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

FORM 10-Q

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

For the quarterly period ended September 30, 2014
OR

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

For the transition period from  _ to _  .

Commission File Number: 000-49862
 

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

Delaware
 
33-0974674
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)

47448 Fremont Boulevard, Fremont, California
 
94538
(Address of principal executive offices)
 
(Zip code)

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

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

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

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

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

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

As of November 6, 2014, the registrant had 20,739,641 shares of its common stock, par value $0.001, outstanding.


PROCERA NETWORKS, INC.
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2014
INDEX

 
Page
PART I. FINANCIAL INFORMATION
 
       
 
Item 1.
 
       
   
3
       
   
4
       
   
5
       
   
6
       
   
7
       
 
Item 2.
23
       
 
Item 3.
37
       
 
Item 4.
37
       
PART II. OTHER INFORMATION
 
       
 
Item 1.
38
       
 
Item 1A. 
38
       
 
Item 2.
56
       
 
Item 3.
56
       
 
Item 4.
57
       
 
Item 5.
57
       
 
Item 6.
57
       
58
 
2

PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

Procera Networks, Inc.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except par value)

   
September 30,
2014
   
December 31,
2013
 
   
(unaudited)
   
(note)
 
ASSETS
       
Current assets:
       
Cash and cash equivalents
 
$
14,248
   
$
90,774
 
Short-term investments
   
87,921
     
15,789
 
Accounts receivable, net of allowance of $122 and $129 at September 30, 2014 and December 31, 2013, respectively
   
19,941
     
25,008
 
Inventories, net
   
15,917
     
18,836
 
Prepaid expenses and other
   
3,351
     
2,128
 
Total current assets
   
141,378
     
152,535
 
                 
Property and equipment, net
   
7,603
     
7,121
 
Intangible assets, net
   
3,320
     
6,270
 
Goodwill
   
960
     
12,326
 
Deferred tax assets
   
866
     
1,101
 
Other non-current assets
   
120
     
83
 
Total assets
 
$
154,247
   
$
179,436
 
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
 
$
3,811
   
$
7,305
 
Deferred revenue
   
11,944
     
11,633
 
Accrued liabilities
   
5,691
     
6,721
 
Total current liabilities
   
21,446
     
25,659
 
                 
Non-current liabilities:
               
Deferred revenue
   
3,116
     
3,273
 
Deferred tax liability
   
866
     
1,690
 
Deferred rent
   
122
     
143
 
Total liabilities
   
25,550
     
30,765
 
                 
Commitments and contingencies
               
                 
Stockholders’ equity:
               
Preferred stock, $0.001 par value; 15,000 shares authorized; none issued and outstanding
   
     
 
Common stock, $0.001 par value; 32,500 shares authorized; 20,730 and 20,652 shares issued and outstanding at September 30, 2014 and December 31, 2013, respectively
   
21
     
21
 
Additional paid-in capital
   
223,844
     
219,763
 
Accumulated other comprehensive loss
   
(2,856
)
   
(1,897
)
Accumulated deficit
   
(92,312
)
   
(69,216
)
Total stockholders’ equity
   
128,697
     
148,671
 
Total liabilities and stockholders’ equity
 
$
154,247
   
$
179,436
 

Note: Amounts have been derived from the December 31, 2013 audited consolidated financial statements.
 
See accompanying notes to condensed consolidated financial statements.
 
3

Procera Networks, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
2014
   
September 30,
2013
   
September 30,
2014
   
September 30,
2013
 
Sales:
               
Product sales
 
$
11,164
   
$
16,301
   
$
35,792
   
$
40,328
 
Support sales
   
4,945
     
5,032
     
15,466
     
13,015
 
Total net sales
   
16,109
     
21,333
     
51,258
     
53,343
 
Cost of sales:
                               
Product cost of sales
   
4,774
     
10,080
     
17,645
     
22,451
 
Support cost of sales
   
1,118
     
896
     
3,269
     
2,442
 
Total cost of sales
   
5,892
     
10,976
     
20,914
     
24,893
 
                                 
Gross profit
   
10,217
     
10,357
     
30,344
     
28,450
 
                                 
Operating expenses:
                               
Research and development
   
4,096
     
3,945
     
12,360
     
12,532
 
Sales and marketing
   
6,497
     
7,322
     
20,425
     
21,293
 
General and administrative
   
2,760
     
2,510
     
8,311
     
9,498
 
Impairment of goodwill and purchased intangible assets
   
12,380
     
     
12,380
     
 
Total operating expenses
   
25,733
     
13,777
     
53,476
     
43,323
 
                                 
Loss from operations
   
(15,516
)
   
(3,420
)
   
(23,132
)
   
(14,873
)
Interest and other income (expense), net
   
(356
)
   
232
     
(245
)
   
203
 
                                 
Loss before income taxes
   
(15,872
)
   
(3,188
)
   
(23,377
)
   
(14,670
)
Income tax benefit
   
(160
)
   
(205
)
   
(281
)
   
(1,688
)
Net loss
 
$
(15,712
)
 
$
(2,983
)
 
$
(23,096
)
 
$
(12,982
)
                                 
Net loss per share – basic
 
$
(0.77
)
 
$
(0.15
)
 
$
(1.13
)
 
$
(0.65
)
Net loss per share – diluted
 
$
(0.77
)
 
$
(0.15
)
 
$
(1.13
)
 
$
(0.65
)
                                 
Shares used in computing net loss per share:
                               
Basic
   
20,500
     
20,031
     
20,395
     
20,007
 
Diluted
   
20,500
     
20,031
     
20,395
     
20,007
 

See accompanying notes to condensed consolidated financial statements.
 
4

Procera Networks, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
(unaudited)

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Net loss
 
$
(15,712
)
 
$
(2,983
)
 
$
(23,096
)
 
$
(12,982
)
                                 
Unrealized gain (loss) on short-term investments
   
12
     
29
     
10
     
(21
)
Foreign currency translation adjustments
   
(829
)
   
566
     
(969
)
   
(987
)
Other comprehensive income (loss)
   
(817
)
   
595
     
(959
)
   
(1,008
)
                                 
Comprehensive loss
 
$
(16,529
)
 
$
(2,388
)
 
$
(24,055
)
 
$
(13,990
)

See accompanying notes to condensed consolidated financial statements.
 
5

Procera Networks, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
   
Nine Months Ended
September 30,
 
   
2014
   
2013
 
Cash flows from operating activities:
       
Net loss
 
$
(23,096
)
 
$
(12,982
)
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation
   
1,744
     
1,342
 
Amortization of intangible assets
   
1,135
     
1,179
 
Stock-based compensation expense:
               
Stock options
   
2,396
     
2,852
 
Restricted stock and restricted stock unit awards
   
1,333
     
962
 
Impairment of goodwill and purchased intangible assets
   
12,380
     
 
Amortization of premium on investments
   
547
     
773
 
Amortization of deferred compensation
   
64
     
4,301
 
Provision for bad debts
   
33
     
49
 
Provision for excess and obsolete inventory
   
408
     
588
 
Loss on asset disposals
   
14
     
 
Changes in deferred taxes
   
(514
)
   
(1,550
)
Changes in assets and liabilities:
               
Accounts receivable
   
4,492
     
(3,171
)
Inventories
   
1,801
     
(6,393
)
Prepaid expenses and other current assets
   
(1,694
)
   
2,205
 
Deferred compensation advanced to escrow
   
     
(2,701
)
Accounts payable
   
(3,397
)
   
(1,220
)
Accrued liabilities
   
(763
)
   
458
 
Deferred revenue
   
622
     
2,557
 
Net cash used in operating activities
   
(2,495
)
   
(10,751
)
                 
Cash flows from investing activities:
               
Purchase of Vineyard Networks Inc., net of cash received
   
     
(8,962
)
Purchase of property and equipment
   
(2,267
)
   
(2,209
)
Purchase of short-term investments
   
(111,443
)
   
(36,019
)
Sale of short-term investments
   
24,164
     
11,212
 
Maturities of short-term investments
   
14,835
     
93,120
 
Net cash provided by (used in) investing activities
   
(74,711
)
   
57,142
 
                 
Cash flows from financing activities:
               
Proceeds from issuance of common stock – exercise of options
   
352
     
428
 
Payments on notes payable
   
     
(497
)
Net cash provided by (used in) financing activities
   
352
     
(69
)
                 
Effect of exchange rates on cash and cash equivalents
   
328
     
(117
)
                 
Net increase (decrease) in cash and cash equivalents
   
(76,526
)
   
46,205
 
                 
Cash and cash equivalents, beginning of period
   
90,774
     
30,933
 
                 
Cash and cash equivalents, end of period
 
$
14,248
   
$
77,138
 
                 
Non-cash investing and financing activities:
               
Issuance of common stock in connection with Vineyard Networks Inc. acquisition
 
$
   
$
11,140
 

See accompanying notes to condensed consolidated financial statements.
 
6

Procera Networks, Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

1. DESCRIPTION OF BUSINESS

Procera Networks, Inc., a Delaware corporation (“Procera” or the “Company”), is a leading provider of Intelligent Policy Enforcement (“IPE”) solutions, based on Deep Packet Inspection technology, that enable mobile and broadband network operators and enterprises managing private networks, including higher education institutions, businesses and government entities (collectively referred to as network operators), to gain enhanced visibility into, and control of, their networks and to create and deploy new services for their end user subscribers.  The Company sells its products through its direct sales force, resellers, distributors, systems integrators and other equipment manufacturers in the Americas, Asia Pacific, Europe, Canada, Africa and the Middle East.

Procera was incorporated in 2002 and its common stock currently trades on the NASDAQ Global Select Market under the trading symbol “PKT”. The Company reincorporated from the state of Nevada to the state of Delaware in June 2013.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

Procera has prepared the condensed consolidated financial statements included herein pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) applicable to interim financial information.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with United States generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to such rules and regulations.  However, in the opinion of management, the financial statements include all the normal and recurring adjustments that are necessary to fairly present the results of the interim periods presented. The interim results presented are not necessarily indicative of results for any subsequent interim period, the year ending December 31, 2014 or any other future period. The consolidated balance sheet at December 31, 2013 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in Procera’s Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on March 11, 2014.

The condensed consolidated financial statements present the accounts of Procera and its wholly-owned subsidiaries.  All significant inter-company balances and transactions have been eliminated.

During the quarter ended March 31, 2013, the Company identified immaterial errors in the consolidated financial statements for the year ended December 31, 2012, related to the recognition of revenue from a sale to a value added reseller, the accounting for inventory and general and administrative fee accruals. Based on a quantitative and qualitative analysis of the errors as required by authoritative guidance, management concluded that the errors had no material impact on any of the Company’s previously issued financial statements, are immaterial to the Company’s results for the first quarter of 2013 and full year 2013 results, and had no material effect on the trend of the Company’s financial results. As a result of the immaterial errors discussed above, the unaudited condensed consolidated financial statements for the nine months ended September 30, 2013 reflect the following immaterial adjustments: the reversal of a revenue deal resulting in a reduction of $0.6 million of revenue and a reduction of $0.2 million of cost of sales, inventory charges resulting in an increase of $0.4 million in cost of sales and additional general and administrative costs of $43,000.
 
7

Significant Accounting Policies

The accounting and reporting policies of the Company conform to GAAP.  There have been no significant changes in the Company’s significant accounting policies during the three and nine months ended September 30, 2014 compared to what was previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on March 11, 2014.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers”, issued as a new Topic, Accounting Standards Codification (“ASC”) Topic 606.  The new revenue recognition standard provides a five-step analysis of transactions to determine when and how revenue is recognized.  The core principle of the guidance is that a company should recognize revenue to depict the transfer of promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  This ASU is effective beginning in fiscal year 2017 and can be adopted by the Company either retrospectively or as a cumulative-effect adjustment as of the date of adoption.  The Company is currently evaluating the effect that adopting this new accounting guidance will have on its consolidated results of operations, cash flows and financial position.

In June 2014, the FASB issued ASU 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 the existing guidance in ASC 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: (1) prospectively to all awards granted or modified after the effective date; or (2) 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.  The adoption of ASU 2014-12 is not expected to have a material effect on the Company’s consolidated financial statements or disclosures.

In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements”, which provides new guidance related to the disclosures around going concern.  The new standard provides guidance around management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted.  The adoption of this standard is not expected to have a material impact on the Company’s consolidated financial statements.

3. CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

The following is a summary of cash equivalents and short-term investments by type of instrument at September 30, 2014 and December 31, 2013 (in thousands):

   
September 30, 2014
 
   
Amortized
   
Gross Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
Treasury and agency notes and bills
 
$
54,567
   
$
26
   
$
(4
)
 
$
54,589
 
Corporate bonds
   
26,210
     
7
     
(8
)
   
26,209
 
Commercial paper
   
9,120
     
3
     
     
9,123
 
Money market funds
   
737
     
     
     
737
 
Total investments
 
$
90,634
   
$
36
   
$
(12
)
 
$
90,658
 
                                 
Reported as:
                               
Cash equivalents
 
$
2,737
   
$
   
$
   
$
2,737
 
Short-term investments
   
87,897
     
36
     
(12
)
   
87,921
 
Total
 
$
90,634
   
$
36
   
$
(12
)
 
$
90,658
 
 
8

   
December 31, 2013
 
   
Amortized
   
Gross Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
Money market funds
 
$
79,869
   
$
   
$
   
$
79,869
 
Commercial paper
   
15,776
     
13
     
     
15,789
 
Total investments
 
$
95,645
   
$
13
   
$
   
$
95,658
 
                                 
Reported as:
                               
Cash equivalents
 
$
79,869
   
$
   
$
   
$
79,869
 
Short-term investments
   
15,776
     
13
     
     
15,789
 
Total
 
$
95,645
   
$
13
   
$
   
$
95,658
 

As of September 30, 2014, all investments were classified as available-for-sale with unrealized gains and losses recorded as a separate component of accumulated other comprehensive loss.  Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase.  Short-term investments have a remaining maturity of greater than three months at the date of purchase. The weighted average maturity of the portfolio does not exceed 12 months.  As of September 30, 2014, the Company had $22.0 million in investments with a maturity of greater than one year.  However, management has the ability, if necessary, to liquidate any of its investments in order to meet the Company’s liquidity needs in the next 12 months.  Accordingly, investments with contractual maturities greater than one year from the date of purchase are classified as short-term on the accompanying condensed consolidated balance sheets.  None of the Company’s short-term investments have been at a continuous unrealized loss position for greater than 12 months.

The Company reviews its investments for impairment quarterly.  For investments with an unrealized loss, the factors considered in the review include the credit quality of the issuer, the duration that the fair value has been less than the adjusted cost basis, severity of impairment, reason for the decline in value and potential recovery period, the financial condition and near-term prospects of the investees, and whether the Company would be required to sell an investment due to liquidity or contractual reasons before its anticipated recovery.  Based on its review, the Company did not identify any investments that were other-than-temporarily impaired during the three and nine months ended September 30, 2014.

The Company did not incur any material realized gains or losses in any of the three and nine months ended September 30, 2014 or 2013.  The cost of securities sold was determined based on the specific identification method.

4. FAIR VALUE MEASUREMENTS

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

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

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

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

Level 3- Unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of assets or liabilities.
 
9

The following is a summary of cash equivalents and short-term investments by type of instrument as of September 30, 2014 and December 31, 2013, measured at fair value on a recurring basis (in thousands):

   
September 30, 2014
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Money market funds
 
$
737
   
$
   
$
   
$
737
 
Treasury and agency notes and bills
   
     
54,589
     
     
54,589
 
Corporate bonds
   
     
26,209
     
     
26,209
 
Commercial paper
   
     
9,123
     
     
9,123
 
Total assets measured at fair value
 
$
737
   
$
89,921
   
$
   
$
90,658
 
 
   
December 31, 2013
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Money market funds
 
$
79,869
   
$
   
$
   
$
79,869
 
Commercial paper
   
     
15,789
     
     
15,789
 
Total assets measured at fair value
 
$
79,869
   
$
15,789
   
$
   
$
95,658
 

In general, and where applicable, the Company uses quoted market prices in active markets for identical assets to determine fair value.  This pricing methodology applies to Level 1 investments which are comprised of money market funds.  If quoted prices in active markets for identical assets are not available, then the Company uses quoted prices for similar assets or inputs other than quoted prices that are observable, either directly or indirectly.  These investments are included in Level 2 and consist of commercial paper, U.S. agency securities and U.S. Government and corporate bonds. U.S. agency securities and U.S. Government and corporate bonds are valued at a consensus price, which is a weighted average price based on market prices from a variety of industry standard data providers used as inputs to a distribution-curve based algorithm. Commercial paper is valued using market prices where available, adjusting for accretion of the purchase price to face value at maturity.

The Company did not have any transfers between Level 1 and Level 2 fair value instruments during any of the three or nine months ended September 30, 2014 or 2013.

5. ACQUISITIONS

On January 9, 2013, the Company completed its acquisition of Vineyard Networks Inc. (“Vineyard”), a privately held developer of Layer 7 Deep Packet Inspection (“DPI”) and application classification technology located in Kelowna, Canada. Vineyard’s integrated DPI and application classification technology provides enterprise and service provider networking infrastructure vendors with these capabilities through its integrated software suite, primarily through a variety of subscription based original equipment manufacturer and partner agreements.  This acquisition complements the Company’s hardware and application software-based IPE and DPI solutions.

The total purchase price was $20.9 million, consisting of $9.8 million cash consideration and $11.1 million in the Company’s common stock in exchange for 100% of the outstanding securities of Vineyard.  Of the consideration paid, $2.0 million and $1.9 million in cash and stock, respectively, was placed into escrow for a period of 18 or 36 months from the closing of the acquisition and to be released subject to resolution of certain contingencies.  In July 2014, $1.9 million and $1.8 million in cash and stock, respectively, was released from escrow.  In addition to the purchase consideration, the Company recorded deferred compensation of $5.9 million, consisting of $2.7 million in cash consideration and $3.2 million in the Company’s common stock, related to retention agreements with Vineyard’s three founders, which was disbursed from the escrow account in January 2014 after one year of continuous employment with the Company.  The Company recognized no compensation costs and $0.1 million in compensation costs related to these retention agreements for the three and nine months ended September 30, 2014, respectively. The Company recognized $1.5 million and $4.3 million in compensation costs related to these retention agreements for the three and nine months ended September 30, 2013, respectively.
 
10

For the three and nine months ended September 30, 2014, Vineyard contributed $1.2 million and $3.3 million in revenue, respectively, and $12.9 million and $13.6 million in net loss, respectively, of which $12.4 million relates to the Company’s impairment charge recorded in the three months ended September 2014. See Note 6 – “Goodwill and Intangible Assets” for additional details.  For the three and nine months ended September 30, 2013, Vineyard contributed $0.8 million and $1.7 million in revenue, respectively, and $0.6 million and $1.7 million in net loss, respectively.

The Company recognized acquisition-related costs for Vineyard of $1.0 million during the first quarter of 2013. These acquisition-related charges were expensed in the period incurred and reported in the Company’s condensed consolidated statements of operations within general and administrative expenses.

The following table summarizes the net assets and liabilities acquired, including identifiable intangible assets, based on their respective fair values at the acquisition date (in thousands):

Assets acquired
   
Cash
 
$
822
 
Accounts receivable
   
525
 
Other current assets
   
2,095
 
Identifiable intangible assets
   
8,460
 
Goodwill (1)
   
12,346
 
Other assets
   
303
 
Total assets acquired
   
24,551
 
Liabilities assumed
       
Accounts payable and other accrued liabilities
   
420
 
Deferred revenue
   
555
 
Notes payable
   
511
 
Deferred tax liability
   
2,141
 
Total liabilities assumed
   
3,627
 
Net assets acquired
 
$
20,924
 

  (1) The Company made an election under Section 338(g) of the Internal Revenue Code of 1986, as amended, which resulted in tax-deductible goodwill related to the Vineyard transaction. The Company estimated that the tax-deductible goodwill and intangibles resulting from the election will approximate $17.6 million, to be amortized for U.S. tax purposes over a 15 year period that began on January 1, 2014.

Intangible Assets Acquired

The following table presents details of the intangible assets acquired in connection with the acquisition of Vineyard, which was completed during the first quarter of 2013 (in thousands, except years):

   
Estimated Useful Life
(in years)
   
Amount
 
Developed technology
   
5
   
$
5,910
 
Customer relationships
   
5
     
2,550
 
Total
         
$
8,460
 
 
11

Acquired technology consists of existing research and development projects at the time of the acquisition that have reached technological feasibility. No in-process research and development was included in acquired intangible assets as of the acquisition date.

Pro Forma Financial Information

The following tables summarize the supplemental condensed consolidated statements of operations information on an unaudited pro forma basis as if the acquisition of Vineyard occurred on January 1, 2012 and include adjustments that were directly attributable to the foregoing transaction or were not expected to have a continuing impact on the Company.  The acquisition of Vineyard was included in the results of operations as of the acquisition date of January 9, 2013.  The pro forma results are for illustrative purposes only for the applicable period and do not purport to be indicative of the actual results that would have occurred had the transaction been completed as of the beginning of the period, nor are they indicative of results of operations that may occur in the future (in thousands, except per share amounts):
 
 
Three Months Ended
September 30,
2013
Nine Months Ended
September 30,
2013
Pro forma revenues
 
$
21,440
   
$
54,474
 
Pro forma net loss
   
(1,408
)
   
(6,393
)
Basic and diluted loss per share
 
$
(0.07
)
 
$
(0.31
)

The pro forma financial information reflects acquisition-related expenses incurred, pro forma adjustments for the additional amortization associated with finite-lived intangible assets acquired, deferred compensation costs related to the retention of certain Vineyard employees, the change in stock compensation expense as a result of the exercise of stock options immediately prior to the closing of the Vineyard transaction, stock compensation related to the stock options granted to Vineyard employees, and the related tax expense. The pro forma net loss per share amounts also reflect the impact of the issuance of 518,000 shares in connection with the acquisition as if they were issued in January 2012.

These adjustments are as follows (in thousands):

   
Three Months Ended
September 30,
2013
   
Nine Months Ended
September 30,
2013
 
Acquisition-related expenses for Vineyard
 
$
   
$
(1,026
)
Intangible amortization
   
     
36
 
Net change in stock compensation expense
   
     
(636
)
Decrease in deferred compensation expense
   
(1,468
)
   
(4,279
)
Increase in weighted average common shares outstanding for shares issued and not already included in the weighted average common shares outstanding
   
302
     
309
 
 
12

6. GOODWILL AND INTANGIBLE ASSETS
 
Changes in the carrying value of goodwill for the nine months ended September 30, 2014 were as follows (in thousands):
 
 
Nine Months Ended
September 30,
2014
Balance at December 31, 2013
 
$
12,326
 
Impairment of goodwill
   
(10,840
)
Translation adjustments
   
(526
)
Balance at September 30, 2014
 
$
960
 

The Company reviews its goodwill for impairment annually during the fourth quarter of the year or more frequently if events or circumstances indicates that an impairment loss may have occurred.  The identification and measurement of goodwill impairment involves the estimation of fair value at a reporting unit level.

During the third quarter of fiscal year 2014, the Company considered the effect of the economic environment in which its Network Application Visibility Library (“NAVL”) reporting unit markets its products and determined that sufficient indicators existed requiring it to perform an interim impairment review of NAVL goodwill.  The indicators consisted primarily of: (1) decelerating revenue growth during the third quarter of fiscal year 2014 and a decline in forecasted revenue in future quarters, and (2) lower than anticipated total addressable market for NAVL products.

The Company performed an impairment review for goodwill at the NAVL reporting unit level.  In step one, the fair value of the NAVL reporting unit was compared to the carrying value.  Based on this review, the Company determined that the carrying value exceeded the fair value indicating potential impairment. Therefore, the Company next performed step two, in which the fair value of the reporting unit was allocated to all of the assets and liabilities of the reporting unit on a fair value basis, including any unrecognized intangible assets, with any excess representing the implied fair value of goodwill.  The fair value was determined using an income approach.  Under the income approach, the present value of estimated future cash flows is determined based on management’s forecast of revenue growth rates and operating margins.  As a result of reduced revenue growth rate assumptions associated with the impairment indicators noted above, the implied fair value of NAVL goodwill was determined to be zero.  Therefore, the Company recorded an impairment charge for goodwill of $10.8 million during the third quarter of fiscal year 2014, 100% of the NAVL goodwill balance at September 30, 2014.  The impairment charge is included in the Company’s consolidated statement of operations.  The Company also recognized a deferred tax benefit of $0.1 million associated with the goodwill impairment charge.

No indicators were present during the third quarter of 2014 that would suggest impairment of the Company’s remaining goodwill balance of $960,000, assigned to the Company’s PacketLogic reporting unit.  The goodwill assigned to the Company’s PacketLogic reporting unit will be tested for impairment during the fourth quarter of 2014 in connection with the Company’s routine annual review of goodwill.

The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable.  Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset.  Measurement of an impairment loss for long-lived assets is based on the amount by which the carrying value of the asset exceeds its fair value based on the discounted future cash flows.
 
13

As a result of the indicators noted above, the Company also evaluated the long-lived assets within the NAVL reporting unit for impairment.  Such assets include acquired intangible assets and property, plant and equipment.  The asset group evaluated included the entire NAVL reporting unit.  The Company determined that the sum of the undiscounted future cash flows of the NAVL reporting unit did not exceed the carrying value of NAVL assets, indicating potential impairment. As a result, the fair value was determined for NAVL long-lived assets using an income approach as described above, which was then compared to the assets’ relative carrying values.  As a result of reduced revenue growth rate assumptions associated with the impairment indicators noted above, the Company determined that the fair value of the NAVL intangible assets was below their carrying value, resulting in a partial impairment of the NAVL intangible assets.  The Company recorded impairment charges for the third quarter of fiscal year 2014 of $0.7 million related to developed technology and $0.8 million related to customer relationships.  The impairment charges are included in the Company’s consolidated statement of operations.

Intangible assets other than goodwill are amortized on a straight-line basis over their estimated remaining useful lives.

The following table is a summary of acquired intangible assets with remaining net book values at September 30, 2014 and December 31, 2013 (in thousands, except weighted average remaining life):
 
 
September 30, 2014
 
Gross
Carrying
Value
Accumulated Amortization
Impairment Charge
Net
Carrying
Value
Weighted Average Remaining Life
Developed technology
 
$
5,189
   
$
(1,794
)
 
$
(705
)
 
$
2,690
     
3.27
 
Customer relationships
   
2,239
     
(774
)
   
(835
)
   
630
     
3.27
 
Balance at September 30, 2014
 
$
7,428
   
$
(2,568
)
 
$
(1,540
)
 
$
3,320
         
 
December 31, 2013
 
Gross
Carrying
Value
Accumulated
Amortization
Net
Carrying
Value
Weighted Average Remaining Life
Developed technology
 
$
5,446
   
$
(1,066
)
 
$
4,380
     
4.01
 
Customer relationships
   
2,350
     
(460
)
   
1,890
     
4.01
 
Balance at December 31, 2013
 
$
7,796
   
$
(1,526
)
 
$
6,270
         

For each of the three and nine months ended September 30, 2014 and September 30, 2013, amortization expense of $0.3 million and $0.8 million, respectively, related to developed technology was recorded in product cost of sales.  For the three and nine months ended September 30, 2014, amortization expense of $0.1 million and $0.3 million, respectively, related to customer relationships was recorded in operating expense.  For the three and nine months ended September 30, 2013, amortization expense of $0.2 million and $0.4 million, respectively, related to customer relationships was recorded in operating expense.

The changes in the carrying value of acquired intangible assets during the nine months ended September 30, 2014 were as follows (in thousands):

   
Gross
Carrying
Value
   
Accumulated
Amortization
   
Net
Carrying
Value
 
Balance at December 31, 2013
 
$
7,796
   
$
(1,526
)
 
$
6,270
 
Impairment of purchased intangible assets
   
(1,540
)
   
     
(1,540
)
Additions
   
     
(1,135
)
   
(1,135
)
Translation adjustments
   
(368
)
   
93
     
(275
)
Balance at September 30, 2014
 
$
5,888
   
$
(2,568
)
 
$
3,320
 
 
14

The following table presents the estimated future amortization of intangible assets as of September 30, 2014 (in thousands):

Fiscal Year
 
Amortization
 
2014 (remaining three months)
 
$
253
 
2015
   
1,015
 
2016
   
1,015
 
2017
   
1,015
 
2018
   
22
 
Total
 
$
3,320
 

7. CERTAIN FINANCIAL STATEMENT INFORMATION

Inventories

Inventories are stated at the lower of cost, which approximates actual costs on a first in, first out basis, or market. Inventories at September 30, 2014 and December 31, 2013 consisted of the following (in thousands):

   
September 30,
2014
   
December 31,
2013
 
Finished goods
 
$
15,746
   
$
18,617
 
Raw materials
   
171
     
219
 
Inventories, net
 
$
15,917
   
$
18,836
 

Property and Equipment

The following is a summary of property and equipment at September 30, 2014 and December 31, 2013 (in thousands):

   
September 30,
2014
   
December 31,
2013
 
Machinery and equipment
 
$
11,114
   
$
9,343
 
Computer equipment
   
605
     
488
 
Office furniture and equipment
   
411
     
387
 
Leasehold improvements
   
568
     
539
 
Software
   
293
     
326
 
Accumulated depreciation
   
(5,388
)
   
(3,962
)
Property and equipment, net
 
$
7,603
   
$
7,121
 

Accrued Liabilities

Accrued liabilities at September 30, 2014 and December 31, 2013 consisted of the following (in thousands):

   
September 30,
2014
   
December 31,
2013
 
Payroll and related
 
$
3,036
   
$
3,179
 
Sales commissions
   
928
     
1,608
 
Warranty
   
87
     
131
 
Audit and legal services
   
138
     
198
 
Other
   
1,502
     
1,605
 
Total accrued liabilities
 
$
5,691
   
$
6,721
 
 
15

Warranty Reserve

The Company warrants its products against material defects for a specific period of time, generally 12 months. The Company provides for the estimated future costs of warranty obligations in cost of sales when the related revenue is recognized. The accrued warranty costs represent the best estimate at the time of sale of the total costs that the Company expects to incur to repair or replace product parts which fail while still under warranty.  The amount of accrued estimated warranty costs is primarily based on current information on repair costs.  The Company periodically reviews the accrued balances and updates the accrual based on historical warranty cost trends.

The following table summarizes warranty reserve activity during the nine months ended September 30, 2014 and 2013 (in thousands):

   
Nine Months Ended
September 30,
 
   
2014
   
2013
 
Warranty accrual, beginning of period
 
$
131
   
$
406
 
Provision for current period sales
   
54
     
 
Changes in liability for pre-existing warranties
   
(20
)
   
(56
)
Deductions for warranty claims processed during the period
   
(78
)
   
(116
)
Warranty accrual, end of period
 
$
87
   
$
234
 

Accumulated Other Comprehensive Loss

The components of accumulated other comprehensive loss as of September 30, 2014 and December 31, 2013, net of taxes, were as follows (in thousands):

   
Foreign Currency Translation Adjustments
   
Net Unrealized Gain (Loss) on Short-Term Investments
   
Total
 
Accumulated other comprehensive loss as of December 31, 2013
 
$
(1,910
)
 
$
13
   
$
(1,897
)
Other comprehensive gain (loss), net of tax
   
(969
)
   
10
     
(959
)
Accumulated other comprehensive loss as of September 30, 2014
 
$
(2,879
)
 
$
23
   
$
(2,856
)

The Company did not have any reclassifications out of accumulated other comprehensive loss for the three and nine months ended September 30, 2014.  The Company did not have any other-than-temporary loss on its available-for-sale securities for all periods presented.
 
16

8. STOCKHOLDERS’ EQUITY

Common Stock Transactions

On January 9, 2013, the Company issued 825,060 unregistered shares with a value of $14.3 million, pursuant to the Company’s acquisition of Vineyard as part of the purchase consideration in exchange for 100% of the outstanding securities of Vineyard and deferred compensation to the founders of Vineyard.  On February 13, 2013, the Company filed with the SEC a Registration Statement on Form S-3 covering the resale of these shares.  The Registration Statement on Form S-3 was declared effective by the SEC on March 7, 2013.  Pursuant to the Vineyard acquisition agreement, 518,000 shares were transferred to the former Vineyard shareholders at closing, with the remainder being held in escrow for a period of 12, 18 or 36 months from the closing of the acquisition.  In January 2014, 178,536 shares were released from the escrow related to the retention agreements with Vineyard’s three founders after one year of continuous employment with the Company.  In July 2014, 123,744 shares were released from escrow related to the resolution of certain contingencies. As of September 30, 2014, 5,084 shares remain in escrow.

Stock Incentive Plans

The Company’s 2007 Equity Incentive Plan, as amended (the “Plan”), provides for the grant of stock options, restricted stock awards and restricted stock unit awards to eligible employees, consultants and non-employee directors of the Company.  As of September 30, 2014, 386,424 shares of the Company’s common stock were available for future grant under the Plan.  On January 9, 2013, the Company granted to certain former Vineyard employees who became employees of the Company upon the closing of the Vineyard acquisition options to purchase an aggregate of 412,000 shares of the Company’s common stock.  These options were granted outside of the Plan as inducements material to such employees joining the Company.

The following table summarizes the Company’s stock option activity for the nine months ended September 30, 2014 and 2013 (in thousands, except per share data):

   
Nine Months Ended September 30,
 
   
2014
   
2013
 
   
Options
   
Weighted
Average
Exercise
Price
   
Options
   
Weighted
Average
Exercise
Price
 
Outstanding at the beginning of the period
   
1,824
   
$
15.07
     
1,332
   
$
14.65
 
Granted
   
152
     
11.34
     
622
     
16.25
 
Exercised
   
(62
)
   
5.67
     
(54
)
   
7.78
 
Cancelled
   
(286
)
   
14.75
     
(240
)
   
18.67
 
Outstanding at the end of the period
   
1,628
   
$
15.14
     
1,660
   
$
15.23
 
Vested and expected to vest at the end of the period
   
1,532
   
$
15.10
     
1,555
   
$
15.08
 
Exercisable at the end of the period
   
850
   
$
14.25
     
609
   
$
11.40
 

As of September 30, 2014, the aggregate intrinsic value of the Company’s options outstanding, options vested and expected to vest and options exercisable each were $0.8 million.  As of September 30, 2014, the weighted average remaining contractual life of options outstanding, options vested and expected to vest and options exercisable was 7.56 years, 7.48 years and 6.53 years, respectively.  The total intrinsic value of options exercised during each of the three and nine months ended September 30, 2014 was $0.3 million.  The total intrinsic value of options exercised during the three and nine months ended September 30, 2013 was $0.2 million and $0.4 million, respectively.
 
17

The weighted average remaining contractual life and weighted average per share exercise price of options outstanding and of options exercisable as of September 30, 2014 were as follows (in thousands, except exercise prices and years):

   
Options Outstanding
   
Options Exercisable
 
Range of Exercise Prices
   
Number of Shares
   
Weighted Average Remaining Contractual Life (years)
   
Weighted Average Exercise Price
   
Number of Shares
   
Weighted Average Exercise Price
 
$
4.30 – $5.70
     
132
     
5.43
   
$
5.08
     
129
   
$
5.07
 
 
6.00 – 9.72
     
131
     
5.45
     
7.71
     
105
     
7.27
 
 
9.76 – 14.49
     
509
     
9.32
     
13.63
     
210
     
13.66
 
 
14.50 – 28.70
     
856
     
8.05
     
18.71
     
406
     
19.27
 
$
4.30 – $28.70
     
1,628
     
7.56
   
$
15.14
     
850
   
$
14.25
 

The following table summarizes the Company’s restricted stock award and restricted stock unit activity for the nine months ended September 30, 2014 and 2013 (in thousands, except per share data):
 
 
Nine Months Ended September 30,
 
2014
2013
 
Awards
Weighted
Average
Grant Date
Fair Value
Awards
Weighted
Average
Grant Date
Fair Value
Unvested outstanding at the beginning of the period
   
302
   
$
16.63
     
253
   
$
15.79
 
Granted
   
317
     
10.67
     
40
     
14.45
 
Vested
   
(42
)
   
14.89
     
(18
)
   
19.05
 
Cancelled
   
(19
)
   
13.08
     
(1
)
   
20.25
 
Unvested outstanding at the end of the period
   
558
   
$
13.49
     
274
   
$
15.36
 

The weighted average remaining contractual term for the unvested restricted stock awards and restricted stock units outstanding as of September 30, 2014 was 2.77 years.

9. NET INCOME (LOSS) PER SHARE

Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted net income per share reflects the potential dilution that could occur from common shares issuable upon the exercise of outstanding stock options or warrants and the vesting of restricted stock awards and restricted stock units, which are reflected in diluted earnings per share by application of the treasury stock method.  Under the treasury stock method, the amount that the employee must pay for exercising stock options or warrants, the amount of stock-based compensation cost for future services that the Company has not yet recognized, and the amount of tax benefit that would be recorded in additional paid-in capital upon exercise of options and warrants are assumed to be used to repurchase shares.
 
18

The following table sets forth the computation of basic and diluted net loss per share and potential shares of common stock that are not included in the diluted net loss per share calculation because their effect is anti-dilutive (in thousands, except per share data):

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
 
 
2014
   
2013
   
2014
   
2013
 
Numerator:
               
Net loss
 
$
(15,712
)
 
$
(2,983
)
 
$
(23,096
)
 
$
(12,982
)
                                 
Denominator:
                               
Weighted average common shares - basic
   
20,500
     
20,031
     
20,395
     
20,007
 
Weighted average common shares - diluted
   
20,500
     
20,031
     
20,395
     
20,007
 
                                 
Net loss per share:
                               
Basic
 
$
(0.77
)
 
$
(0.15
)
 
$
(1.13
)
 
$
(0.65
)
Diluted
 
$
(0.77
)
 
$
(0.15
)
 
$
(1.13
)
 
$
(0.65
)
                                 
Antidilutive securities:
                               
Options, restricted stock and restricted stock units
   
1,322
     
1,192
     
1,361
     
1,185
 

10. STOCK-BASED COMPENSATION

The following table summarizes employee stock-based compensation expense, net of income tax, as it relates to the Company’s statement of operations for the three and nine months ended September 30, 2014 and 2013 (in thousands):

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Cost of goods sold
 
$
92
   
$
101
   
$
282
   
$
281
 
Research and development
   
314
     
218
     
998
     
933
 
Sales and marketing
   
443
     
385
     
1,249
     
1,348
 
General and administrative
   
429
     
365
     
1,200
     
1,252
 
Total stock-based compensation expense
 
$
1,278
   
$
1,069
   
$
3,729
   
$
3,814
 

Stock-based compensation in the three and nine months ended September 30, 2013 includes a one-time $0.7 million charge associated with the acceleration of Vineyard option grants at the closing of the acquisition.

No stock-based compensation related income tax benefits were recognized in any of the three or nine months ended September 30, 2014 or 2013 due to operating losses.  No stock-based compensation has been capitalized in inventory due to the immateriality of such amounts.

As of September 30, 2014, total unrecognized compensation cost related to unvested stock options was $6.2 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 2.56 years.

As of September 30, 2014, total unrecognized compensation cost related to unvested restricted stock awards and restricted stock units was $5.0 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 2.77 years.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model.  The fair value of each restricted stock award and restricted stock unit is calculated based upon the closing stock price of the Company’s common stock on the date of grant.  The expense for stock-based awards is recognized over the requisite service period using the straight-line attribution approach.
 
19

The following assumptions were used in determining the fair value of stock options granted during the three and nine months ended September 30, 2014 and 2013:

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Expected term (years)
   
5.84
     
4.77
     
5.12
     
4.84
 
Expected volatility
   
63.5
%
   
78.2
%
   
66.26
%
   
78.2
%
Risk-free interest rate
   
1.80
%
   
1.43
%
   
1.62
%
   
0.92
%
Expected dividend yield
   
0
%
   
0
%
   
0
%
   
0
%

The weighted average grant date fair value of options granted during the nine months ended September 30, 2014 and 2013 was $5.54 and $8.71, respectively.

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

11. COMMITMENTS AND CONTINGENCIES

Legal

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

Operating Leases

The Company leases its operating and office facilities for various terms under long-term, non-cancelable operating lease agreements.  The leases expire at various dates through 2024.  In the normal course of business, it is expected that these leases will be renewed or replaced by leases on other properties.  The leases provide for increases in future minimum annual rental payments based on defined increases which are generally meant to correlate with the Consumer Price Index, subject to certain minimum increases.  Also, the lease agreements generally require the Company to pay executory costs (real estate taxes, insurance and repairs).

As of September 30, 2014, future minimum lease payments due under operating leases were as follows (in thousands):

Fiscal years ending December 31,
 
Amount
 
2014 (remaining three months)
 
$
247
 
2015
   
870
 
2016
   
824
 
2017
   
693
 
2018
   
419
 
Thereafter
   
1,433
 
Total minimum lease payments
 
$
4,486
 

 
 
 
 
 

 
 
 
20

Purchase Commitments

The Company issues purchase orders to third-party suppliers that may not be cancelable.  As of September 30, 2014, the Company had open non-cancelable purchase orders amounting to $7.7 million, primarily with the Company’s third-party suppliers.  In addition, in October 2014, the Company issued a purchase order to one of its main hardware suppliers for $7.9 million.  If certain shipment date milestones are not met, the Company may reduce the number of committed hardware orders.

In March 2014, the Company entered into a lease agreement with B.C. Ltd, as landlord, relating to office space located in Kelowna, British Columbia. Tenant improvements were completed near the end of October 2014, and the Company is in the process of moving its Canadian offices to this new location.  The Company accrued a liability of $0.6 million associated with the construction of the leasehold improvements beginning in the leasehold construction period of May 2014 to October 2014. Payments to reduce the liability will begin in November 2014.

Concentrations

For the three months ended September 30, 2014, one customer represented 37% of net revenue, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2014, one customer represented 11% of net revenue, with no other single customer accounting for more than 10% of net revenue.For the three months ended September 30, 2013, revenue from two customers represented 33% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2013, revenue from Shaw Communications, Inc. represented 13% of net revenue, and two other customers represented 13% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue. 

At September 30, 2014, accounts receivable from two customers represented 31% and 12% of total accounts receivable, with no other single customer accounting for more than 10% of the accounts receivable balance.  At December 31, 2013, accounts receivable from one customer represented 32% of total accounts receivable, with no other single customer accounting for more than 10% of the accounts receivable balance. As of September 30, 2014 and December 31, 2013, 80% and 86%, respectively, of the Company’s total accounts receivable were due from customers outside the United States.

Indemnification

The Company generally agrees to indemnify customers against legal claims that the Company’s products infringe certain third party property rights. As of September 30, 2014, the Company had not been required to make any payments resulting from infringement claims asserted against customers and had not recorded any related reserves.

12. INCOME TAXES

The Company's effective tax rate was 1% for the nine months ended September 30, 2014 and 12% for the nine months ended September 30, 2013.  For the three and nine months ended September 30, 2014, the Company recorded an income tax benefit of $0.2 million and $0.3 million, respectively, on a loss before provision for income taxes of $15.9 million and $23.4 million, respectively.  For the three and nine months ended September 30, 2013, the Company recorded an income tax benefit of $0.2 million and $1.7 million, respectively, on a loss before provision for income taxes of $3.2 million and $14.7 million, respectively.  The effective tax rate for the nine months ended September 30, 2014 differs from the federal statutory tax rate as a result of the valuation allowance placed on the Canadian net deferred tax asset, state taxes, foreign withholding taxes, earnings taxed in foreign jurisdictions and unbenefited losses. The effective tax rate for the nine months ended September 30, 2013 differs from the federal statutory tax rate as a result of the amortization of acquired intangible assets, state taxes, earnings taxed in foreign jurisdictions and unbenefited losses.

Since inception, the Company established a valuation allowance for its deferred tax assets in all jurisdictions except for the Canadian deferred tax assets.  At September 30, 2014, the Company has placed a valuation allowance against the Canadian deferred tax assets in excess of its deferred tax liabilities.
 
21

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

The Company recognizes interest and penalties related to uncertain tax positions in income tax expense.  As of September 30, 2014, the Company had no accrued interest or penalties related to uncertain tax positions.   The Company’s federal returns for the years ended 2010 through the current period and most state returns for the years ended 2009 through the current period remain open to examination.  In addition, all of the net operating losses and research and development credit carryforwards that may be used in future years are still subject to adjustment.  The Company is also subject to examinations in Australia, Canada, Japan, Singapore and Sweden beginning in 2006 through the current period.

At September 30, 2014, the Company had $0.2 million of unrecognized tax benefits which would affect the Company’s effective tax rate if recognized. The Company does not anticipate that the total unrecognized tax benefits will change significantly over the next 12 months.

13. SEGMENT INFORMATION

The Company operates in one business segment providing specialized products and related services that enable network operators to manage and control their networks.  Sales for geographic regions are based upon the customer’s location.  The location of long-lived assets is based on the physical location of the Company’s regional offices.

The following are summaries of net sales by geographical region (in thousands):

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Sales:
               
Europe, Middle East and Africa
 
$
9,202
   
$
9,737
   
$
24,106
   
$
19,108
 
United States
   
2,983
     
4,572
     
10,000
     
13,916
 
Asia Pacific
   
3,061
     
5,316
     
11,549
     
11,918
 
Canada and Latin America
   
863
     
1,708
     
5,603
     
8,401
 
Total
 
$
16,109
   
$
21,333
   
$
51,258
   
$
53,343
 

The following are summaries of property and equipment, net, by geographical region (in thousands):

   
September 30,
2014
   
December 31,
2013
 
Property and equipment, net:
       
United States
 
$
1,267
   
$
1,444
 
Canada
   
1,803
     
1,019
 
Europe
   
4,527
     
4,655
 
Asia Pacific
   
6
     
3
 
Total
 
$
7,603
   
$
7,121
 
 
22

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

The following unaudited discussion and analysis of financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on March 11, 2014.

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

Cautionary Note Regarding Forward-Looking Statements

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

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

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

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

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

our liquidity and financial resources, including anticipated capital expenditures, funding of capital expenditures and anticipated levels of indebtedness; and

our expectations regarding our financial results for fiscal year 2014 and subsequent periods.

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

We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. We also provide cautionary discussion of risks and uncertainties related to our businesses which are identified under the caption “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q.  We believe these factors, individually or in the aggregate, as well as general risks and uncertainties such as those relating to general economic conditions and demand for our products and services, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties.
 
23

Overview

We are a leading provider of Internet Intelligence solutions designed for network operators worldwide. Our solutions are focused on enhancing the subscriber experience in fixed, mobile and enterprise broadband networks.  Our PacketLogic solutions are targeted towards service providers, and enable operators to gain insights and take action to deliver personalized services with a high quality of experience.  Telecom and network equipment vendors use our Network Application Visibility Library, or NAVL, solutions to enhance their products by adding application intelligence to their portfolio.  We believe that the intelligence our products provide about users and their usage enables our network operator customers to make better business decisions that result in greater profitability and to deliver a better broadband experience.  Our network operator customers include service provider customers and enterprises.  Our service provider customers include mobile service providers and broadband service providers, which include cable multiple system operators and internet service providers.  Our enterprise customers include educational institutions, commercial enterprises and government and municipal agencies.  We sell our products directly to network operators through partners, value added resellers and system integrators, and to other network solution suppliers for incorporation into their network solutions.

Our Internet Intelligent products are classified as part of the high-growth Deep Packet Inspection, or DPI, market for mobile packet and broadband core products.  The market for DPI products was $1.4 billion in 2013 and is expected to grow to $2.9 billion in 2018, a 2013 to 2018 compounded annual growth rate of 14%.  Our bundled products containing hardware and software elements deliver a solution that is a key element of the mobile packet and broadband core ecosystems.  Our technology is transitioning to a software-focused solution as the trends in Network Function Virtualization, or NFV, and Software Defined Networking, or SDN, take hold in the service provider network core. Our solutions are often integrated with additional elements in the mobile packet and broadband core, including policy management and charging functions, and are compliant with the widely adopted 3rd Generation Partnership Program standard.  In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, network operators are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers.  We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products, and the drive for NFV will open up new opportunities for our solutions.

Our embedded solutions enable network solutions suppliers to more quickly add Internet Intelligence to their platforms, since our NAVL products have been designed to be highly portable among many platforms and processors. NAVL eliminates the need for network solutions providers to research and develop their own DPI technology, saving significant time and resources while enabling them to more effectively compete in their market space.

We have recently announced several new development initiatives that are designed to expand our product offerings and our addressable market.  These initiatives include: (1) RAN Perspectives, a Radio Access Network awareness solution, to gain device and location intelligence that will compete with a new set of probe and Customer Experience Assurance solutions, (2) Video Perspectives, a new Video Intelligence offering that will compete with Big Data solutions, and (3) Network Function Virtualization versions of our PacketLogic products that will change our business model to shift more towards software sales rather than hardware with embedded software. We believe that these new initiatives, if successful, will increase our addressable market opportunity to include portions of the Telco Big Data and Customer Experience Assurance markets, where the breadth of our product offerings will provide a broader view of the subscriber experience than current offerings in those markets.

Our products are marketed under the PacketLogic and NAVL brand names.  We have a broad spectrum of products delivering intelligence at the access, edge and core layers of the network.  Our products are designed to offer maximum flexibility to our customers and enable differentiated services and revenue-enhancing applications, all while delivering a high quality of service for subscribers.
 
24

We face competition from suppliers of standalone and integrated Intelligence Policy Enforcement, or IPE, and DPI products, including Allot Communications Ltd., Blue Coat Systems, Brocade Communications Systems, Cisco Systems, Inc., Citrix Systems (acquired Bytemobile), Ericsson, F5 Networks, Huawei Technologies Company, Qosmos, SAIC (acquired Cloudshield Technologies), Sandvine Corporation, and Tektronix (acquired Arbor Networks).  Some of our competitors supply platform products with different degrees of DPI functionality, such as switch/routers, routers, session border controllers and voice-over Internet protocol, or VoIP, switches.  In addition, we face competition from large integrators that package third-party IPE solutions into their products, including Alcatel-Lucent and Nokia Siemens.  It is possible that these companies will develop their own IPE solutions or strategically acquire existing competitor IPE vendors in the future.  Some of our competitors are also our customers.

Most of our competitors are larger and more established enterprises with substantially greater financial and other resources.  Some competitors may be willing to reduce prices and accept lower profit margins to compete with us.  As a result of such competition, we could lose market share and sales, or be forced to reduce our prices to meet competition.  However, we do not believe there is a dominant supplier in our market.  Based on our belief in the superiority of our technology, we believe that we have an opportunity to increase our market share and benefit from what we believe will be growth in the DPI market.

On January 9, 2013, we completed our acquisition of Vineyard Networks Inc., or Vineyard, a privately held developer of Layer 7 DPI and application classification technology located in Kelowna, Canada.  Vineyard’s integrated DPI and application classification technology provides enterprise and service provider networking infrastructure vendors with these capabilities through its integrated software suite, primarily through a variety of subscription-based original equipment manufacturer and partner license agreements.  This acquisition complements our hardware and application software-based IPE and DPI solutions.

We are headquartered in Fremont, California, and we have key operating entities in Kelowna, Canada and Varberg, Sweden, as well as a geographically dispersed sales force.  We sell our products through our direct sales force, resellers, distributors, systems integrators and other equipment manufacturers in the Americas, Asia Pacific, Europe and the Middle East.

Critical Accounting Estimates

The discussion and analysis of our financial condition and results of operations are based upon financial statements that have been prepared in accordance with United States generally accepted accounting principles, or GAAP.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities.  On an ongoing basis, we evaluate these estimates.  We base our estimates on historical experience and on assumptions that are believed to be reasonable.  These estimates and assumptions provide a basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions, and these differences may be material.

We believe the following critical accounting policies reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements:

Revenue Recognition;
Valuation of Long-Lived Assets and Goodwill;
Inventory Valuation;
Stock-Based Compensation; and
Accounting for Income Taxes.

These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on March 11, 2014.
 
25

Results of Operations

Comparison of Three and Nine Months Ended September 30, 2014 and 2013

Revenue

Revenue for the three and nine months ended September 30, 2014 and 2013 was as follows (in thousands, except percentages):

 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
   
 
2014
   
2013
 
Change
 
2014
   
2013
 
Change
 
         
Net product revenue
 
$
11,164
   
$
16,301
     
(32
)%
 
$
35,792
   
$
40,328
     
(11
)%
Net support revenue
   
4,945
     
5,032
     
(2
)%
   
15,466
     
13,015
     
19
%
Total revenue
 
$
16,109
   
$
21,333
     
(24
)%
 
$
51,258
   
$
53,343
     
(4
)%

Our revenue is derived from two sources: (1) product revenue, which includes sales of our hardware appliances bundled with software licenses, separate software licenses and software upgrades; and (2) service revenue, which consists primarily of software maintenance and customer support revenue and secondarily of professional services.  Maintenance and customer support revenue is recognized over the support period, which is typically 12 months. Our product revenues tend to vary seasonally and are typically higher in the second half of the year as compared to the first half of the year.

Product revenue for the three and nine months ended September 30, 2014 was $11.2 million and $35.8 million, respectively, which represents a decrease of 32% and 11%, respectively, compared to the three and nine months ended September 30, 2013. The decreases were driven by fewer large product orders primarily from Tier 1 customers in North America as compared to the prior periods.

Support revenue for the three months ended September 30, 2014 was $4.9 million, a decrease of 2%, compared to the three months ended September 30, 2013.  The decrease in support revenue for the three months ended September 30, 2014 was due to a $0.2 million decrease in professional service revenue due to fewer project completions, offset by a $0.1 million increase in support service revenue.  Support revenue for the nine months ended September 30, 2014 was $15.5 million, an increase of 19% compared to the nine months ended September 30, 2013.  The increase in support revenue for the nine months ended September 30, 2014 was due to a $2.3 million increase in support revenue and a $0.1 million increase in professional service revenue.  The increase in support revenue in the three and nine months ended September 30, 2014 reflected the continued expansion of the installed base of our product to which we have sold ongoing support services. Total support revenue will fluctuate over time depending on the number of new customers, support renewals from continuing customers, and completed professional service projects during the period.

By region, sales to customers located in Europe, the Middle East and Africa, or EMEA, as a percentage of revenue were 57% and 47% for the three and nine months ended September 30, 2014, respectively, compared to 46% and 36% for the three and nine months ended September 30, 2013, respectively.  See Note 13 – “Segment Information” of the Notes to Condensed Consolidated Financial Statements for additional details.

For the three months ended September 30, 2014, one customer represented 37% of net revenue, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2014, one customer represented 11% of net revenue with no other single customer accounting for more than 10% of net revenue.For the three months ended September 30, 2013, revenue from two customers represented 33% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2013, revenue from Shaw Communications, Inc. represented 13% of net revenue, and two other customers represented 13% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue. 
 
26

For the year ending December 31, 2014, we expect total revenue to approximate the total revenue for the year ended December 31, 2013.

Cost of Sales

Cost of sales includes material costs and direct labor for products sold, amortization of acquired developed technology, costs expected to be incurred for warranty, adjustments to inventory values, including the write-down of slow moving or obsolete inventory, and costs for support and professional services personnel.

The following table presents the breakdown of cost of sales by category for the three and nine months ended September 30, 2014 and 2013 (in thousands, except percentages):

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
Change
   
2014
   
2013
   
Change
 
Product costs
 
$
4,774
   
$
10,080
     
(53
)%
 
$
17,645
   
$
22,451
     
(21
)%
Percent of net product revenue
   
43
%
   
62
%
           
49
%
   
56
%
       
                                                 
Support costs
   
1,118
     
896
     
25
%
   
3,269
     
2,442
     
34
%
Percent of net support revenue
   
23
%
   
18
%
           
21
%
   
19
%
       
                                                 
Total cost of sales
 
$
5,892
   
$
10,976
     
(46
)%
 
$
20,914
   
$
24,893
     
(16
)%
Percent of total net revenue
   
37
%
   
51
%
           
41
%
   
47
%
       

Total cost of sales in the three and nine months ended September 30, 2014 decreased by $5.1 million and $4.0 million, respectively, compared to the three and nine months ended September 30, 2013, due to lower material costs associated with a decrease in product sales, offset by higher employee-related costs from an increase in customer support and professional services headcount.  Cost of sales as a percentage of revenue decreased by 14 percentage points and 6 percentage points for the three and nine months ended September 30, 2014, respectively, compared to the same period in the prior year.  The decrease as a percentage of revenue for the three and nine month comparable periods was primarily due to a product mix shift within product revenue to appliances from chassis based product sales. Appliance product sales tend to yield a greater margin compared with chassis based product sales.  Stock-based compensation recorded to cost of sales in each of the three and nine months ended September 30, 2014 and 2013 was $0.1 million and $0.3 million, respectively.

Gross Profit

Gross profit for the three and nine months ended September 30, 2014 and 2013 was as follows (in thousands, except percentages):

   
Three Months Ended
 September 30,
   
Nine Months Ended
 September 30,
 
   
2014
 
2013
   
Change
   
2014
   
2013
   
Change
 
                         
Gross profit
 
$
10,217
   
$
10,357
     
(1)
%
 
$
30,344
   
$
28,450
     
7
%
Percent of total net revenue
   
63
%
   
49
%
           
59
%
   
53
%
       

Gross profit for the three months ended September 30, 2014 decreased by $0.1 million as compared to the three months ended September 30, 2013. The decrease in gross profit was driven by lower overall revenue.  Gross profit for the nine months ended September 30, 2014 increased by $1.9 million as compared to the nine months ended September 30, 2013 due to higher support and professional services revenue.  Our gross profit margin for the three and nine months ended September 30, 2014 increased by 14 and 6 percentage points compared to the same period in the prior year, respectively, to 63% and 59%, respectively. The increase in gross profit margin for the three and nine months ended September 30, 2014 was due to support revenue representing a higher proportion of total revenue and higher margins earned on product sales. Support revenue tends to have a greater gross profit margin compared with product sales. The higher margins earned on product sales reflect a product mix shift to appliances from chassis based product sales. Appliance product sales tend to yield a greater margin compared with chassis based product sales.
 
27

On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangible assets and cost reduction efforts, the gross margin for the three and nine months ended September 30, 2014 was 66% and 62%, respectively, as compared to 50% and 55% for the three and nine months ended September 30, 2013, respectively.  The increase in non-GAAP gross profit margin for the three and nine months ended September 30, 2014 was primarily due to support revenue representing a higher proportion of total revenue and higher margins earned on product sales.   (See page 33 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.)

Our gross margin rate in any given period is impacted by the revenue and product mix in that period, and we expect variability in our gross margin rate to continue in the future.  We expect our gross profit margin to be a higher percentage of total net revenue in the year ending December 31, 2014 as compared to the year ended December 31, 2013.

Operating Expenses

Operating expenses for the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands, except percentages):

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2014
 
2013
 
Change
 
2014
 
2013
 
Change
 
             
Research and development
 
$
4,096
   
$
3,945
     
4
%
 
$
12,360
   
$
12,532
     
(1
)%
Sales and marketing
   
6,497
     
7,322
     
(11
)%
   
20,425
     
21,293
     
(4
)%
General and administrative
   
2,760
     
2,510
     
10
%
   
8,311
     
9,498
     
(12
)%
Impairment of goodwill and purchased intangible assets
   
12,380
     
     
n/a
 
   
12,380
     
     
n/a
 
Total
 
$
25,733
   
$
13,777
     
87
%
 
$
53,476
   
$
43,323
     
23
%

Our total operating expenses for the three and nine months ended September 30, 2014 increased compared to the three and nine months ended September 30, 2013 as a result of impairment charges of $12.4 million associated with NAVL goodwill and purchased intangible assets.  Excluding these charges, total operating expenses for the three and nine months ended September 30, 2014 decreased $0.4 million and $2.2 million, respectively, from the prior year periods.  The decrease was  primarily due to a decrease in amortization of deferred compensation costs associated with retention agreements with Vineyard’s three founders, which were $0.1 million in the nine months ended September 30, 2014 as these costs became fully amortized, compared to $1.5 million and $4.3 million in the three and nine months ended September 30, 2013, respectively.  The decrease in the nine months ended September 30, 2014 also reflected the absence of acquisition related costs, which were $1.6 million in the nine months ended September 30, 2013.  These reductions were partially offset by increases in the three and nine months ended September 30, 2014 of product development costs for our next generation PacketLogic products, severance and related costs associated with cost reduction efforts and higher compensation costs associated with additional investment in sales and business development and research and development personnel.

On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangible assets, cost reduction efforts, impairment of goodwill and intangible assets, deferred compensation and business development expenses, operating expenses in the three and nine months ended September 30, 2014 were $11.7 million and $36.5 million, respectively, compared to $11.2 million and $33.5 million for the three and nine months ended September 30, 2013, respectively.  The increase in operating expenses on a non-GAAP basis for the three and nine months ended September 30, 2014 reflected investment in sales and business development personnel and in product development and quality.  (See page 33 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.)
 
28

We took certain cost reduction steps in the three and nine months ended September 30, 2014 to contain spending in order to improve our profitability.  These steps consisted of a reduction in workforce, which resulted in severance and other employee-related costs of $0.3 million and $1.0 million in the three and nine months ended September 30, 2014, respectively, and also included steps to reduce spending on outside professionals.

In total, we anticipate that new employee and contractor hiring in fiscal year 2014 will be substantially reduced compared with the hiring activity in fiscal year 2013; therefore, we expect our headcount will be similar or will increase somewhat from that reported for the year ended December 31, 2013.

Research and Development

Research and development expenses include costs associated with personnel focused on the development or improvement of our products, prototype materials, initial product certifications, testing equipment and software costs.  Research and development costs include sustaining and enhancement efforts for products already released and development costs associated with planned new products.  Research and development expenses for the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands, except percentages):

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2014
 
2013
 
Change
 
2014
 
2013
 
Change
 
             
Research and development
 
$
4,096
   
$
3,945
     
4
%
 
$
12,360
   
$
12,532
     
(1
)%
As a percentage of net revenue
   
25
%
   
18
%
           
24
%
   
23
%
       

Research and development expenses for the three months ended September 30, 2014 increased by $0.2 million as compared to the three months ended September 30, 2013 primarily due to increases in product development costs of $0.7 million, compensation costs associated with increased headcount of $0.1 million, stock compensation of $0.1 million, and depreciation expense of $0.1 million, offset by the reduction of amortization of deferred compensation costs of $0.8 million.  Deferred compensation was fully amortized in the first quarter of 2014.

Research and development expenses for the nine months ended September 30, 2014 decreased by $0.2 million from the comparable prior year period.  The decrease resulted primarily from a reduction in amortization of deferred compensation costs of $2.2 million, offset by increased product development costs of $0.9 million, compensation costs associated with increased headcount of $0.5 million, stock compensation expense of $0.1 million, depreciation expense of $0.3 million and severance and related costs of $0.2 million.

On a non-GAAP basis, after adjusting for stock-based compensation, cost reduction efforts and deferred compensation, research and development expenses for the three and nine months ended September 30, 2014 were $3.8 million and $11.1 million, respectively, as compared to $3.0 million and $9.4 million for the three and nine months ended September 30, 2013, respectively.  The increase resulted primarily from higher product development costs and compensation costs associated with additional personnel as we continue to expand our research and development group to develop the next generation PacketLogic solutions and other new product initiatives.  (See page 33 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.)
 
29

Sales and Marketing

Sales and marketing expenses primarily include personnel costs, sales commissions and marketing expenses, such as trade shows, channel development and literature.  Sales and marketing expenses for the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands, except percentages):
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
Change
   
2014
   
2013
   
Change
 
   
($ in thousands)
       
($ in thousands)
     
                         
Sales and marketing
 
$
6,497
   
$
7,322
     
(11
)%
 
$
20,425
   
$
21,293
     
(4
)%
As a percentage of net revenue
   
40
%
   
34
%
           
40
%
   
40
%
       
 
Sales and marketing expenses for the three and nine months ended September 30, 2014 decreased by $0.8 million and $0.9 million, respectively, compared to the three and nine months ended September 30, 2013. The decreases in the three and nine months ended September 30, 2014 were primarily a result of a reduction in the amortization of deferred compensation costs of $0.7 million and $2.1 million, respectively, and lower sales commissions of $0.5 million and $0.1 million, respectively, associated with the lower levels of revenue.  These reductions were partially offset by severance and related costs of $0.3 million and $0.5 million in the three and nine months ended September 30, 2014, respectively, and an increase in compensation and related costs associated with the hiring of additional sales and marketing personnel in the EMEA region of $0.1 million and $0.6 million, respectively.

On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangible assets, cost reduction efforts and deferred compensation, sales and marketing expenses for the three months ended September 30, 2014 were $5.6 million as compared to $6.1 million for the three months ended September 30, 2013.  The $0.5 million decrease was mainly due to a $0.4 million decrease in sales commissions from lower quarterly revenues in the three months ended September 30, 2014.  Non-GAAP sales and marketing expenses for the nine months ended September 30, 2014 were $18.3 million as compared to $17.5 million for the nine months ended September 30, 2013.  The increase of $0.8 million was primarily due to compensation costs associated with higher headcount. (See page 33 for a reconciliation of this non-GAAP measure to the most comparable GAAP financial measure and other important information.)

General and Administrative

General and administrative expenses consist primarily of personnel and facilities costs related to our executive and finance functions and fees for professional services.  Professional services include costs for legal advice and services, accounting and tax professionals, independent auditors and investor relations. General and administrative expenses for the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands, except percentages):
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
Change
   
2014
   
2013
   
Change
 
   
($ in thousands)
       
($ in thousands)
     
                         
General and administrative
 
$
2,760
   
$
2,510
     
10
%
 
$
8,311
   
$
9,498
     
(12
)%
As a percentage of net revenue
   
17
%
   
12
%
           
16
%
   
18
%
       
 
General and administrative expenses for the three months ended September 30, 2014 increased by $0.3 million compared to the three months ended September 30, 2013. The increase was mainly due to a $0.2 million increase in legal and professional service costs.

General and administrative expenses for the nine months ended September 30, 2014 decreased by $1.2 million compared to the nine months ended September 30, 2013.  The decrease resulted from the reduction of business development costs of $1.6 million related to accounting and investment banking fees, partially offset by an increase in rent expense of $0.4 million and compensation-related expenses of $0.3 million associated with higher headcount.
 
30

On a non-GAAP basis, after adjusting for stock-based compensation, cost reduction efforts and business development costs, general and administrative expenses for the three and nine months ended September 30, 2014 were $2.3 million and $7.1 million, respectively, as compared to $2.1 million and $6.6 million for the three and nine months ended September 30, 2013, respectively.  The increase in the three and nine months ended September 30, 2014 was mainly due to an increase in compensation costs associated with higher headcount.  (See page 33 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.)

Impairment of Goodwill and Purchased Intangible Assets

During the third quarter of fiscal year 2014, we considered the effect of the economic environment in which our NAVL reporting unit markets our products and determined that sufficient indicators existed requiring us to perform an interim impairment review of the NAVL reporting unit goodwill and long-lived assets.  The indicators consisted primarily of: (1) decelerating revenue growth during the third quarter of fiscal year 2014 and a decline in forecasted revenue in future quarters, and (2) lower than anticipated total addressable market for NAVL products.  As a result, we performed impairment reviews of our NAVL goodwill and long-lived assets within the NAVL reporting unit. The reviews were performed at the NAVL reporting unit level.  Based on our reviews, we recorded total impairment charges of $12.4 million; $10.8 million to write down the value of NAVL goodwill to zero, and $0.7 and $0.8 million to write down the carrying values of NAVL developed technology and customer relationship intangible assets, respectively, to their current estimated fair values.  See Note 6 – “Goodwill and Intangible Assets” of the Notes to Condensed Consolidated Financial Statements for additional details.

Interest and Other Income (Expense), Net
 
 
 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
 
 
2014
   
2013
   
Change
   
2014
   
2013
   
Change
 
 
 
($ in thousands)
   
   
($ in thousands)
   
 
 
 
   
   
   
   
   
 
Interest and other income (expense), net
 
$
(356
)
 
$
232
     
(253
)%
 
$
(245
)
 
$
203
     
(221
)%
 
Interest and other income (expense), net decreased in the three and nine months ended September 30, 2014 compared to the three and nine months ended September 30, 2013.  The decrease in the three and nine months ended September 30, 2014 was mainly due to an increase in foreign currency losses.

Benefit from Income Taxes
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2014
   
2013
   
Change
   
2014
   
2013
   
Change
 
   
($ in thousands)
       
($ in thousands)
     
                         
Income tax benefit
 
$
(160
)
 
$
(205
)
   
(22
)%
 
$
(281
)
 
$
(1,688
)
   
(83
)%
 
We are subject to taxation primarily in the U.S., Australia, Canada, Japan, Singapore and Sweden, as well as in a number of U.S. states, including California.   The benefit for income tax in the three months ended September 30, 2014 was largely comprised of the reversal of the US deferred tax liability related to the impairment of goodwill.    The reduction in the tax benefit for the nine months ended September 30, 2014 relates to the valuation allowance placed on the Canadian net deferred tax asset which has the effect of limiting the tax benefit.  The tax benefits were offset by state taxes, foreign withholding taxes and earnings taxed in foreign jurisdictions.
 
31

We have established a valuation allowance for substantially all of our deferred tax assets.  We calculated the valuation allowance in accordance with the provisions of Accounting Standards Codification, or ASC, Topic 740, which requires that a valuation allowance be established or maintained when it is “more likely than not” that all or a portion of deferred tax assets will not be realized.  We will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal.

Important Information Regarding non-GAAP Financial Measures

In this Quarterly Report on Form 10-Q, we include non-GAAP financial measures.  Our management believes that certain non-GAAP financial measures provide investors with additional useful information and regularly uses these supplemental non-GAAP financial measures internally to understand and manage our business and forecast future periods.  In addition, our management believes that these non-GAAP financial measures, when taken together with the corresponding GAAP measures, provide incremental insight into the underlying factors and trends affecting both our performance and our cash-generating potential.

Our non-GAAP financial measures include adjustments for stock-based compensation expenses; business development expenses; cost reduction efforts; acquisition-related intangible asset and deferred compensation amortization; and income tax effects. We have excluded the effect of stock-based compensation, the cost of outside professional services for negotiating and performing legal, accounting and tax due diligence for potential mergers and acquisitions, expenses connected with cost reduction efforts, acquisition-related intangible asset and deferred compensation amortization, impairment of goodwill and intangible assets and income tax effects from our non-GAAP gross profit, operating expenses and net income measures. Stock-based compensation, which represents the estimated fair value of stock options, restricted stock and restricted stock units granted to employees, is excluded since grant activities vary significantly from quarter to quarter in both quantity and fair value. In addition, although stock-based compensation will recur in future periods, excluding this expense allows us to better compare core operating results with those of our competitors who also generally exclude stock-based compensation from their core operating results and who may have different granting patterns and types of equity awards and who may use different option valuation assumptions than we do. Business development expenses are necessary as part of certain growth strategies, such as through mergers and acquisitions, and will occur when such transactions are pursued. We have excluded these expenses because they can vary materially from period-to-period and transaction-to-transaction and expenses associated with these business development activities are not considered a key measure of our operating performance. Cost reduction efforts occur with shifts in objectives and evolving requirements of the business and can result in fluctuating expenses connected with reducing employment in certain areas.  We have excluded these expenses because they can vary significantly from period-to-period and are not considered a key measure of our operating performance.  Acquisition-related intangible assets and deferred compensation amortization and income tax effects represent non-cash charges and benefits that result from the accounting for acquisitions. We have excluded these items because, in any period, they may not directly correlate to the underlying performance of our business and can vary materially from period-to-period and transaction-to-transaction. In addition, we exclude these acquisition-related costs and benefits when evaluating our current operating performance.

Our non-GAAP financial measures may not reflect the full economic impact of our activities. Further, these non-GAAP financial measures may be unique to us as they may differ from non-GAAP financial measures used by other companies, including our competitors. As such, this presentation of non-GAAP financial measures may not enhance the comparability of our results to the results of other companies. Therefore, these non-GAAP financial measures are limited in their usefulness and investors are cautioned not to place undue reliance on our non-GAAP financial measures. In addition, investors are cautioned that these non-GAAP financial measures are not intended to be considered in isolation and should be read in conjunction with our consolidated financial statements prepared in accordance with GAAP.
 
32

A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measure, net loss, is as follows:

   
Three Months Ended
   
Nine Months Ended
 
   
Sept 30,
2014
   
Sept 30,
2013
   
Sept 30,
2014
   
Sept 30,
2013
 
Sales:
               
Product sales
 
$
11,164
   
$
16,301
   
$
35,792
   
$
40,328
 
Support sales
   
4,945
     
5,032
     
15,466
     
13,015
 
Total net sales
   
16,109
     
21,333
     
51,258
     
53,343
 
Cost of sales:
                               
Product cost of sales, GAAP
   
4,774
     
10,080
     
17,645
     
22,451
 
Non-GAAP adjustments:
                               
Stock-based compensation (1)
   
(7
)
   
(19
)
   
(29
)
   
(58
)
Amortization of intangibles (2)
   
(264
)
   
(275
)
   
(793
)
   
(819
)
Cost reduction efforts (3)
   
     
     
(237
)
   
 
Product cost of sales, non-GAAP
   
4,503
     
9,786
     
16,586
     
21,574
 
Support cost of sales, GAAP
   
1,118
     
896
     
3,269
     
2,442
 
Non-GAAP adjustments:
                               
Stock-based compensation (1)
   
(85
)
   
(82
)
   
(253
)
   
(223
)
Support cost of sales, non-GAAP
   
1,033
     
814
     
3,016
     
2,219
 
Total cost of sales, non-GAAP
   
5,536
     
10,600
     
19,602
     
23,793