43,216

 
38,391

 
4,825

 
13

 
12

Intersegment adjustments (2)
(46
)
 
(6
)
 
(40
)
 
667

 
820

Total
$
43,170

 
$
38,385

 
$
4,785

 
12
 %
 
12
 %
 
 
 
 
 
 
 
 
 
 
___________________________________
(1)
Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
(2)
Adjustments represent the elimination of intersegment revenue.


23

Consolidated revenue for the three months ended September 30, 2014, increased $4.8 million, or 12%, compared to the three months ended September 30, 2013, due to a $5.7 million, or 36%, increase in Network Integration revenue, offset by a $0.8 million, or 4%, decrease in Network Equipment revenue.

Network Equipment.    Revenue generated from Network Equipment decreased $0.8 million, or 4%, for the three months ended September 30, 2014, compared to the three months ended September 30, 2013. The decrease is primarily due to lower product revenues that were partially offset by higher service revenue volume. Revenues for our optical transport and out of band products increased in the third quarter of 2014 compared to same period in the prior year, which was offset by a decrease in network infrastructure management and carrier Ethernet networking. Geographically, the decrease in revenues was attributable to lower sales in the United States, Latin America and Europe. In Asia Pacific, there was increased order volume over the same period in the prior year from a Tier One carrier. Our Americas region was primarily down due to delays on some orders from some of our larger South American customers. The foreign exchange impact to Network Equipment revenue was not material.

The following table summarizes Network Equipment revenue by geographic region (dollars in thousands):

 
 
 
 
 
Favorable/(Unfavorable)
Three months ended September 30:
2014
 
2013
 
$ Change
 
% Change
Revenue, excluding intersegment sales:
 
 
 
 
 
 
 
United States
$
13,253

 
$
15,010

 
$
(1,757
)
 
(12
)%
Americas (Excluding the U.S.)
197

 
972

 
(775
)
 
(80
)
Europe
4,316

 
5,691

 
(1,375
)
 
(24
)
Asia Pacific
4,167

 
1,127

 
3,040

 
270

Total external sales
21,933

 
22,800

 
(867
)
 
(4
)
Sales to Network Integration:
 
 
 
 
 
 
 
Europe
46

 
6

 
40

 
667

Total intersegment sales
46

 
6

 
40

 
667

Total Network Equipment revenue
$
21,979

 
$
22,806

 
$
(827
)
 
(4
)%
 
 
 
 
 
 
 
 

Network Integration.    Revenue generated from Network Integration increased $5.7 million, or 36%, for the three months ended September 30, 2014, compared to the three months ended September 30, 2013. The $5.7 million increase in revenue was due to a $5.3 million, or 81%, increase in product revenue and a $0.4 million, or 4%, increase in service revenues at Tecnonet. Tecnonet has seen an increase in product revenue order volume arising from large orders from the two largest telecommunication carriers in Italy. The increase in service revenue was the result of our continued focus on this aspect of the business that has higher margins. The foreign exchange impact to Network Integration revenue was not material.

Gross Profit

The following table summarizes gross profit by segment (dollars in thousands):
 
 
 
 
 
Favorable/(Unfavorable)
Three months ended September 30:
2014
 
2013
 
$
Change
 
%
Change
 
 % Change constant
currency (1)
Network Equipment
$
11,062

 
$
12,041

 
$
(979
)
 
(8
)%
 
(8
)%
Network Integration
3,654

 
2,934

 
720

 
25

 
24

Before intersegment adjustments
14,716

 
14,975

 
(259
)
 
(2
)
 
—

Adjustments (2)
—

 
(1
)
 
1

 
(100
)
 
(2
)
Total
$
14,716

 
$
14,974

 
$
(258
)
 
(2
)%
 
(2
)%
 
 
 
 
 
 
 
 
 
 

(1)
Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
(2)
Adjustments represent the change in the elimination of intersegment profit in ending inventory in order to reconcile to consolidated gross profit.

24


Consolidated gross profit decreased $0.3 million in the three months ended September 30, 2014, compared to the three months ended September 30, 2013, principally due to variances in material costs from standard costs and the effect of adjustments in the valuation of service inventory partially offset by the 12% increase in revenue. Gross margin for the third quarter of 2014 was 34.1%, as compared to 39.0% in the third quarter of 2013. The 4.9 percentage point decrease was due to the variances in material costs and costs adjustments in Network Equipment. These decreases in gross margin were partially offset by a more favorable consolidated product to service revenue mix in the third quarter of 2014 as compared to the third quarter of 2013. In the third quarter of 2014, the consolidated effect of the change in constant currency did not materially impact gross profit. The above discussion includes the out-of-period adjustment of $0.2 million related to the elimination of intercompany profit in inventory, which decreased consolidated gross profit by $0.2 million in the current period and impacted consolidated gross margin by 0.5 percentage points.
 
Network Equipment.  Gross profit for Network Equipment decreased $1.0 million in the three months ended September 30, 2014, compared to the three months ended September 30, 2013, principally due to cost variances due to lower production volumes and adjustments to the valuation of service inventory. These effects were partially offset by the lower production labor and overhead costs arising from cost saving initiatives implemented during the fourth quarter of 2013. Gross margin for the three months ended September 30, 2014, was 50.3%, a decline of 2.5% percentage points from 52.8% for the three months ended September 30, 2013, principally caused by the cost variances along with an out-of-period adjustment of $0.2 million related to the elimination of intercompany profit in inventory and impacted Network Equipment gross margin by 1.0 percentage points. The foreign exchange impact to Network Equipment gross profit was not material.

Network Integration.  Gross profit for Network Integration increased $0.7 million, or 25% in the three months ended September 30, 2014, as compared to the three months ended September 30, 2013. The increase was essentially the result of the volume impact of the $5.7 million increase in revenue, $5.3 million of which was product related at substantially lower margins than our service revenue generates. Our gross margin was 17.2% and 18.8% for the quarter ended September 30, 2014 and 2013, respectively. The 1.6% percentage point decline was the result of the significant increase in product revenues in the quarter compared to the comparable prior year quarter. The foreign exchange impact to Network Integration gross profit was not material.

Operating Expenses

The following table summarizes operating expenses by segment (dollars in thousands):

 
 
 
 
 
(Favorable)/Unfavorable
Three months ended September 30:
2014
 
2013
 
$
Change
 
%
Change
 
% Change constant
currency (1)
Network Equipment
$
12,016

 
$
11,954

 
$
62

 
1
 %
 
1
 %
Network Integration
1,892

 
1,408

 
484

 
34
 %
 
34
 %
Total segment operating expenses
13,908

 
13,362

 
546

 
4
 %
 
4
 %
Corporate unallocated operating expenses and adjustments (2)
1,232

 
1,573

 
(341
)
 
(22
)%
 
(22
)%
Total
$
15,140

 
$
14,935

 
$
205

 
1
 %
 
1
 %
 
 
 
 
 
 
 
 
 
 

(1)
Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
(2)
Corporate unallocated operating expenses include unallocated product development, and selling, general and administrative expenses.

Consolidated operating expenses for the three months ended September 30, 2014, were $15.1 million, or 35% of revenue, compared to $14.9 million, or 39% of revenue, for the three months ended September 30, 2013, an increase of $0.2 million. The increase was primarily due to an increase in Network Integration expenses of $0.5 million and an increase of $0.1 million in expenses at Network Equipment offset by a $0.3 million decrease of Corporate unallocated operating expenses as discussed below. In the third quarter of 2014, the consolidated effect of the change in constant currency was not material.
    

25

Network Equipment.    Operating expenses in Network Equipment for the three months ended September 30, 2014, were $12.0 million, or 55% of revenue, compared to $12.0 million, or 52% of revenue in three months ended September 30, 2013. The $0.1 million, or 1%, increase was due to a $0.4 million increase in salary costs for engineers supporting our product development initiatives and $0.5 million increase in salaries to enhance the U.S. sales organization, partially offset by $0.5 million decrease in external labor related to the ERP system implementation in 2013 and a $0.3 million decrease in general administrative charges related to bad debt and facility maintenance. The foreign exchange impact to Network Equipment operating expenses was not material.

Network Integration.    Operating expenses in Network Integration for the three months ended September 30, 2014, were $1.9 million, or 9% of revenue, compared to $1.4 million, or 9% of revenue, for the three months ended September 30, 2013. The $0.5 million increase was mainly due to $0.3 million of sales labor support costs to support increased revenue volume and an increase of $0.2 million in general and administrative charges related to accounting fees. In the third quarter of 2014, the foreign exchange impact to Network Integration operating expenses was not material.

Corporate. Corporate expenses decreased by $0.3 million for the three months ended September 30, 2014, compared to the three months ended September 30, 2013. The decrease was primarily related to a decrease in salaries and wages of $0.2 million and a decrease of $0.4 million in administrative overhead charges, as the prior year period was burdened by $0.2 million in warrant revaluation charges and $0.2 million in professional fees for financial advisory services that were not incurred in the current year to date periods. These amounts were offset by an increase in accounting fees of $0.3 million incurred during the period. The foreign exchange impact to corporate operating expenses was not material.

Operating Income (Loss)

The following table summarizes operating income (loss) by segment (dollars in thousands):

 
 
 
 
 
Favorable/(Unfavorable)
Three months ended September 30:
2014
 
2013
 
$
Change
 
%
Change
 
% Change constant
currency(1)
Network Equipment
$
(953
)
 
$
87

 
$
(1,040
)
 
(1,195
)%
 
(1,195
)%
Network Integration
1,762

 
1,525

 
237

 
16

 
15

Total segment operating income (loss)
809

 
1,612

 
(803
)
 
(50
)
 
(51
)
Corporate unallocated and adjustments (2)
(1,233
)
 
(1,573
)
 
340

 
22

 
(22
)
Total  
$
(424
)
 
$
39

 
$
(463
)
 
(1,187
)%
 
(1,217
)%
 
 
 
 
 
 
 
 
 
 

(1)
Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
(2) 
Adjustments represent the elimination of intersegment revenue and profit in inventory in order to reconcile to consolidated operating income (loss).

Network Equipment.   Network Equipment reported an operating loss of $1.0 million for three months ended September 30, 2014, compared to operating income of $0.1 million for the three months ended September 30, 2013. The $1.0 million change in operating results was primarily due to the $1.0 million decrease in gross profit, offset by the $0.1 million increase in operating expenses. Operating margin was (4)% in 2014 and 0.4% in 2013.

Network Integration.   Network Integration reported operating income of $1.8 million for the three months ended September 30, 2014, compared to $1.5 million for three months ended September 30, 2013. The increase was primarily due to the $0.7 million increase in gross profit that was partially offset by a $0.5 million increase in operating costs. Network Integration operating margin was 8% and 10% for the three months ended September 30, 2014 and 2013, respectively.


26

Interest Expense and Other Expense, Net

Interest expense was $0.1 million for the three months ended September 30, 2014, compared to $0.04 million for the three months ended September 30, 2013. Other expense, net, principally includes interest income on cash, cash equivalents and investments and gains and losses on foreign currency transactions.

Provision for Income Taxes

The tax provision for the three months ended September 30, 2014, and 2013, was $0.7 million and $0.01 million, respectively. Our income tax provision fluctuates based on the amount of pre-tax income or loss generated in the various jurisdictions where we conduct operations and pay income tax. The income tax expense of $0.7 million on the loss before provision for income taxes of $0.3 million for the three months ended September 30, 2014, is due to income tax associated with our foreign subsidiaries that do not benefit from our federal net operating loss carryforwards.
Tax Loss Carryforwards

As of December 31, 2013, we had net operating losses ("NOLs") of $172.3 million, $93.1 million, and $95.8 million for federal, state, and foreign income tax purposes, respectively. Additionally, the Company has capital loss carryforwards of $110.5 million and $24.0 million for federal and state tax purposes, respectively. The capital loss carry forwards, which were generated by the sale of Source Photonics, expire in 2015. Under the Internal Revenue Code, if a corporation undergoes an "ownership change," the corporation's ability to use its pre-change NOLs, capital loss carry forwards and other pre-change tax attributes to offset its post-change income may be limited. An ownership change is generally defined as a greater than 50% change in its equity ownership by value over a three-year period. We may experience an ownership change in the future as a result of subsequent shifts in our stock ownership. If we were to trigger an ownership change in the future, our ability to use any NOLs and capital loss carry forwards existing at that time could be limited. As of September 30, 2014, the US federal and state NOLs had a full valuation allowance.
Nine months ended September 30, 2014 Compared To Nine months ended September 30, 2013

Revenue

The following table summarizes revenue by segment, including intersegment sales (dollars in thousands):
 
 
 
 
 
Favorable/(Unfavorable)
Nine months ended September 30:
2014
 
2013
 
$
Change
 
%
Change
 
% Change constant
currency (1)
Network Equipment group
$
66,131

 
$
64,852

 
$
1,279

 
2
%
 
2
%
Network Integration group
62,644

 
50,701

 
11,943

 
24

 
20

Before intersegment adjustments
128,775

 
115,553

 
13,222

 
11

 
10

Intersegment adjustments (2)
(163
)
 
(88
)
 
(75
)
 
85

 
85

Total
$
128,612

 
$
115,465

 
$
13,147

 
11
%
 
10
%
 
 
 
 
 
 
 
 
 
 
___________________________________
(1)
Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
(2)
Adjustments represent the elimination of intersegment revenue.

Consolidated revenue for the nine months ended September 30, 2014, increased $13.1 million, or 11%, compared to the nine months ended September 30, 2013. This increase was due to an $11.9 million increase in Network Integration revenue, a $1.3 million increase in Network Equipment revenue, offset by the $0.1 million increase in Intersegment adjustments, which are eliminated in consolidation. Consolidated revenue would have been $1.8 million lower if foreign currency exchange rates had remained the same as they were in the first nine months of 2013. The above discussion includes the out-of-period adjustment of $2.0 million recorded during the three months ended June 30, 2014, related to deferred revenue. Of this amount, the Company recognized $1.2 million during the three months ended September 30, 2014, reducing the impact on deferred revenues for the out-of-period adjustment recorded in the prior quarter to $0.8 million as of September 30, 2014.


27

Network Equipment Group.    Revenue generated from the Network Equipment group increased $1.3 million in the nine months ended September 30, 2014, compared to the nine months ended September 30, 2013. Revenues increased primarily due to a $1.7 million increase in product revenue offset by a $0.4 million decrease in service revenue. Revenues for our optical transport products increased during the nine months ended September 30, 2014, compared to the prior year period, offset by a decrease in carrier Ethernet networking and out of band products. Service revenues were down 5% as compared to same period last year primarily due to the roll off of older deferred service contracts that related to revenues scheduled for recognition prior to the effective date of ASU 2009-13. Geographically, Asia Pacific and Europe revenues increased $4.9 million that was partially offset by a $3.7 million decrease in OCS Americas. The decrease in OCS Americas was primarily due to a revenue decline in the South American portion of the region that was partially offset by modest revenue growth in the North American portion of the region.

The following table summarizes Network Equipment revenue by geographic region (dollars in thousands):

 
 
 
 
 
Favorable/(Unfavorable)
Nine months ended September 30:
2014
 
2013
 
$ Change
 
% Change
Revenue, excluding intersegment sales:
 
 
 
 
 
 
 
United States
$
39,665

 
$
40,811

 
$
(1,146
)
 
(3
)%
Americas (Excluding the U.S.)
879

 
3,452

 
(2,573
)
 
(75
)%
Europe
16,009

 
15,864

 
145

 
1

Asia Pacific
9,416

 
4,637

 
4,779

 
103

Total external sales
65,969

 
64,764

 
1,205

 
2

Sales to Network Integration group:
 
 
 
 
 
 
 
Europe
163

 
88

 
75

 
85

Total intersegment sales
163

 
88

 
75

 
85

Total Network Equipment revenue
$
66,132

 
$
64,852

 
$
1,280

 
2
 %
 
 
 
 
 
 
 
 

Network Integration Group.    Revenue generated from the Network Integration group was $11.9 million, or 24% higher for the nine months ended September 30, 2014, compared to the nine months ended September 30, 2013. This increase was due to a $10.2 million, or 42% increase in product revenue and $1.7 million, or 6% increase in service revenues at Tecnonet. Tecnonet has seen an increase in product revenue order volume primarily as a result of significant projects in 2014 that may not continue in the future. The increase in service revenue was a result of market share gains resulting from our continued focus on this aspect of the business that has higher margins and potential for growth. Revenue would have been $1.9 million lower for the nine months ended September 30, 2014 had foreign currency exchange rates remained the same as they were in the nine months ended September 30, 2013. All revenue in the Network Integration group was generated in Italy. The above discussion includes the out-of-period adjustment of $2.0 million recorded during the three months ended June 30, 2014, related to deferred revenue. Of this amount, the Company recognized $1.2 million during the three months ended September 30, 2014, reducing the impact on deferred revenues for the out-of-period adjustment recorded in the prior quarter to $0.8 million as of September 30, 2014.


28

Gross Profit

The following table summarizes gross profit by segment (dollars in thousands):

 
 
 
 
 
Favorable/(Unfavorable)
Nine months ended September 30:
2014
 
2013
 
$
Change
 
%
Change
 
 % Change constant
currency (1)
Network Equipment group
$
33,007

 
$
33,990

 
$
(983
)
 
(3
)%
 
(3
)%
Network Integration group
9,742

 
7,378

 
2,364

 
32

 
28

Before intersegment adjustments
42,749

 
41,368

 
1,381

 
3

 
3

Adjustments (2)
—

 
5

 
(5
)
 
(100
)
 
(80
)
Total
$
42,749

 
$
41,373

 
$
1,376

 
3
 %
 
3
 %
 
 
 
 
 
 
 
 
 
 

(1)
Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
(2)
Adjustments represent the change in the elimination of intersegment profit in ending inventory in order to reconcile to consolidated gross profit.

Consolidated gross profit increased $1.4 million, or 3% for the nine months ended September 30, 2014, from the prior year period, principally due to the 11% increase in revenue offset by the pressure on pricing and revenue mix. Gross margin for the nine months ended September 30, 2014, was 33.2% compared to 35.8% for the nine months ended September 30, 2013. The 2.6 percentage point decline in gross margins was due to the shift of segment revenue mix toward a higher percentage of total revenue coming from Network Integration, which has lower gross margins than Network Equipment, and due to a decrease in Network Equipment gross margins. These decreases in gross margin were partially offset by a more favorable consolidated product to service revenue mix in the nine months ended September 30, 2014, as compared to the nine months ended September 30, 2013. Gross profit would have been $0.3 million lower for the nine months ended September 30, 2014, if foreign currency exchange rates had remained the same as they were in the nine months ended September 30, 2013. The above discussion includes the out-of-period adjustment of $0.2 million recorded during the three months ended June 30, 2014, related to deferred revenue. Of this amount, the Company recognized $0.1 million during the three months ended September 30, 2014, reducing the impact on consolidated gross profit for the out-of-period adjustment recorded in the prior quarter to $0.1 million for the nine months ended September 30, 2014. The above discussion also includes the out-of-period adjustment of $0.2 million related to the elimination of intercompany profit in inventory, which decreased consolidated gross profit by $0.2 million in the current period and impacted consolidated gross margin by 0.2 percentage points.

Network Equipment Group.    Gross profit for the Network Equipment segment decreased $1.0 million or 3% for the nine months ended September 30, 2014, compared to the nine months ended September 30, 2013, principally due to a shift in the mix of product revenue toward our lower margin products and a negative effect on costs from lower production volumes. These effects were partially offset by lower production labor and overhead arising from cost saving initiatives implemented during the fourth quarter of 2013. Gross margin for the nine months ended September 30, 2014, was 49.9% a decline of 2.5% percentage points from 52.4% for the nine months ended September 30, 2013, principally caused by a decrease in sales to our European channel partners, which have a lower gross margin and lower pricing of mature products in advance of new products. This was partially offset by strong sales of our new OptiDriver product to a Tier 1 customer in Asia Pacific, which have a higher gross margin. The above discussion includes the out-of-period adjustment of $0.2 million related to the elimination of intercompany profit in inventory, which decreased Network Equipment gross profit by $0.2 million in the current period and impacted Network Equipment gross margin by 0.3 percentage points. Gross profit would have been flat in the nine months ended September 30, 2014, had foreign currency exchange rates remained the same as they were in the nine months ended September 30, 2013.


29

Network Integration Group.    Gross profit for the Network Integration segment increased $2.4 million, or 32% for the nine months ended September 30, 2014, compared to nine months ended September 30, 2013, primarily due to the $11.9 million increase in revenue for the nine months ended September 30, 2014, compared to the prior year period as discussed above. Gross margin for the nine months ended September 30, 2014, was 15.6% an increase of 1% percentage point from 14.6% for the nine months ended September 30, 2013, principally due to an improvement in product revenue gross margins. Gross profit would have been $0.3 million lower in the nine months ended September 30, 2014, had foreign currency exchange rates remained the same as they were in the nine months ended September 30, 2013. The above discussion includes the out-of-period adjustment of $0.2 million recorded during the three months ended June 30, 2014, related to deferred revenue. Of this amount, the Company recognized $0.1 million during the three months ended September 30, 2014, reducing the impact on Network Integration gross profit for the out-of-period adjustment recorded in the prior quarter to $0.1 million for the nine months ended September 30, 2014.
 
Operating Expenses

The following table summarizes operating expenses by segment (dollars in thousands):

 
 
 
 
 
(Favorable)/Unfavorable
Nine months ended September 30:
2014
 
2013
 
$
Change
 
%
Change
 
% Change constant
currency (1)
Network Equipment group
$
38,302

 
$
35,318

 
$
2,984

 
8
 %
 
8
 %
Network Integration group
5,431

 
4,486

 
945

 
21
 %
 
18
 %
Total segment operating expenses
43,733

 
39,804

 
3,929

 
10
 %
 
374
 %
Corporate unallocated operating expenses and adjustments (2)
4,415

 
6,078

 
(1,663
)
 
(27
)%
 
(27
)%
Total
$
48,148

 
$
45,882

 
$
2,266

 
5
 %
 
5
 %
 
 
 
 
 
 
 
 
 
 

(1)
Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
(2)
Corporate unallocated operating expenses include unallocated product development, and selling, general and administrative expenses.

Consolidated operating expenses were $48.1 million, or 37% of revenue, for the nine months ended September 30, 2014, compared to $45.9 million, or 40% of revenue, for the nine months ended September 30, 2013, an increase of $2.3 million, or 5%, including $1.0 million due to insurance proceeds recorded in the second quarter of 2013 in conjunction with a derivative litigation settled that quarter. The remaining increase included a $3.0 million increase in Network Equipment and $0.9 million increase in Network Integration related to investments in the core business offset by a $1.7 million decrease in Corporate, excluding the effect of the insurance proceeds.
    
Network Equipment Group.    Operating expenses in the Network Equipment group for the nine months ended September 30, 2014, were $38.3 million, or 58% of revenue, compared to $35.3 million, or 54% of revenue for the nine months ended September 30, 2013. The $3.0 million or 8% increase was due to $2.3 million in additional costs related to the planned higher investment in engineering and product development to drive future product development, an increase in sales and back office support costs of $1.2 million, offset by a decrease in general and administrative overhead of $0.5 million of costs in 2013 related to the implementation of our Oracle ERP system.

Network Integration Group.    Operating expenses in the Network Integration group for the nine months ended September 30, 2014, were $5.4 million, or 9% of revenue, compared to $4.5 million, or 9% of revenue, for the nine months ended September 30, 2013. The $0.9 million or 21% increase in operating expense was primarily due to additional sales costs for labor and commissions and administrative costs principally for audit related services. Operating expenses would have been $0.2 million lower for the nine months ended September 30, 2014, had foreign currency exchange rates remained the same as they were in the prior year period.


30

Corporate.    Operating expenses decreased $1.7 million in the nine months ended September 30, 2014, compared to the nine months ended September 30, 2013. This decrease partially resulted from $1.4 million in lower labor and consulting fees incurred during the 2013 ERP system conversion and $0.1 million in lower auditing fees and accounting support fees. The nine months ended September 30, 2013, were also burdened by $1.3 million in legal fees arising from the derivative litigation that was settled in June 2013 and costs for an investigation of claims by a former employee that were partially offset by $1.0 million in insurance recovery for legal fees incurred during the derivative litigation that was settled in June 2013.
Operating Income (Loss)
The following table summarizes operating income (loss) by segment (dollars in thousands):
 
 
 
 
 
Favorable/(Unfavorable)
Nine months ended September 30:
2014
 
2013
 
$
Change
 
%
Change
 
% Change constant
currency(1)
Network Equipment group
$
(5,296
)
 
$
(1,328
)
 
$
(3,968
)
 
299
 %
 
299
 %
Network Integration group
4,311

 
2,891

 
1,420

 
49

 
45

Total segment operating income (loss)
(985
)
 
1,563

 
(2,548
)
 
(163
)
 
(171
)
Corporate unallocated and adjustments (2)
(4,414
)
 
(6,072
)
 
1,658

 
27

 
(27
)
Total  
$
(5,399
)
 
$
(4,509
)
 
$
(890
)
 
20
 %
 
23
 %
 
 
 
 
 
 
 
 
 
 

(1) 
Percentage information in constant currencies in the table above and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results were calculated by translating the current year results at prior year average exchange rates.
(2) 
Adjustments represent the elimination of intersegment revenue and profit in inventory in order to reconcile to consolidated operating income (loss).

The $2.3 million, or 5%, increase in operating expenses offset by the $1.4 million, or 3%, increase in gross profit primarily led to a $0.9 million increase in our operating loss. Operating losses included share-based compensation expense of $0.7 million and $0.5 million for the nine months ended September 30, 2014 and 2013, respectively. Our operating loss would have been $0.1 million lower for the nine months ended September 30, 2014, had foreign currency exchange rates remained the same as they were in the prior year period. The above discussion includes the out-of-period adjustment of $0.2 million recorded during the three months ended June 30, 2014, related to deferred revenue. Of this amount, the Company recognized $0.1 million during the three months ended September 30, 2014, reducing the impact on deferred revenue for the out-of-period adjustment recorded in the prior quarter to $0.1 million as of September 30, 2014. The above discussion also includes the out-of-period adjustment of $0.2 million recorded in the three months ended September 30, 2014, related to the elimination of intercompany profit in inventory which increased consolidated operating loss by $0.2 million for the nine months ended September 30, 2014.

Network Equipment Group.    The Network Equipment group reported an operating loss of $5.3 million and $1.3 million for the nine months ended September 30, 2014 and 2013, respectively. The change in operating profit was due to the $3.5 million planned increase in operating expenses. Operating margin was (8)% for the nine months ended September 30, 2014, and (2)% for the nine months ended September 30, 2013. The above discussion includes the out-of-period adjustment of $0.2 million recorded in the three months ended September 30, 2014, related to the elimination of intercompany profit in inventory, which increased Network Equipment operating loss by $0.2 million for the nine months ended September 30, 2014.

Network Integration Group.    The Network Integration group reported operating income of $4.3 million for the nine months ended September 30, 2014, compared to operating income of $2.9 million for the nine months ended September 30, 2014. The increase in operating profit was primarily due to the 24% increase in Network Integration revenues. The Network Integration group operating margin was 7% for the nine months ended September 30, 2014 compared to 6% for the nine months ended September 30, 2013. The Network Integration group recorded an out-of-period adjustment related to deferred revenue during the three months ended June 30, 2014, that increased its operating loss by $0.2 million for the six months ended June 30, 2014. Of this amount, the Company recognized $0.1 million during the three months ended September 30, 2014, reducing the impact on deferred revenue for the out-of-period adjustment recorded in the prior quarter to $0.1 million as of September 30, 2014.


31

Interest Expense and Other Expense, Net

Interest expense was $0.3 million in the nine months ended September 30, 2014, and $0.4 million the nine months ended September 30, 2013, respectively. Other expense, net, principally includes interest income on cash, cash equivalents and investments and gains and losses on foreign currency transactions.

Provision for Income Taxes

The tax provision for the nine months ended September 30, 2014 and 2013 was $1.7 million and $0.4 million, respectively. Our income tax provision fluctuates based on the amount of pre-tax income or loss generated in the various jurisdictions where we conduct operations and pay income tax. The income tax expense of $1.7 million on the loss before provision for income taxes of $5.9 million for the nine months ended September 30, 2014, is due to income tax associated with our foreign subsidiaries that do not benefit from our federal net operating loss carryforwards and from the accrual of an income tax liability, including interest and penalties, of $0.3 million on a settlement of a tax audit of Tecnonet.

Italy Tax Audit Settlement

In 2013, the Italian Tax Authorities commenced an examination of Tecnonet and proposed a 100% disallowance of the deduction of certain sponsorship and advertising expenses for the years 2006 to 2011. The Company's management felt strongly that the deductions were fully supported by Italian tax law and that we would more-likely-than not prevail if we litigated the disallowance in the Italian tax courts. Therefore, there was no unrecognized benefit or income tax liability accrued in 2013 and the first quarter of 2014 related to the tax audit. During the three months ended June 30, 2014, the Italian tax authorities offered to reduce the 100% disallowance by 60%. Our local external tax advisers advised management that the 60% offer was a good result and that litigating the matter in Italian courts could be a protracted process despite the strong technical merits of our tax position. In consideration of our tax adviser’s assessment and management's desire to resolve this uncertainty, management accepted the 60% offer and settled with the Italian tax authorities in July 2014.

The Company recorded the interest and penalties of $0.1 million related to the accrued income tax expense of $0.2 million in income tax expense in the accompanying Condensed Consolidated Statement of Operations. Accrued interest and penalties are included in the related income tax liability in the Condensed Consolidated Balance Sheet. The interest and penalties of $0.1 million and accrued VAT expense of $0.1 million related to the settlement are recognized in other expenses in the accompanying Condensed Consolidated Statement of Operations. Accrued interest and penalties are included in the related current accrued liability in the Condensed Consolidated Balance Sheet in June 2014. The accrued income tax liability and accrued VAT liability including interest and penalties of $0.5 million were paid in full on October 3, 2014.

Liquidity and Capital Resources

During the nine months ended September 30, 2014, our cash and restricted time deposits decreased from $27.8 million to $25.0 million, a decrease of $2.9 million. Our cash outflows included a net loss of $7.5 million adjusted for non-cash expenses of $4.7 million including depreciation and amortization, share-based compensation, provision for doubtful accounts, and deferred taxes. In addition, there were cash outflows from working capital of $2.4 million, including a $1.4 million increase in inventory due to increased purchases of certain products due to the transition from inside production to contract manufacturing of those products and timing of shipments, a $7.3 million increase in other assets due to increased factoring of receivables at Tecnonet, a $2.3 million decrease in accrued liabilities due to timing of payments of accrued expenses, offset by a $10.2 million decrease in accounts receivable due to increased factoring of receivables at Tecnonet, a $0.2 million increase in accounts payable due to an increase in materials purchased, and a $2.9 million increase in deferred revenue as a result of the timing of shipments. Cash used in investing activities included $1.9 million in purchases of property, plant, and equipment. Cash provided by financing activities included additional borrowings at Tecnonet of $17.5 million, partially offset by payments on short-term debt of $15.8 million at Tecnonet.


32

We periodically review our capital position and consider returning capital to stockholders through special dividends or share repurchases when cash on hand exceeds our foreseeable cash needs. We also periodically review the capital needs of our business units. We plan to invest approximately $4.0 million over the next 12 months to upgrade our infrastructure and equipment needed to support the Company's growth objectives in the carrier Ethernet and optical transport markets among others. The nature of the Tecnonet business requires significant levels of working capital to finance the longer term receivables and the extended acceptance periods for its larger customers. The financing for its working capital needs is partially met through the use of factoring certain receivables. Tecnonet has minimal capital requirements and does not conduct research and development. Therefore, we do not anticipate Tecnonet's business to require significant investment to support our strategic objectives in the Italian information technology market. We believe that cash on hand and existing financing will be sufficient to satisfy current operating needs, capital expenditures, and product development and engineering requirements for at least the next 12 months. We may seek to obtain additional debt or equity financing if we believe it appropriate. We may limit our ability to use available NOLs and capital loss carryforwards if we seek financing through issuance of additional equity securities.

The following table summarizes MRV's cash position, including cash and cash equivalents, restricted time deposits and our short-term debt position (dollars in thousands):

 
September 30,
2014
 
December 31, 2013
Cash
 
 
 
Cash and cash equivalents
$
24,533

 
$
27,591

Restricted time deposits
436

 
249

 
24,969

 
27,840

Short-term debt
5,175

 
4,320

Cash in excess of debt
$
19,794

 
$
23,520

Ratio of cash to debt (1)
4.8

 
6.4

 
 
 
 

(1)
Determined by dividing total cash by total debt.

Short-term Debt

Our short-term debt is related to Tecnonet, our Italian Network Integration subsidiary. Customer accounts receivables of Tecnonet have been pledged as collateral on the related borrowings.

The following table summarizes our short-term debt (in thousands):

 
September 30,
2014
 
December 31, 2013
 
Increase (decrease)
Lines of credit secured by accounts receivable
$
5,175

 
$
4,320

 
$
855

 
 
 
 
 
 

The increase in short-term debt at September 30, 2014, includes additional borrowings of $17.5 million, offset by payments of $15.8 million and the impact of changes in foreign currency exchange rates.


33

Working Capital

The following table summarizes our working capital position (dollars in thousands).
 
September 30,
2014
 
December 31, 2013
Current assets
$
107,892

 
$
117,170

Current liabilities
56,375

 
58,921

Working capital
$
51,517

 
$
58,249

Current ratio (1)
1.9
 
2.0
 
 
 
 

(1)
Determined by dividing total current assets by total current liabilities.

Off-Balance Sheet Arrangements

We do not have transactions, arrangements or other relationships with unconsolidated entities that are reasonably likely to affect our liquidity or capital resources. We have no special purpose or limited purpose entities that provided off-balance sheet financing, liquidity or market or credit risk support, engaged in leasing, hedging, research and development services, or other relationships that expose us to liability that is not reflected on the face of the financials.

Contractual Obligations

During the three months ended September 30, 2014, there were no material changes in our contractual obligations.

Internet Access to Our Financial Documents

We maintain a website at www.mrv.com. We make available, free of charge, either by direct access or hyperlink, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. Our reports filed with, or furnished to, the SEC are also available directly at the SEC's website at www.sec.gov.


34

Item 3.
Quantitative and Qualitative Disclosures About Market Risk

Market risk represents the risk of loss that may impact our Consolidated Financial Statements through adverse changes in financial market prices and rates and inflation. Our market risk exposure results primarily from fluctuations in foreign exchange and interest rates. We manage our exposure to these market risks through our regular operating and financing activities and, in certain instances, through the use of derivative financial instruments. These derivative instruments are used to manage risks of volatility in interest and foreign exchange rate movements on certain assets, liabilities or anticipated transactions and create a relationship in which gains or losses on derivative instruments are expected to counter-balance the losses or gains on the assets, liabilities or anticipated transactions exposed to such market risks. As of September 30, 2014, we did not have any such derivative financial instruments outstanding.

Interest Rates.    Our investments and short-term borrowings expose us to interest rate fluctuations. Our cash and short-term investments are subject to limited interest rate risk, and are primarily maintained in money market funds and bank deposits. Our variable-rate short-term borrowings are also subject to limited interest rate risk because of their short-term maturities. Through certain foreign offices, and from time to time, we enter into interest rate swap contracts. As of September 30, 2014, we did not have any interest rate swap contracts outstanding. The economic purpose of entering into interest rate swap contracts is to protect our variable interest debt from significant interest rate fluctuations.

Foreign Exchange Rates.    We operate on an international basis with a significant portion of our revenues and expenses transacted in currencies other than the U.S. dollar. Fluctuation in the value of these foreign currencies affects our results and will cause U.S. dollar translation of such currencies to vary from one period to another. We cannot predict the effect of exchange rate fluctuations upon future operating results. However, because we have revenues and expenses in each of these foreign currencies, the effect on our results of operations from currency fluctuations is reduced.

Through certain foreign offices, and from time to time, we enter into foreign exchange contracts in an effort to minimize the currency exchange risk related to accounts receivable or purchase commitments denominated in foreign currencies. These contracts cover periods commensurate with known or expected exposures, generally less than three months. As of September 30, 2014, we did not have any foreign exchange contracts outstanding.

Certain assets and liabilities, including certain bank accounts, accounts receivables, and accounts payables of some of our business units, exist in currencies other than the functional currency of the related business units and are sensitive to foreign currency exchange rate fluctuations. These currencies principally include the U.S. dollar, the euro, the Taiwan dollar, and the Israeli new shekel. Additionally, Tecnonet, which has a functional currency of the euro, has certain of its lines of credit denominated in U.S. dollars. When these transactions are settled in a currency other than the functional currency, we recognize a foreign currency transaction gain or loss.

When we translate the financial position and results of operations of subsidiaries with functional currencies other than the U.S. dollar, we recognize a translation gain or loss in other comprehensive income. Approximately 65.0% and 66.0% of our cost of sales and operating expenses are reported by these subsidiaries for the nine months ended September 30, 2014 and 2013. These currencies were generally stronger against the U.S. dollar for the nine months ended September 30, 2014 compared to the same period for 2013, so revenues and expenses in these countries translated into more dollars than they would have in the first nine months of 2013. For the nine months ended September 30, 2014, we had approximately:
•
$58.3 million in cost of goods and operating expenses recorded in euros;
•
$0.7 million in cost of goods and operating expenses recorded in Taiwan dollars.

Had rates of these various foreign currencies been 10% higher relative to the U.S. dollar during the nine months ended September 30, 2014, our costs would have increased to approximately:
•
$64.1 million cost of goods and operating expenses recorded in euros;
•
$0.8 million in cost of goods and operating expenses recorded in Taiwan dollars.


35

Fluctuations in currency exchange rates of foreign currencies have an impact on the U.S. dollar equivalent of such currencies included in cash and cash equivalents reported in our financial statements. The following table summarizes cash and cash equivalents held in various currencies and translated into U.S. dollars (in thousands).
 
September 30, 2014
 
December 31, 2013
U.S. dollars
$
17,680

 
$
24,162

Euros
5,777

 
1,744

Taiwan dollars
21

 
63

Israeli new shekels
563

 
1,148

Other
492

 
474

Total cash and cash equivalents
$
24,533

 
$
27,591

 
 
 
 

Macro-economic uncertainties.  We believe that the past few years of sustained softness in the global economy has affected our revenues and operating results, particularly in the Italian market.  When economic uncertainties increase, our customers often take a more cautious approach in their capital expenditures, resulting in order delays, slowing deployments, and lengthening sales cycles. This may lead to increased competition for projects and price pressures resulting in lower gross margins. Although we started to see an improvement in market conditions in the latter part of 2013, such market opportunities and dynamics are in their early stages, and it remains uncertain as to their current and long term effect on our business. Despite these economic uncertainties, we believe that our customers need to continue investing in their networks to meet the growth in consumer and enterprise use of high-bandwidth communications services.  We believe in our longer term market opportunities, but we are uncertain how long the downturn in economic conditions will continue and how our customers will interpret and react to market conditions.

Item 4.
Controls and Procedures.

We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) that are designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective at the reasonable assurance level as of the end of the period covered by this Quarterly Report as a result of the unremediated material weakness related to the inadequate design of internal controls over the accounting for revenue in our Italian subsidiary, Tecnonet as further described below.

Changes in Internal Controls

We designed and implemented remediation measures to address the material weakness identified as of June 30, 2014, and enhance our internal control over financial reporting. The material weakness related to the inadequate design of the internal control over the accounting for revenue in Tecnonet. Specifically, due to the Tecnonet personnel’s insufficient knowledge of the U.S. GAAP requirements related to maintenance of adequate documentation in support of certain revenue transactions, we did not have adequate controls in place to ensure that revenue was properly deferred in accordance with U.S. GAAP. Management has implemented monitoring controls to ensure that transactions requiring revenue deferral are identified, evaluated, and properly recognized. These controls were tested at the end of the third quarter of 2014 with no exceptions identified. Management will continue evaluating the internal controls over the accounting for deferred revenue during the last quarter of 2014 to ensure the material weakness has been fully remediated.


36

Additionally, we designed and implemented remediation measures to address the material weakness identified as of December 31, 2013, and enhance our internal control over financial reporting. The material weakness related to the inadequate design of the internal control over the accounting for deferred revenue specific to the revenue cut-off procedures. Management has implemented changes in the design of our internal control over the revenue cut-off procedures and performed testing of these control changes through June 30, 2014, to determine whether implemented controls operate as management intended. Based on the testing results, management has determined that, as of June 30, 2014, our controls associated with the monthly cut-off procedures were adequate and that the implementation of the additional control procedures have fully remediated this material weakness.

There have been no other changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or 15d-15 under the Exchange Act that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. We are committed to a strong internal control environment and will continue to review the effectiveness of our internal controls over financial reporting and other disclosure controls and procedures.

37

PART II - OTHER INFORMATION

Item 1.

    
We are subject to legal claims and litigation in the ordinary course of business, including but not limited to product liability, employment and intellectual property claims. The outcome of any such matters is currently not determinable. In addition, we were party to the litigation set forth below.
From June to August 2008, five purported stockholder derivative and securities class action lawsuits were filed in the U.S. District Court in the Central District of California and one derivative lawsuit was filed in the Superior Court of the State of California against the Company and certain of our former officers and directors. The five lawsuits filed in the Central District of California were consolidated. Claims were asserted under Section 10(b) and 20(a) of the Exchange Act, and Rule 10b-5 promulgated thereunder. In November 2010, the judge overseeing the securities class action lawsuits gave final approval to a stipulated $10.0 million settlement agreement, which was covered by our director and officer insurance policies. The federal and state derivative lawsuits were not settled and continued to be litigated.

As of January 4, 2013, all pending litigation in the federal and state derivative actions was stayed by agreement of the parties pending final Federal Court approval of a settlement between derivative plaintiffs, individual defendants and the Company. On April 8, 2013 the Federal Court preliminarily approved a Stipulation of Settlement (the "Settlement Stipulation"), which included, among other things, (a) a release of all claims relating to the derivative litigation for the Company, the individual defendants and the plaintiffs; (b) a provision that $2.5 million in cash be paid to the Company by the Company's insurance carriers; (c) payment of attorneys' fees to plaintiffs' counsel including $500,000 in cash and 250,000 warrants to purchase the Company's Common Stock, with a five-year term and strike price of the closing price of the Company's Common Stock on the date an order of the federal District Court approving the settlement becomes final; (d) the continued payment by the Company of applicable reasonable attorneys' fees for the individual defendants. On June 6, 2013, the Federal Court granted final approval of the Settlement Stipulation and on June 13, 2013 entered Judgment dismissing the federal derivative action with prejudice. On June 24, 2013, the State Court entered a dismissal with prejudice of the state derivative action. The Company was also required to undertake certain corporate governance reform actions, all of which are either in process of implementation or have been implemented.

A majority of the costs related to the Company's and defendants' defense of these actions was paid by the Company's insurance carriers under its director and officer insurance policies, including the securities class action settlement. Insurance proceeds paid to the Company upon settlement of the derivative litigation were $1.0 million. However, MRV paid $1.9 million in payment for services of defense counsel and other parties through December 31, 2013 above the insured amount.
In May 2014, a former customer of Tecnonet S.p.A.(Tecnonet), the Company's Italian subsidiary, filed a claim in an Italian civil court alleging that Tecnonet, and two of its third-party subcontractors, breached certain supply agreements with the customer, entered into between 2009 and 2011, by failing to have performed the contracted services. The plaintiff further alleges that Tecnonet was aware, at the time of entering into the supply agreements, that the customer’s managing director had a conflict of interest involving the subcontractors. The plaintiff is claiming damages and restitution from Tecnonet and the subcontractors, jointly and severally, of approximately $3.0 million in the aggregate, plus costs. While we believe that Tecnonet has valid defenses to the plaintiff's claims, we cannot provide assurance that such claims will not result in any liability to Tecnonet.

Nhan T. Vo, individually and on behalf of other aggrieved employees vs. the Company, Superior Court of California, County of Los Angeles. On June 27, 2013, the plaintiff in this matter filed a lawsuit against the Company alleging claims for failure to properly pay overtime or provide meal and rest breaks to its non-exempt employees in California, among other things. The complaint seeks an unspecified amount of damages and penalties under provisions of the Labor Code, including the Labor Code Private Attorneys General Act. The Company has filed an answer denying all allegations regarding the plaintiff’s claims and asserting various defenses. The Company is currently in the discovery phase of this case.  As the ultimate outcome of this matter is uncertain no amounts have been accrued by the Company as of the date of this report. Depending on the actual outcome of this case, provisions could be recorded in the future which may have a material adverse effect on the Company’s operating results.


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From time to time, MRV has received notices from third parties alleging possible infringement of patents with respect to product features or manufacturing processes. Management believes such notices are common in the communications industry because of the large number of patents that have been filed on these subjects. The Company's policy is to discuss these notices with the parties in an effort to demonstrate that MRV's products and/or processes do not violate any patents. The Company has been involved in such discussions with Alcatel-Lucent SA, Apcon, Inc., Finisar Corporation, International Business Machines, Mediacom Broadband LLC, Ortel Communications, Ltd., Nortel Networks Corporation, Rockwell Automation, Inc. and The Lemelson Foundation in the past.
MRV and its subsidiaries have been named as a defendant in other lawsuits involving matters that management considers routine to the nature of its business. Management is of the opinion that the ultimate resolution of such matters will not have a material adverse effect on our business, operating results and financial condition.
Item 1A.
Risk Factors

There have been no material changes in our risk factors from those set forth in our Annual Report on Form 10-K for the year ended December 31, 2013. For a more complete understanding of the risks associated with an investment in our securities, you should carefully consider and evaluate all of the information in this Form 10-Q, in combination with the more detailed description of our business in our 2013 Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

Issuer Purchases of Equity Securities

In August 2013, the Company's Board of Directors approved a repurchase plan for up to $7,013,838 of the Company's Common Stock. This repurchase plan expired on May 14, 2014. No repurchases were made during the three and nine months ended September 30, 2014, under this plan.
 
 
 
 
Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5  - Other Information

Adoption of Amended and Restated Bylaws

On November 5, 2014, the Company’s Board of Directors adopted the Amended and Restated Bylaws of MRV Communications, Inc. (the “Amended and Restated Bylaws”).  The Amended and Restated Bylaws adopt advance notice procedures requiring that for any stockholder to nominate persons for election to the Company’s Board of Directors or to propose other business for an annual meeting of the Company, such stockholder must notify the Company no later than 90 days and no earlier than 120 days prior to the anniversary of the prior year’s annual meeting.  The Amended and Restated Bylaws specify the information and documents that must be included in such stockholder notice. 

The Amended and Restated Bylaws also provide procedures governing stockholder proposals to call a special meeting of the stockholders.  For any stockholder to nominate persons for election to the Company’s Board of Directors or to propose other business for a special meeting of stockholders, such stockholder must notify the Company no later than 90 days and no earlier than 120 days prior to the special meeting.  The Amended and Restated Bylaws specify the information and documents that must be included in such stockholder notice. 

The foregoing description of the Amended and Restated Bylaws is not complete and is subject to and qualified in its entirety by reference to the Amended and Restated Bylaws, a copy of which is attached as Exhibit 3.1, and which Amended and Restated Bylaws are incorporated herein by reference. 


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Item 6.
Exhibits

(a)    Exhibits
No.
Description
 
 
3.1

 
Amended and Restated Bylaws of MRV Communications, Inc. (as amended through November 5, 2014)
 
 
 
31.1

 
Certification of the Principal Executive Officer required by Rule 13a-14(a) of the Exchange Act (filed herewith)
 
 
31.2

 
Certification of the Principal Financial Officer required by Rule 13a-14(a) of the Exchange Act (filed herewith)
 
 
32.1

 
Certification of the Principal Executive Officer pursuant to 18 U.S.C. Section 1350 (furnished herewith)
 
 
32.2

 
Certification of the Principal Financial Officer pursuant to 18 U.S.C. Section 1350 (furnished herewith)
 
 
 
101.INS

 
XBRL Instance Document (filed herewith)
 
 
101.SCH

 
XBRL Taxonomy Extension Schema Document (filed herewith)
 
 
101.CAL

 
XBRL Taxonomy Calculation Linkbase Document (filed herewith)
 
 
101.LAB

 
XBRL Taxonomy Label Linkbase Document (filed herewith)
 
 
101.PRE

 
XBRL Taxonomy Presentation Linkbase Document (filed herewith)
 
 
101.DEF

 
XBRL Taxonomy Extension Definition Document (filed herewith)

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SIGNATURES

Pursuant to the requirements of the Exchange Act, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized on November 5, 2014.


 
MRV COMMUNICATIONS, INC.
 
 
 
By: /s/ David S. Stehlin
 
David S. Stehlin
 
Chief Executive Officer
 
Principal Executive Officer
 
 
 
By: /s/ Mark J. Bonney
 
Mark J. Bonney
 
Chief Financial Officer
 
Principal Financial Officer

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MRV COMMUNICATIONS INC Reports