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EX-32.1 - EXHIBIT 32.1 - PROCERA NETWORKS, INC.ex32_1.htm
EX-31.2 - EXHIBIT 31.2 - PROCERA NETWORKS, INC.ex31_2.htm
EX-31.1 - EXHIBIT 31.1 - PROCERA NETWORKS, INC.ex31_1.htm
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-Q

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

For the quarterly period ended March 31, 2015
OR

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 ☑    No ☐

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

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

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

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

As of April 30, 2015, the registrant had 20,788,385 shares of its common stock, par value $0.001, outstanding.
 


PROCERA NETWORKS, INC.
FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2015
INDEX
 
 
Page
PART I. FINANCIAL INFORMATION
 
       
 
Item 1.
 
       
   
3
       
   
4
       
   
5
       
   
6
       
   
7
       
 
Item 2.
21
       
 
Item 3.
32
       
 
Item 4.
32
       
PART II. OTHER INFORMATION
 
       
 
Item 1.
33
       
 
Item 1A.
33
       
 
Item 2.
53
       
 
Item 3.
53
       
 
Item 4.
54
       
 
Item 5.
54
       
 
Item 6.
54
       
55
 
2

PART I. FINANCIAL INFORMATION

Item 1.
Condensed Consolidated Financial Statements

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

   
March 31,
2015
   
December 31,
2014
 
   
(unaudited)
   
(note)
 
ASSETS
       
Current assets:
       
Cash and cash equivalents
 
$
23,114
   
$
17,939
 
Short-term investments
   
84,537
     
84,542
 
Accounts receivable, net of allowance of $31 and $47 at March 31, 2015 and December 31, 2014, respectively
   
15,397
     
21,447
 
Inventories, net
   
14,949
     
14,837
 
Prepaid expenses and other
   
4,094
     
4,913
 
Total current assets
   
142,091
     
143,678
 
                 
Property and equipment, net
   
7,172
     
8,322
 
Intangible assets, net
   
2,466
     
2,957
 
Goodwill
   
960
     
960
 
Other non-current assets
   
172
     
154
 
Total assets
 
$
152,861
   
$
156,071
 
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
 
$
3,434
   
$
5,207
 
Deferred revenue
   
13,577
     
11,821
 
Accrued liabilities
   
6,226
     
7,235
 
Total current liabilities
   
23,237
     
24,263
 
                 
Non-current liabilities:
               
Deferred revenue
   
3,711
     
3,113
 
Deferred rent
   
520
     
583
 
Total liabilities
   
27,468
     
27,959
 
                 
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; 20,782 and 20,756 shares issued and outstanding at March 31, 2015 and December 31, 2014, respectively
   
21
     
21
 
Additional paid-in capital
   
226,417
     
225,313
 
Accumulated other comprehensive loss
   
(3,714
)
   
(3,190
)
Accumulated deficit
   
(97,331
)
   
(94,032
)
Total stockholders’ equity
   
125,393
     
128,112
 
Total liabilities and stockholders’ equity
 
$
152,861
   
$
156,071
 

Note: Amounts have been derived from the December 31, 2014 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
 
   
March 31,
2015
   
March 31,
2014
 
Sales:
       
Product sales
 
$
15,172
   
$
9,504
 
Support sales
   
5,331
     
5,037
 
Total net sales
   
20,503
     
14,541
 
Cost of sales:
               
Product cost of sales
   
7,155
     
5,091
 
Support cost of sales
   
1,238
     
1,066
 
Total cost of sales
   
8,393
     
6,157
 
                 
Gross profit
   
12,110
     
8,384
 
                 
Operating expenses:
               
Research and development
   
3,431
     
4,548
 
Sales and marketing
   
7,159
     
6,877
 
General and administrative
   
4,217
     
3,110
 
Total operating expenses
   
14,807
     
14,535
 
                 
Loss from operations
   
(2,697
)
   
(6,151
)
Interest and other income (expense), net
   
(591
)
   
28
 
                 
Loss before income taxes
   
(3,288
)
   
(6,123
)
Income tax provision (benefit)
   
11
     
(147
)
Net loss
 
$
(3,299
)
 
$
(5,976
)
                 
Net loss per share – basic
 
$
(0.16
)
 
$
(0.29
)
Net loss per share – diluted
 
$
(0.16
)
 
$
(0.29
)
                 
Shares used in computing net loss per share:
               
Basic
   
20,674
     
20,329
 
Diluted
   
20,674
     
20,329
 

See accompanying notes to condensed consolidated financial statements.
 
4

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

   
Three Months Ended
March 31,
 
   
2015
   
2014
 
         
Net loss
 
$
(3,299
)
 
$
(5,976
)
                 
Unrealized gain (loss) on short-term investments
   
39
     
(35
)
Foreign currency translation adjustments
   
(563
)
   
(635
)
Other comprehensive loss
   
(524
)
   
(670
)
                 
Comprehensive loss
 
$
(3,823
)
 
$
(6,646
)

See accompanying notes to condensed consolidated financial statements.
 
5

Procera Networks, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
   
Three Months
Ended
March 31,
 
   
2015
   
2014
 
Cash flows from operating activities:
       
Net loss
 
$
(3,299
)
 
$
(5,976
)
Adjustments to reconcile net loss to net cash provided by operating activities:
               
Depreciation
   
664
     
565
 
Amortization of intangible assets
   
225
     
375
 
Stock-based compensation expense:
               
Stock options
   
651
     
915
 
Restricted stock and restricted stock unit awards
   
556
     
398
 
Amortization of premium on investments
   
207
     
136
 
Amortization of deferred compensation
   
     
65
 
Provision for (recovery of) bad debts
   
(22
)
   
5
 
Provision for excess and obsolete inventory
   
407
     
1
 
Loss on asset disposals
   
2
     
6
 
Changes in deferred taxes
   
     
(178
)
Changes in assets and liabilities:
               
Accounts receivable
   
5,413
     
11,965
 
Inventories
   
(729
)
   
(1,700
)
Prepaid expenses and other current assets
   
614
     
(264
)
Accounts payable
   
(1,772
)
   
(3,650
)
Accrued liabilities
   
(253
)
   
(766
)
Deferred revenue
   
2,803
     
(1,422
)
Net cash provided by operating activities
   
5,467
     
475
 
                 
Cash flows from investing activities:
               
Purchase of property and equipment
   
(582
)
   
(839
)
Purchase of short-term investments
   
(18,919
)
   
(64,598
)
Maturities of short-term investments
   
18,755
     
7,000
 
Net cash used in investing activities
   
(746
)
   
(58,437
)
                 
Cash flows from financing activities:
               
Proceeds from issuance of common stock – exercise of options
   
     
69
 
Restricted stock units withheld for employee taxes
   
(102
)
   
 
Net cash provided by (used in) financing activities
   
(102
)
   
69
 
                 
Effect of exchange rates on cash and cash equivalents
   
556
     
(4
)
                 
Net increase (decrease) in cash and cash equivalents
   
5,175
     
(57,897
)
                 
Cash and cash equivalents, beginning of period
   
17,939
     
90,774
 
                 
Cash and cash equivalents, end of period
 
$
23,114
   
$
32,877
 
                 

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 Subscriber Experience Assurance (“SEA”) 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 and Europe.

Procera was incorporated in 2001 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.

Merger Agreement with Francisco Partners

On April 21, 2015, Procera entered into an Agreement and Plan of Merger (the “Merger Agreement”) with KDR Holding, Inc., a Delaware corporation (“Parent”), and KDR Acquisition, Inc., a Delaware corporation and a wholly owned subsidiary of Parent (“Purchaser”). Parent and Purchaser are beneficially owned by affiliates of Francisco Partners IV, L.P. and Francisco Partners IV-A, L.P. (collectively, “Francisco Partners”).

Pursuant to the terms of the Merger Agreement, Purchaser will commence a tender offer (the “Offer”) to purchase all of the outstanding shares of common stock, par value $0.001 per share, of Procera (the “Shares”), at a price of $11.50 per Share, net to the seller thereof in cash, without interest (such amount, as it may be adjusted on the terms set forth in the Merger Agreement, the “Offer Price”), and subject to deduction for any required withholding of taxes. Pursuant to the terms of the Merger Agreement, Purchaser is obligated to commence the Offer as promptly as practicable, but in no event later than May 5, 2015. The board of directors of Procera (the “Board”) has unanimously adopted the Merger Agreement.

The consummation of the Offer is subject to customary closing conditions, including, among other things: (i) the expiration or termination of the waiting period under any applicable antitrust laws; (ii) there having been validly tendered and not validly withdrawn prior to the expiration of the Offer that number of Shares representing one Share more than 50% of the total number of Shares then-outstanding on a fully diluted basis; (iii) the absence of a material adverse effect with respect to Procera; and (iv) other customary conditions to the Offer set forth in Annex A to the Merger Agreement. The consummation of the Offer is not subject to any financing condition.

Following the consummation of the Offer, and subject to the satisfaction or waiver of the conditions set forth in the Merger Agreement, Purchaser will be merged with and into Procera, with Procera continuing as the surviving corporation and a wholly owned subsidiary of Parent (the “Merger”). The Merger Agreement provides that the Merger will be effected pursuant to Section 251(h) of the General Corporation Law of the State of Delaware, without a vote of the stockholders of Procera.

At the effective time of the Merger (the “Effective Time”), each Share that is outstanding immediately prior to the Effective Time, other than the Shares owned by Procera, Parent or Purchaser, or by stockholders who have validly exercised and perfected their appraisal rights under Delaware law, will be canceled and converted into the right to receive the Offer Price, payable to the holder thereof on the terms and subject to the conditions set forth in the Merger Agreement.
 
7

In addition, at the Effective Time, (i) each option to purchase Shares, to the extent vested as of the Effective Time (each, a “Vested Company Option”), will be canceled and converted into the right to receive an amount in cash equal to the product of (a) the excess, if any, of the Offer Price over the exercise price of such Vested Company Option and (b) the number of Shares that may be acquired upon exercise of such Vested Company Option, without interest and subject to deduction for any required withholding of taxes, and (ii) each restricted stock unit award, to the extent vested as of the Effective Time (but for which Shares have not yet been issued) (each, a “Vested Company RSU”), and each restricted stock award that remains subject to vesting conditions (each, an “Unvested Company RSA”), will be canceled and converted into the right to receive an amount in cash equal to the product of (y) the excess, if any, of the Offer Price over the purchase price payable for such Vested Company RSU or Unvested Company RSA, if any, and (z) the number of Shares subject to (or deliverable under) such Vested Company RSU or Unvested Company RSA, in each case without interest and subject to deduction for any required withholding of taxes. At the Effective Time, each option to purchase Shares that is unvested as of the Effective Time, each restricted stock unit award that is unvested as of the Effective Time, and each option to purchase Shares with an exercise price at or above of the Offer Price, will be canceled for no consideration.

Procera, Parent and Purchaser have made customary representations, warranties and covenants in the Merger Agreement. Procera’s covenants include, among other things, covenants regarding the operation of Procera’s business prior to the Effective Time and covenants not to solicit third party proposals relating to alternative transactions or provide information or enter into discussions in connection with alternative transactions, subject to exceptions to permit the Board to comply with its fiduciary duties

The Merger Agreement also includes customary termination rights in favor of each of Procera and Parent, including, among others, if the transactions contemplated by the Merger Agreement are not consummated on or before August 30, 2015 or if Procera terminates the Merger Agreement in compliance with its terms in order to accept a superior proposal. Upon termination of the Merger Agreement under certain circumstances, Procera has agreed to pay Parent a termination fee of approximately $7.2 million.

The foregoing description of the Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the Merger Agreement, which is filed as Exhibit 2.1 to this Quarterly Report on Form 10-Q and incorporated herein by reference.

If Procera consummates the Merger, Procera will become a wholly-owned subsidiary of Parent. Accordingly, the remainder of this Quarterly Report on Form 10-Q, which assumes Procera remains a standalone business, should be read with the understanding that should the Merger be completed, Parent will have the power to control the conduct of Procera’s business.

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, 2015 or any other future period. The consolidated balance sheet at December 31, 2014 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, 2014, filed with the SEC on March 13, 2015.

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.
 
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 months ended March 31, 2015 compared to what was previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014, filed with the SEC on March 13, 2015.
 
8

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 will be effective for fiscal 2018, including interim periods within that reporting period 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 financial statements.

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”, 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 March 31, 2015 and December 31, 2014 (in thousands):

   
March 31, 2015
 
   
Amortized
   
Gross Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
Money market funds
 
$
62
   
$
   
$
   
$
62
 
Commercial paper
   
12,982
     
6
     
     
12,988
 
Treasury and agency notes and bills
   
55,942
     
15
     
(1
)
   
55,956
 
Corporate bonds
   
21,737
     
10
     
(4
)
   
21,743
 
Total investments
 
$
90,723
   
$
31
   
$
(5
)
 
$
90,749
 
                                 
Reported as:
                               
Cash equivalents
 
$
6,211
   
$
1
   
$
   
$
6,212
 
Short-term investments
   
84,512
     
30
     
(5
)
   
84,537
 
Total investments
 
$
90,723
   
$
31
   
$
(5
)
 
$
90,749
 
 
9

   
December 31, 2014
 
   
Amortized
   
Gross Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
Money market funds
 
$
109
   
$
   
$
   
$
109
 
Commercial paper
   
10,794
     
2
     
     
10,796
 
Treasury and agency notes and bills
   
54,442
     
5
     
(6
)
   
54,441
 
Corporate bonds
   
25,419
     
2
     
(16
)
   
25,405
 
Total investments
 
$
90,764
   
$
9
   
$
(22
)
 
$
90,751
 
                                 
Reported as:
                               
Cash equivalents
 
$
6,208
   
$
1
   
$
   
$
6,209
 
Short-term investments
   
84,556
     
8
     
(22
)
   
84,542
 
Total investments
 
$
90,764
   
$
9
   
$
(22
)
 
$
90,751
 
 
As of March 31, 2015 and December 31, 2014, all investments were classified as available-for-sale with unrealized gains and losses recorded as a separate component of accumulated other comprehensive income (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 and an effective maturity of up to 24 months.  The weighted average maturity of the portfolio does not exceed 12 months.  As of March 31, 2015 and December 31, 2014, the Company had certain investments with a maturity greater than one year.  As of March 31, 2015 and December 31, 2014, the Company had $10.7 million and $12.8 million, respectively, 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 months ended March 31, 2015 and 2014.

The Company did not incur any material realized gains or losses in either of the three months ended March 31, 2015 or 2014.  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.
 
10

The following is a summary of cash equivalents and short-term investments by type of instrument as of March 31, 2015 and December 31, 2014, measured at fair value on a recurring basis (in thousands):

   
March 31, 2015
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Money market funds
 
$
62
   
$
   
$
   
$
62
 
Commercial paper
   
     
12,988
     
     
12,988
 
Treasury and agency notes and bills
   
     
55,956
     
     
55,956
 
Corporate bonds
   
     
21,743
     
     
21,743
 
Total assets measured at fair value
 
$
62
   
$
90,687
   
$
   
$
90,749
 

   
December 31, 2014
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Money market funds
 
$
109
   
$
   
$
   
$
109
 
Commercial paper
   
     
10,796
     
     
10,796
 
Treasury and agency notes and bills
   
     
54,442
     
     
54,442
 
Corporate bonds
   
     
25,404
     
     
25,404
 
Total assets measured at fair value
 
$
109
   
$
90,642
   
$
   
$
90,751
 

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 in either of the three months ended March 31, 2015 or 2014.
 
5. INTANGIBLE ASSETS

Intangible assets 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 March 31, 2015 and December 31, 2014 (in thousands, except weighted average remaining life):

 
March 31, 2015
 
 
Gross
Carrying
Value
 
 
Accumulated
Amortization
 
 
Net
Carrying
Value
 
Weighted
Average
Remaining
Life
 
Developed technology
 
$
3,931
   
$
(1,933
)
 
$
1,998
     
2.77
 
Customer relationships
   
1,231
     
(763
)
   
468
     
2.77
 
Balance at March 31, 2015
 
$
5,162
   
$
(2,696
)
 
$
2,466
         
 
 
December 31, 2014
 
 
Gross
Carrying
Value
 
 
Accumulated
Amortization
 
 
Net
Carrying
Value
 
Weighted
Average
Remaining
Life
 
Developed technology
 
$
4,323
   
$
(1,927
)
 
$
2,396
     
3.02
 
Customer relationships
   
1,354
     
(793
)
   
561
     
3.02
 
Balance at December 31, 2014
 
$
5,677
   
$
(2,720
)
 
$
2,957
         
 
11

For the three months ended March 31, 2015 and 2014, amortization expense of $0.2 million and $0.3 million, respectively, related to developed technology was recorded in product cost of sales.  For the three months ended March 31, 2015 and 2014, amortization expense of $43,000 and $113,000, respectively, related to customer relationships was recorded in sales and marketing expense.

The changes in the carrying value of acquired intangible assets during the three months ended March 31, 2015 were as follows (in thousands):

   
Gross
Carrying
Value
   
Accumulated
Amortization
   
Net
Carrying
Value
 
Balance at December 31, 2014
 
$
5,677
   
$
(2,720
)
 
$
2,957
 
Additions
   
     
(225
)
   
(225
)
Translation adjustments
   
(515
)
   
249
     
(266
)
Balance at March 31, 2015
 
$
5,162
   
$
(2,696
)
 
$
2,466
 

The following table presents the estimated future amortization of intangible assets as of March 31, 2015 (in thousands):

Fiscal Year
 
Amortization
 
2015 (remaining nine months)
 
$
667
 
2016
   
890
 
2017
   
890
 
2018
   
19
 
Total
 
$
2,466
 

6. CERTAIN FINANCIAL STATEMENT INFORMATION

Inventories

Inventories are stated at the lower of cost (on a specific identification or weighted average cost basis), or market. Inventories at March 31, 2015 and December 31, 2014 consisted of the following (in thousands):

   
March 31,
2015
   
December 31,
2014
 
Finished goods
 
$
14,682
   
$
14,638
 
Raw materials
   
267
     
199
 
Inventories, net
 
$
14,949
   
$
14,837
 

Inventories also include demonstration units located at various customer locations and customer service inventories.  The demonstration units and customer service inventories are stated at lower of cost (on a specific identification or weighted average cost basis) or market.  The Company provides demonstration units to customers who evaluate the Company's products, and upon a successful trial, may purchase such products.  The Company carries customer service inventories because it generally provides product warranties for 12 months and earns revenue by providing enhanced and extended support contracts during and beyond this warranty period.  Customer service inventories are provided for customer use permanently or on a temporary basis while the defective unit is being repaired.  The Company reduces the carrying value of demonstration units and customer service inventories for differences between cost and estimated net realizable value, taking into consideration expected demand, technological obsolescence, the physical condition of the unit and other information.  If actual results vary significantly from expectations, additional write-downs may be required, resulting in additional charges to operations.
 
12

Property and Equipment

The following is a summary of property and equipment as of March 31, 2015 and December 31, 2014 (in thousands):

   
March 31,
2015
   
December 31,
2014
 
Machinery and equipment
 
$
10,050
   
$
10,787
 
Computer equipment
   
553
     
563
 
Office furniture and equipment
   
565
     
581
 
Leasehold improvements
   
1,758
     
1,894
 
Software
   
246
     
274
 
Accumulated depreciation
   
(6,000
)
   
(5,777
)
Property and equipment, net
 
$
7,172
   
$
8,322
 

Accrued Liabilities

Accrued liabilities at March 31, 2015 and December 31, 2014 consisted of the following (in thousands):

   
March 31,
2015
   
December 31,
2014
 
Payroll and related
 
$
2,851
   
$
3,398
 
Sales commissions
   
1,487
     
1,778
 
Warranty
   
135
     
113
 
Audit and legal services
   
811
     
231
 
Other
   
942
     
1,715
 
Total accrued liabilities
 
$
6,226
   
$
7,235
 

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 historical warranty cost trends.

The following table summarizes warranty reserve activity during the three months ended March 31, 2015 and 2014 (in thousands):

   
Three Months Ended
March 31,
 
   
2015
   
2014
 
Warranty accrual, beginning of period
 
$
113
   
$
131
 
Provision for current period sales
   
54
     
36
 
Changes in liability for pre-existing warranties
   
(19
)
   
(10
)
Deductions for warranty claims processed during the period
   
(13
)
   
(20
)
Warranty accrual, end of period
 
$
135
   
$
137
 
 
13

Accumulated Other Comprehensive Income (Loss):

The components of accumulated other comprehensive loss as of March 31, 2015 and December 31, 2014, 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, 2014
 
$
(3,177
)
 
$
(13
)
 
$
(3,190
)
Other comprehensive income (loss), net of tax
   
(563
)
   
39
     
(524
)
Accumulated other comprehensive income (loss) as of March 31, 2015
 
$
(3,740
)
 
$
26
   
$
(3,714
)

The Company did not have any reclassifications out of accumulated other comprehensive loss in either of the three months ended March 31, 2015 or 2014.  The Company did not have any other-than-temporary loss on its available-for-sale securities for all periods presented.

7. STOCKHOLDERS’ EQUITY

Common Stock Transactions

On January 9, 2013, pursuant to the Company’s acquisition of Vineyard, the Company issued 825,000 unregistered shares of its common stock with a value of approximately $14.3 million 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, 178,000 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, 124,000 shares were released from escrow related to the resolution of certain contingencies. As of March 31, 2015, 5,000 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 March 31, 2015, 224,000 shares of the Company’s common stock were available for future grant under the Plan.

The following table summarizes the Company’s stock option activity for the three months ended March 31, 2015 and 2014 (in thousands, except per share data):

   
Three Months Ended March 31,
 
   
2015
   
2014
 
   
Options
   
Weighted
Average
Exercise
Price
   
Options
   
Weighted
Average
Exercise
Price
 
Outstanding at the beginning of the period
   
1,645
   
$
14.71
     
1,824
   
$
15.07
 
Granted
   
70
     
9.28
     
74
     
12.25
 
Exercised
   
     
     
(8
)
   
8.56
 
Cancelled
   
(30
)
   
15.19
     
(67
)
   
16.53
 
Outstanding at the end of the period
   
1,685
   
$
14.47
     
1,823
   
$
14.93
 
Vested and expected to vest at the end of the period
   
1,590
   
$
14.57
     
1,714
   
$
14.86
 
Exercisable at the end of the period
   
957
   
$
14.83
     
792
   
$
13.31
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
14

As of March 31, 2015, the aggregate intrinsic value of the Company’s options outstanding, options vested and expected to vest and options exercisable were $1.1 million, $1.1 million and $0.8 million, respectively.  As of March 31, 2015, the weighted average remaining contractual life of options outstanding, options vested and expected to vest and options exercisable was 7.52 years, 7.44 years and 6.70 years, respectively. The total intrinsic value of options exercised during the three months ended March 31, 2015 and 2014 was $0 and $24,000, respectively.

The weighted average remaining contractual life and weighted average per share exercise price of options outstanding and of options exercisable as of March 31, 2015 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
     
4.68
   
$
5.08
     
131
   
$
5.08
 
 
6.00 – 9.70
     
308
     
7.85
     
7.57
     
98
     
7.13
 
 
9.76 – 14.49
     
457
     
8.60
     
13.82
     
262
     
13.99
 
 
14.50 – 30.32
     
788
     
7.27
     
19.12
     
466
     
19.67
 
$
4.30 – $30.32
     
1,685
     
7.52
   
$
14.47
     
957
   
$
14.83
 
 
The following table summarizes the Company’s restricted stock award and restricted stock unit activity for the three months ended March 31, 2015 and 2014 (in thousands, except per share data):

 
Three Months Ended March 31,
 
2015
2014
 
Awards
 
 
Weighted-
Average
Grant Date
Fair Value
 
Awards
 
 
Weighted-
Average
Grant Date
Fair Value
 
Unvested outstanding at the beginning of the period
   
586
   
$
11.58
     
302
   
$
16.63
 
Granted
   
     
     
121
     
11.57
 
Vested
   
(39
)
   
10.75
     
(7
)
   
14.41
 
Cancelled
   
(4
)
   
12.18
     
(1
)
   
16.95
 
Unvested outstanding at the end of the period
   
543
   
$
11.63
     
415
   
$
15.20
 

The weighted average remaining contractual term for the unvested restricted stock awards and restricted stock units outstanding as of March 31, 2015 was 2.65 years.  As of March 31, 2015, the aggregate pre-tax intrinsic value of the unvested restricted stock awards and restricted stock units outstanding was $5.1 million.

8. 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.
 
15

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
March 31,
 
   
2015
   
2014
 
Numerator:
       
Net loss
 
$
(3,299
)
 
$
(5,976
)
                 
Denominator:
               
Weighted average common shares - basic
   
20,674
     
20,329
 
                 
Weighted average common shares - diluted
   
20,674
     
20,329
 
                 
Net loss per share:
               
Basic
 
$
(0.16
)
 
$
(0.29
)
Diluted
 
$
(0.16
)
 
$
(0.29
)
                 
Antidilutive securities:
               
Options, restricted stock and restricted stock units
   
1,413
     
1,427
 

9. 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 months ended March 31, 2015 and 2014 (in thousands):

 
Three Months Ended
March 31,
 
2015
 
2014
 
     
Cost of goods sold
 
$
111
   
$
97
 
Research and development
   
359
     
388
 
Sales and marketing
   
297
     
408
 
General and administrative
   
440
     
420
 
Total stock-based compensation expense
 
$
1,207
   
$
1,313
 

No income tax benefits were recognized in either of the three months ended March 31, 2015 or 2014 due to operating losses.  No stock-based compensation has been capitalized in inventory due to the immateriality of such amounts.

As of March 31, 2015, total unrecognized compensation cost related to unvested stock options was $5.0 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 2.30 years, and total unrecognized compensation cost related to unvested restricted stock awards and restricted stock units was $4.4 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 2.65 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 the grant.  The expense for stock-based awards is recognized over the requisite service period using the straight-line attribution approach.
 
16

The following assumptions were used in determining the fair value of stock options granted during the three months ended March 31, 2015 and 2014:

   
Three Months Ended
March 31,
 
   
2015
   
2014
 
Expected term (years)
   
5.27
     
4.91
 
Expected volatility
   
62.1
%
   
70.42
%
Risk-free interest rate
   
1.44
%
   
1.56
%
Expected dividend yield
   
0
%
   
0
%

The weighted average grant date fair value of options granted during the three months ended March 31, 2015 and 2014 was $4.99 and $7.09, respectively.

The Company calculated the expected term of stock options granted 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.

10. 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.  Except as set forth under the caption “Litigation Relating to the Company’s Pending Merger with Francisco Partners” below, 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.

Litigation Relating to the Company’s Pending Merger with Francisco Partners
                                                          
Following the announcement that the Company had entered into the Merger Agreement with Parent and Purchaser on April 21, 2015, eight putative stockholder class action complaints challenging the Offer, the Merger and the transactions contemplated thereby were filed on behalf of purported Company stockholders in the Court of Chancery of the State of Delaware. These complaints were: (1) Sverdlov v. Procera Networks, Inc., et al., Case No.10951, filed on April 28, 2015, (2) Feniello v. Brear, et al., Case No. 10952, filed on April 28, 2015, (3) Lemmon v. Brear, et al., Case No. 10961, filed on April 29, 2015, (4) Clark v. Procera Networks, Inc., et al., Case No. 10968, filed on April 29, 2015, (5) Torpey v. Procera Networks, Inc., et al., Case No. 10969, filed on April 29, 2015, (6) Schiller v. Procera Networks, Inc., et al., Case No. 10971, filed on April 30, 2015, (7) Rosenfeld v. Procera Networks, Inc., et al., Case No. 10973, filed on April 30, 2015, and (8) Stupar v. Procera Networks, Inc., et al., Case No. 10975, filed on May 1, 2015 (collectively, the “Complaints”).
                                                            
The Sverdlov, Torpey, Schiller and Rosenfeld complaints name the Company, the members of the Board, Francisco Partners, Parent and Purchaser as defendants. The Clark and Stupar complaints name the Company, the members of the Board, Parent and Purchaser as defendants. The Feniello complaint names the members of the Board, Francisco Partners, Parent and Purchaser as defendants. The Lemmon complaint names the members of the Board, Francisco Partners, Francisco Partners Management, L.P., Parent and Purchaser as defendants.
                                                                                 
In general, the Complaints allege that the members of the Board breached their fiduciary duties to the Company’s stockholders by taking one or more of the following actions: (i) agreeing to an unfair and inadequate Offer Price for the Shares, (ii) accepting unreasonable deal protection measures in the Merger Agreement that dissuades other potential bidders from making competing offers, (iii) failing to properly value the Company and take steps to maximize the value of the Company, (iv) engaging in self-dealing, and (v) ignoring the conflicts of interest present in the Company’s financial advisor.
 
17

The Complaints also allege that one or more of the following defendants: the Company, Francisco Partners, Francisco Partners Management, L.P., Parent and Purchaser aided and abetted the members of the Board in breaching their fiduciary duties to the Company’s stockholders.
                                                             
In each Complaint, the plaintiffs have requested certification as a class, injunctive relief, monetary damages, an award of attorneys’ fees, other costs and fees and other equitable relief that the court may deem just and proper. The Feniello, Lemmon, Clark, Schiller and Rosenfeld complaints have also requested that the court rescind and set aside the transactions in the event that the Offer and the Merger are consummated.
                                                                       
These lawsuits are in their early stages and it is not possible to determine the potential outcome of any of these lawsuits or to make any estimate of probable losses at this time. Each of the Company, the Board, Francisco Partners, Francisco Partners Management, L.P., Parent and Purchaser believes that these lawsuits are completely without merit and each intends to vigorously defend against all allegations that have been asserted.

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 agreements generally require the Company to pay executory costs (real estate taxes, insurance and repairs).

As of March 31, 2015, future minimum lease payments due under operating leases are as follows (in thousands):

Fiscal years ending December 31,
 
Amount
 
2015 (remaining nine months)
 
$
794
 
2016
   
919
 
2017
   
704
 
2018
   
476
 
2019
   
281
 
Thereafter
   
1,041
 
Total minimum lease payments
 
$
4,215
 

Purchase Commitments

The Company issues purchase orders to third-party suppliers that may not be cancelable.  As of March 31, 2015, the Company had open non-cancelable purchase orders amounting to approximately $11.4 million, primarily with the Company’s third-party suppliers.

Concentrations

For the three months ended March 31, 2015, revenue from Itochu Techno-Solutions Corp. represented 14% of net revenue, British Telecommunications plc represented 13% of net revenue, and revenue from Shaw Communications, Inc. and one other customer each represented 11% of net revenue with no other single customer accounting for more than 10% of net revenue.  For the three months ended March 31, 2014, no customer accounted for more than 10% of net revenue.

At March 31, 2015, accounts receivable from two customers represented 30% and 10%, respectively, of total accounts receivable, with no other single customer accounting for more than 10% of the accounts receivable balance.  At December 31, 2014, accounts receivable from one customer represented 13% of total accounts receivable with no other single customer accounting for more than 10% of the accounts receivable balance.  As of March 31, 2015 and December 31, 2014, approximately 92% and 93%, 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 March 31, 2015 and 2014, the Company has not been required to make any payments resulting from infringement claims asserted against customers and has not recorded any related reserves.
 
18

11. INCOME TAXES

The Company’s effective tax rate was approximately zero percent for the three months ended March 31, 2015 and 2% for the three months ended March 31, 2014.  For the three months ended March 31, 2015, the Company recorded an income tax expense of $11,000 on a loss before provision for income taxes of $3.3 million.  For the three months ended March 31, 2014, the Company recorded an income tax benefit of $0.1 million on a loss before provision for income taxes of $6.1 million. The effective tax rate for each of the three months ended March 31, 2015 and 2014 differs from the federal statutory tax rate as a result of the income tax expense related to the amortization of the indefinite life intangibles, state taxes and earnings taxed in foreign jurisdictions and unbenefited losses due to full valuation allowances in the US, Canada and Sweden.

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

The Company recognizes interest and penalties related to uncertain tax positions in income tax expense.  As of March 31, 2015, the Company had no accrued interest or penalties related to uncertain tax positions.   The federal returns for the years ended 2011 through the current period and most state returns for the years ended 2010 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 2007 through the current period.

At March 31, 2015, the Company had $196,000 of unrecognized tax benefits, none of which would affect the Company’s effective tax rate if recognized.  The Company currently has a full valuation allowance against its U.S. net deferred tax assets which would impact the timing of the effective tax rate benefit should any of these uncertain tax positions be favorably settled in the future.  The Company does not anticipate that the total unrecognized tax benefits will change significantly over the next twelve months.

12. SEGMENT INFORMATION

The Company has one reportable operating segment representing the PacketLogic business. The Company’s Chief Operating Decision Maker (“CODM”) evaluates the performance of segments and makes decisions regarding allocation of resources based on certain metrics including segment revenue, gross profit and operating income (loss) measures before other income (expense), net and income taxes. Certain operating expenses, including stock-based compensation expenses; business development expenses; cost reduction efforts; acquisition-related intangible asset and impairment charges, and deferred compensation amortization are not allocated to segments.  The CODM does not review asset information by segment.

The following table presents information for the Company’s reportable segment (All Other represents the Company’s NAVL business; amounts in thousands):

   
PacketLogic
   
All Other
   
Total
 
Three months ended March 31, 2015:
           
Sales
 
$
19,534
   
$
969
   
$
20,503
 
Gross profit
   
11,601
     
802
     
12,403
 
Profit (loss) from operations
 
$
(468
)
 
$
394
   
$
(74
)
                         
Three months ended March 31, 2014:
                       
Sales
 
$
13,505
   
$
1,036
   
$
14,541
 
Gross profit
   
8,081
     
899
     
8,980
 
Loss from operations
 
$
(3,584
)
 
$
(270
)
 
$
(3,854
)
 
19

The following table reconciles segment gross profit and segment operating loss to consolidated results (in thousands):

   
Three Months Ended
March 31,
 
   
2015
   
2014
 
         
Segment gross profit
 
$
12,403
   
$
8,980
 
Unallocated amounts:
               
Stock-based compensation
   
(111
)
   
(97
)
Amortization of intangibles
   
(182
)
   
(262
)
Cost reduction efforts
   
     
(237
)
Consolidated gross profit
   
12,110
     
8,384
 
                 
Segment operating loss
   
(74
)
   
(3,854
)
Unallocated amounts:
               
Stock-based compensation
   
(1,207
)
   
(1,313
)
Amortization of intangibles
   
(225
)
   
(375
)
Cost reduction efforts
   
     
(544
)
Deferred compensation
   
     
(65
)
Business development expenses
   
(1,191
)
   
 
Consolidated operating loss
 
$
(2,697
)
 
$
(6,151
)

Sales for geographic regions are based upon the customer’s location.  The following are summaries of net sales by geographical region (in thousands):

   
Three Months Ended
March 31,
 
   
2015
   
2014
 
Sales:
       
United States
 
$
2,840
   
$
2,954
 
Canada and Latin America
   
3,031
     
2,906
 
Europe, Middle East and Africa
   
9,249
     
5,455
 
Asia Pacific
   
5,383
     
3,226
 
Total
 
$
20,503
   
$
14,541
 

The location of long-lived assets is based on the physical location of the Company’s regional offices.  The following are summaries of property and equipment, net, by geographical region (in thousands):

   
March 31,
2015
   
December 31,
2014
 
Property and equipment, net:
       
United States
 
$
1,016
   
$
1,207
 
Canada
   
2,514
     
2,811
 
Europe
   
3,635
     
4,299
 
Asia Pacific
   
7
     
5
 
Total
 
$
7,172
   
$
8,322
 

13.
SUBSEQUENT EVENTS

The information under “Merger Agreement with Francisco Partners” in Note 1 above is incorporated into this Note 13 by reference.
 
20

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, 2014, filed with the Securities and Exchange Commission (“SEC”) on March 13, 2015.

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 2015 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.
 
21

Overview

Recent Developments – Entry into Merger Agreement with Francisco Partners

The information set forth in Note 1 of the Notes to Condensed Consolidated Financial Statements under the caption “Merger Agreement with Francisco Partners” included in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.

Our Business

We are a leading provider of Subscriber Experience Assurance, or SEA, solutions designed for network operators worldwide.  Our PacketLogic solutions enable network operators to gain insights, make decisions and take actions to ensure a high quality experience for Internet connected devices.  Network operators deploy our technology to gain insights on their subscribers and networks, make decisions on service packaging and then deliver those solutions to subscribers connected to their network.  We believe that the intelligence our products provide about subscribers and their experience enables our network operator customers to make better-informed business decisions and increases customer satisfaction in the highly competitive worldwide broadband market.  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, telecommunications companies, Wi-Fi network operators and Internet service providers.  Our enterprise customers include educational institutions, commercial enterprises, 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 products are delivered to network operators through pre-packaged hardware or as virtualized software, which we expect will become a large part of our business going forward and open up new partnership opportunities.

Our SEA solutions are part of the high-growth market for mobile packet and broadband core and access products.  This market is composed of three separate addressable market opportunities:

Deep Packet Inspection (“DPI”) Market

Our products are sold either bundled with hardware or as pure software to deliver a solution that is a key element of the mobile packet and broadband core ecosystems.  Our solutions are often integrated with additional elements in the mobile packet and broadband core, including Policy Management and Charging functions, and are compliant with the widely adopted 3rd Generation Partnership Program standard.  In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, service providers 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. We also sell our embedded Network Application Visibility Library, or NAVL, solutions to other network equipment vendors.  Our embedded solutions enable network solutions suppliers to more quickly add application awareness to their platforms, since our NAVL DPI engine 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.  NAVL enables us to achieve indirect market share in the DPI market by supplying embedded solutions with our DPI engine.  The market for DPI products was $852.0 million in 2014 and, according to Infonetics Research, is expected to grow to just under $2.0 billion by 2019.

Customer Experience Management (“CEM”) Market

In 2014, we launched two significant products that increase our total addressable market: RAN Perspectives and our Insights Product Family.  RAN Perspectives is a Subscriber Identity Module, or SIM-based applet, that a mobile operator can deploy on devices connected to their network.  The applet will report the subscriber’s location and the signal strength and quality that their device has with the mobile network.  This enables our solutions to have real-time location awareness and visibility into the Radio Access Network, or RAN, to complement our existing visibility into the broadband data network.  By combining these two intelligence metrics, we are now competing in the CEM, market with companies such as Gigamon, NetScout, Ericsson, Huawei and other larger telecom vendors.  MarketsandMarkets forecasts the CEM market to grow from $3.77 billion in 2014 to $8.39 billion in 2019.  This represents a CAGR of 17.3% from 2014 to 2019.
 
22

Telecom Big Data Analytics Market

Our Insights Product Family consists of unique visualization of our SEA solutions based on different roles inside of a network operator – Engineering, Customer Care, Marketing and Executives.  These products will compete with traditional big data products from companies such as IBM, Guavus and Zettics.  Mind Commerce expects the Big Data driven telecom analytics market to grow at a CAGR of nearly 50% between 2014 and 2019.  By the end of 2019, the market will eventually account for $5.4 billion in annual revenue.

Our products are marketed under the PacketLogic and NAVL brand names.  We have a broad spectrum of products delivering SEA 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 experience for subscribers.  These products are offered as virtual or hardware appliances to customers, enabling them to choose their platform based upon their deployment needs and preferences.

Our Company is 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 and Europe.

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, 2014, filed with the SEC on March 13, 2015.

Results of Operations

Comparison of Three Months Ended March 31, 2015 and 2014
 
23

Revenue

Revenue for the three months ended March 31, 2015 and 2014 was as follows (in thousands, except percentages):

 
Three Months Ended
March 31,
 
2015
   
2014
 
 
Increase/
(Decrease)
 
     
Net product revenue
 
$
15,172
   
$
9,504
     
60
%
Net support revenue
   
5,331
     
5,037
     
6
%
Total revenue
 
$
20,503
   
$
14,541
     
41
%

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.
                                              
Total product revenue in the three months ended March 31, 2015 was $15.2 million and increased 60%, compared with $9.5 million in the three months ended March 31, 2014. The increase in product revenue in the three months ended March 31, 2015 compared to the comparable prior year period reflected growth in sales from tier-one service provider customers in international markets, including Europe, the Middle East and Asia-Pacific.  
                                                  
Support revenue for the three months ended March 31, 2015 was $5.3 million, an increase of 6%, compared to the three months ended March 31, 2014.  The increase in support revenue was due to a $0.1 million increase in support service revenue and a $0.2 million increase in professional service revenue.  These increases reflected the continued expansion of the installed base of our product to which we have sold ongoing support services, and a higher level of professional service project completions. Total support revenue fluctuates over time depending on the number of new customers, support renewals from continuing customers, and completed professional service projects during the period.
                                                     
For the three months ended March 31, 2015, revenue from Itochu Techno-Solutions Corp. represented 14% of net revenue, British Telecommunications plc represented 13% of net revenue, and Shaw Communications, Inc. and one other customer each represented 11% of net revenue with no other single customer accounting for more than 10% of net revenue.  For the three months ended March 31, 2014, no customer accounted for more than 10% of net revenue.  
                                                              
Sales made to customers located outside the United States as a percentage of total net revenues were 86% and 80% for the three months ended March 31, 2015 and 2014, respectively.
                                                                
For the year ending December 31, 2015, we expect total revenue to increase approximately 15% compared to total revenue for the year ended December 31, 2014.

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 months ended March 31, 2015 and 2014 (in thousands, except percentages):

   
Three Months Ended
March 31,
 
   
2015
   
2014
   
Increase/
(Decrease)
 
Product costs
 
$
7,155
   
$
5,091
     
41
%
Percent of net product revenue
   
47
%
   
54
%
       
                         
Support costs
 
$
1,238
   
$
1,066
     
16
%
Percent of net support revenue
   
23
%
   
21
%
       
                         
Total cost of sales
 
$
8,393
   
$
6,157
     
36
%
Percent of total net revenue
   
41
%
   
42
%
       
 
24

Total cost of sales in the three months ended March 31, 2015 increased by $2.2 million, compared to the three months ended March 31, 2014.  Cost of sales as a percentage of revenue decreased by 1 percentage point for the three months ended March 31, 2015, compared to the same period in the prior year.  The increase in cost of sales in the first quarter of 2015 primarily reflected an increase in material costs associated with an increase in product sales.  The decrease in cost of sales as a percentage of revenue was primarily due to higher margin earned on product sales in the three months ended March 31, 2015 as compared to the corresponding period of 2014.  Stock-based compensation recorded to cost of sales in each of the three months ended March 31, 2015 and 2014 was $0.1 million.
                                                                   
Gross Profit

Gross profit for the three months ended March 31, 2015 and 2014 was as follows (in thousands, except percentages):

 
Three Months Ended
March 31,
 
2015
 
2014
 
Increase
 
             
Gross profit
 
$
12,110
   
$
8,384
     
44
%
Percent of total net revenue
   
59
%
   
58
%
       

Our total gross profit margin for the three months ended March 31, 2015 increased by 1 percentage point, compared to the three months ended March 31, 2014.  The increase resulted from higher margins earned on product sales in the three months ended March 31, 2015 and the absence of severance costs associated with our cost reduction efforts, which totaled $0.2 million in the three months ended March 31, 2014. On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangibles and cost reduction efforts, the gross margin rate for the three months ended March 31, 2015 was 60%, as compared to 62% for the three months ended March 31, 2014.  (See page 28 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 product mix in that period, and we expect variability in our gross margin rate to continue in the future.

Operating Expenses

Operating expenses for the three months ended March 31, 2015 and 2014 were as follows (in thousands, except percentages):
 
 
Three Months Ended
March 31,
 
2015
 
2014
 
 
Increase/
(Decrease)
 
       
Research and development
 
$
3,431
   
$
4,548
     
(25
)%
Sales and marketing
   
7,159
     
6,877
     
4
%
General and administrative
   
4,217
     
3,110
     
36
%
Total
 
$
14,807
   
$
14,535
     
2
%
                                                         
In the three months ended March 31, 2015, our total operating expenses increased primarily due to higher general and administrative expenses, reflecting an increase in business development costs associated with our strategic review process.  This increase was offset by a decrease in research and development expense resulting from lower employee compensation and product development costs.  On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangibles, cost reduction efforts, deferred compensation and business development expenses, operating expenses in the three months ended March 31, 2015 were $12.5 million, a decrease of $0.3 million as compared to $12.8 million in the three months ended March 31, 2014.  This decrease was due mainly to reduced research and development expenses associated with lower non-recurring engineering and new prototype costs, partially offset by higher sales and marketing expenses, primarily commissions associated with higher revenue.  (See page 28 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.)
                                                                            
25

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 months ended March 31, 2015 and 2014 were as follows (in thousands, except percentages):

 
Three Months Ended
March 31,
 
2015
 
2014
   
Increase
 
         
Research and development
 
$
3,431
   
$
4,548
     
(25
)%
As a percentage of net revenue
   
17
%
   
31
%
       
                                                             
Research and development expenses for the three months ended March 31, 2015 decreased by $1.1 million, compared to the three months ended March 31, 2014, as a result of a decrease in employee compensation costs of $0.5 million, the absence of severance costs associated with our cost reduction efforts of $0.2 million in the three months ended March 31, 2014, and lower product development costs of $0.4 million relating to non-recurring engineering and testing of new products.  Stock-based compensation recorded to research and development expenses in each of the three months ended March 31, 2015 and 2014 was $0.4 million.  Research and development expenses as a percentage of revenue decreased by fourteen percentage points from the three months ended March 31, 2014, reflecting the decrease in research and development expense on higher revenue.  On a non-GAAP basis, after adjusting for stock-based compensation, cost reduction efforts and deferred compensation, research and development expenses for the three months ended March 31, 2015 were $3.1 million, a decrease of $0.8 million compared to $3.9 million in the three months ended March 31, 2014, as a result of the decrease in employee compensation and product development costs.  (See page 28 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.)
                                                         
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 months ended March 31, 2015 and 2014 were as follows (in thousands, except percentages):

 
Three Months Ended
March 31,
 
2015
 
2014
   
Increase
 
         
Sales and marketing
 
$
7,159
   
$
6,877
     
4
%
As a percentage of net revenue
   
35
%
   
47
%
       
                                                          
Sales and marketing expenses for the three months ended March 31, 2015 increased by $0.3 million, compared to the three months ended March 31, 2014.  The increase reflected higher commission expense of $0.6 million on the higher level of revenue offset by a $0.3 million decrease in other compensation related expenses.  Stock-based compensation recorded to sales and marketing expenses in the three months ended March 31, 2015 and 2014 was $0.3 million and $0.4 million, respectively.   Sales and marketing expenses as a percentage of revenue decreased by twelve percentage points from the three months ended March 31, 2014 as the increase in revenue was greater than the increase in sales and marketing expense.  On a non-GAAP basis, after adjusting for stock-based compensation, amortization of intangibles, cost reduction efforts and deferred compensation, sales and marketing expenses for the three months ended March 31, 2015 were $6.8 million, which is an increase of $0.5 million, compared to $6.3 million in the three months ended March 31, 2014.  The increase primarily reflected the higher commissions earned in the three months ended March 31, 2015. (See page 28 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.)
                                                         
26

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 months ended March 31, 2015 and 2014 were as follows (in thousands, except percentages):

 
Three Months Ended
March 31,
 
2015
 
2014
   
Decrease
 
         
General and administrative
 
$
4,217
   
$
3,110
     
36
%
As a percentage of net revenue
   
21
%
   
21
%
       
                                                            
General and administrative expenses for the three months ended March 31, 2015 increased by $1.1 million, compared to the three months ended March 31, 2014, due to $1.2 million in business development costs comprised of legal, investment banking fees and consultation costs primarily associated with our strategic review process resulting in entering into the Merger Agreement with Francisco Partners.  In connection with the proposed Merger, we entered into retention agreements with certain of our employees, excluding our CEO and CFO, to retain their services through the completion of the Merger.  We expect that in 2015, general and administrative expenses will increase as a result of the merger-related transaction costs associated with the Merger Agreement with Francisco Partners.  Stock-based compensation recorded to general and administrative expense in each of the three months ended March 31, 2015 and 2014 was $0.4 million.  General and administrative expenses as a percentage of revenue remained unchanged for the three months ended March 31, 2015, compared to the corresponding period in 2014 as the increase in general and administrative expense corresponded with increased revenue.  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 months ended March 31, 2015 were $2.6 million, which is a decrease of $0.1 million as compared to $2.7 million in the three months ended March 31, 2014.  (See page 28 for a reconciliation of this non-GAAP financial measure to the most comparable GAAP measure and other important information.)
                                                           
Interest and Other Income (Expense), Net

 
Three Months Ended
March 31,
 
2015
 
2014
 
Increase
 
 
($ in thousands)
   
       
Interest and other income (expense), net
 
$
(591
)
 
$
28
     
(2,211
)%

Interest and other income expense, net increased in the three months ended March 31, 2015 compared to the three months ended March 31, 2014 due to an increase in foreign currency losses associated with the weakening of foreign currencies against the U.S. dollar.
                                                                            
Provision (Benefit) from Income Taxes

 
Three Months Ended
March 31,
 
2015
 
2014
 
Decrease
 
 
($ in thousands)
   
       
Provision (benefit) from income taxes
 
$
11
   
$
(147
)
   
107
%

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 tax provision for the three months ended March 31, 2015 primarily reflects state taxes and earnings taxed in foreign jurisdictions.
 
27

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 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 additional 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 and other strategic transactions, 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 other strategic transactions, 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.
 
28

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

   
Three Months Ended
March 31,
 
   
2015
   
2014
 
   
($ in thousands)
 
Sales:
       
Product sales
 
$
15,172
   
$
9,504
 
Support sales
   
5,331
     
5,037
 
Total sales
   
20,503
     
14,541
 
Cost of sales:
               
Product cost of sales, GAAP
   
7,155
     
5,091
 
Non-GAAP adjustments:
               
Stock-based compensation (1)
   
(9
)
   
(15
)
Amortization of intangibles (2)
   
(182
)
   
(262
)
Cost reduction efforts (3)
   
     
(237
)
Product cost of sales, non-GAAP
   
6,964
     
4,577
 
Support cost of sales, GAAP
   
1,238
     
1,066
 
Non-GAAP adjustments:
               
Stock-based compensation (1)
   
(102
)
   
(82
)
Support cost of sales, non-GAAP
   
1,136
     
984
 
Total cost of sales, non-GAAP
   
8,100
     
5,561
 
                 
Gross profit, non-GAAP
   
12,403
     
8,980
 
                 
Operating expenses:
               
Research and development, GAAP
   
3,431
     
4,548
 
Non-GAAP adjustments:
               
Stock-based compensation (1)
   
(359
)
   
(388
)
Cost reduction efforts (3)
   
     
(206
)
Deferred compensation (4)
   
     
(65
)
Research and development, non-GAAP
   
3,072
     
3,889
 
Sales and marketing, GAAP
   
7,159
     
6,877
 
Non-GAAP adjustments:
               
Stock-based compensation (1)
   
(297
)
   
(408
)
Amortization of intangibles (2)
   
(43
)
   
(113
)
Cost reduction efforts (3)
   
     
(74
)
Sales and marketing, non-GAAP
   
6,819
     
6,282
 
General and administrative, GAAP
   
4,217
     
3,110
 
Non-GAAP adjustments:
               
Stock-based compensation (1)
   
(440
)
   
(420
)
Cost reduction efforts (3)
   
     
(27
)
Business development expenses (5)
   
(1,191
)
   
 
General and administrative, non-GAAP
   
2,586
     
2,663
 
Total operating expenses, non-GAAP
   
12,477
     
12,834
 
                 
Loss from operations, non-GAAP
   
(74
)
   
(3,854
)
                 
Interest and other income (expense), net
   
(591
)
   
28
 
                 
Income tax provision (benefit)
   
11
     
(147
)
Non-GAAP adjustments (6):
   
     
179
 
Income tax provision, non- GAAP
   
11
     
32
 
Non-GAAP net loss
 
$
(676
)
 
$
(3,858
)
                 
Non-GAAP net loss per common share – diluted
 
$
(0.03
)
 
$
(0.19
)
                 
Weighted average number of shares used in per share calculation-diluted
   
20,674
     
20,329
 
                 
Reconciliation of net income (loss):
               
U.S. GAAP as reported
 
$
(3,299
)
 
$
(5,976
)
Non-GAAP adjustments:
               
Stock-based compensation (1)
   
1,207
     
1,313
 
Amortization of intangibles (2)
   
225
     
375
 
Cost reduction efforts (3)
   
     
544
 
Deferred compensation (4)
   
     
65
 
Business development expenses (5)
   
1,191
     
 
Income tax provision, non-GAAP (6)
   
     
(179
)
As adjusted
 
$
(676
)
 
$
(3,858
)
                 
Reconciliation of diluted net income (loss) per share:
               
U.S. GAAP as reported
 
$
(0.16
)
 
$
(0.29
)
Non-GAAP adjustments:
               
Stock-based compensation (1)
   
0.06
     
0.06
 
Amortization of intangibles (2)
   
0.01
     
0.02
 
Cost reduction efforts (3)
   
     
0.03
 
Deferred compensation (4)
   
     
 
Business development expenses (5)
   
0.06
     
 
Income tax provision, non-GAAP (6)
   
     
(0.01
)
As adjusted
 
$
(0.03
)
 
$
(0.19
)
                 
Shares used in computing diluted net loss per share:
               
Diluted
   
20,674
     
20,329
 
 
29

(1)
Stock-based compensation expense is calculated in accordance with the fair value recognition provisions of Accounting Standards Codification Topic 718.
(2)
Amortization expense associated with intangible assets acquired in the acquisition of Vineyard in January 2013.
(3)
Severance and other employee-related costs in connection with our cost-reduction efforts.
(4)
Deferred compensation includes amortization of amounts paid under retention agreements with Vineyard’s three founders. These amounts were paid during the first quarter of 2014, after one year of continuous employment with us.
(5)
Business development expenses include the cost of outside professional services for negotiating and performing legal, accounting and tax due diligence for potential mergers and acquisitions and other significant partnership arrangements.
(6)
Income tax benefit associated with the following Vineyard acquisition related items: reversal of Vineyard’s pre-existing income tax valuation allowance upon acquisition, amortization of acquired intangible assets and book to tax differences on deferred revenue.

Liquidity and Capital Resources

Cash, Cash Equivalents and Investments

The following table summarizes the changes in our cash balance for the periods indicated:

 
Three Months Ended
March 31,
 
2015
   
2014
 
 
($ in thousands)
 
Net cash provided by operating activities
 
$
5,467
   
$
475
 
Net cash used in investing activities
   
(746
)
   
(58,437
)
Net cash provided by (used in) financing activities
   
(102
)
   
69
 
Effect of exchange rate changes on cash and cash equivalents
   
556
     
(4
)
Net increase (decrease) in cash and cash equivalents
 
$
5,175
   
$
(57,897
)
                                                        
During the three months ended March 31, 2015, we generated $5.5 million in cash from operating activities as compared to $0.5 million in cash generated for the three months ended March 31, 2014.  Cash provided by operating activities during the three months ended March 31, 2015 primarily consisted of net working capital sources of cash of $6.1 million and non-cash charges of $2.7 million, offset by our net loss of $3.3 million. Working capital sources of cash mainly consisted of a decrease in accounts receivable of $5.4 million due to strong collections and a $2.8 million increase in deferred revenues due to increased deferred support revenue, reflecting new support contracts on higher product sales and renewals of existing support contracts. Working capital uses of cash consisted primarily of a decrease in accounts payable of $1.8 million associated with payments on inventory purchases and an increase in inventory of $0.7 million associated with anticipated product sales.  Non-cash charges consisted primarily of stock-based compensation of $1.2 million, amortization of intangible assets of $0.2 million, amortization of premium on investments of $0.2 million, depreciation expense of $0.7 million and the provision for excess and obsolete inventory of $0.4 million.
                                                               
Cash provided by operating activities during the three months ended March 31, 2014 primarily consisted of net working capital sources of cash of $4.2 million and non-cash charges of $2.3 million, offset by our net loss of $6.0 million. Working capital sources of cash mainly consisted of a decrease in accounts receivable of $12.0 million due to strong collections. Working capital uses of cash consisted primarily of a decrease in accounts payable of $3.7 million associated with payments on inventory purchases, an increase in inventory of $1.7 million resulting from material purchases in anticipation of future sales and a $1.4 million decrease in deferred revenues due to the recognition of product revenues that were deferred in the prior year.  Non-cash charges consisted primarily of stock-based compensation of $1.3 million, amortization of intangible assets of $0.4 million, amortization of premium on investments of $0.1 million and depreciation expense of $0.6 million, offset by changes in deferred taxes of $0.2 million.
 
30

Net cash used in investing activities of $0.7 million during the three months ended March 31, 2015 consisted of purchases of short-term investments of $18.9 million and fixed assets of $0.6 million offset by proceeds from maturities of short-term investments of $18.8 million.
                                             
Net cash used in investing activities of $58.4 million during the three months ended March 31, 2014 consisted of purchases of short-term investments of $64.6 million offset by proceeds from maturities of short-term investments of $7.0 million and equipment purchases primarily of lab and testing equipment for use in research and development of $0.8 million.
                                           
Net cash used in financing activities of $0.1 million during the three months ended March 31, 2015 consisted of funds paid for employee taxes associated with restricted stock units withheld.
                                           
Net cash provided by financing activities of $0.1 million during the three months ended March 31, 2014 consisted of proceeds from the exercise of stock options.

Our cash, cash equivalents and short-term investments at March 31, 2015 consisted of bank deposits with third party financial institutions, money market funds, U.S. agency securities, commercial paper and corporate bonds.  Our investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relationship to our investment guidelines and market conditions.  Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase.  Short-term investments have a remaining maturity of greater than three months at the date of purchase and the portfolio of short-term investments have a weighted average maturity of less than one year.  All investments are classified as available for sale.

Based on our current cash, cash equivalents and short-term investment balances, and anticipated cash flow from operations, we believe that our working capital will be sufficient to meet the cash needs of our business for at least the next 12 months.  Our future capital requirements will depend on many factors, including our rate of growth, the expansion of our sales and marketing activities, development of additional channel partners and sales territories, the infrastructure costs associated with supporting a growing business and greater installed base of customers, introduction of new products, enhancement of existing products and the continued acceptance of our products.  We may also enter into arrangements that require investment such as entering into complementary businesses, service expansion, technology partnerships or acquisitions.

Off-Balance Sheet Arrangements

As of March 31, 2015, we had no off-balance sheet items as described by Item 303(a)(4) of Regulation S-K.  We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments or other contingent arrangements that expose us to material continuing risks, contingent liabilities or any other obligations under a variable interest in an unconsolidated entity that provide us with financing, liquidity, market risk or credit risk support.

Contractual Obligations

We lease facility space under non-cancelable operating leases in California, Canada and Sweden that extend through 2024. The details of these contractual obligations are further explained in Note 10 of the Notes to Condensed Consolidated Financial Statements.

We use third-party suppliers to assemble and test our hardware products.  In order to reduce manufacturing lead-times and ensure an adequate supply of inventories, our agreements with some of these suppliers allow them to procure long lead-time component inventory based on rolling production forecasts provided by us.  We may be contractually obligated to purchase long lead-time component inventory procured by certain suppliers in accordance with our forecasts.  In addition, we issue purchase orders to our third-party suppliers that may not be cancelable at any time.  As of March 31, 2015, we had open non-cancelable purchase orders amounting to approximately $11.4 million, primarily with our third-party suppliers.
 
31

Item 3.
Quantitative and Qualitative Disclosures about Market Risk

Foreign Currency Risk

Our sales contracts are denominated predominantly in U.S. Dollars, Swedish Krona, British Pounds, Australian Dollars, Canadian Dollars and the Euro.  We incur operating expenses in U.S. Dollars, Swedish Krona and Canadian Dollars.  Therefore, we are subject to fluctuations in these foreign currency exchange rates.  To date, exchange rate fluctuations have not had a material impact on our revenues, operating results and cash flows, and we have not used derivative instruments to hedge our foreign currency exposures.  However, the effect of a 10% change in foreign currency exchange rates could have a material effect on our future operating results or cash flows, depending on which foreign currency exchange rates change and the directional change against the U.S. Dollar.
                                                       
Interest Rate Sensitivity

We had unrestricted cash, cash equivalents and short-term investments totaling approximately $107.7 million at March 31, 2015.  Cash equivalents and short-term investments are composed of money market funds, U.S. agency securities, commercial paper and corporate bonds.  Our investment policy requires investments to be of high credit quality, primarily rated A/A2, with the objective of minimizing the potential risk of principal loss.  Short-term investments generally have an effective maturity of less than one year and are classified as available-for-sale and, consequently, are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income (loss).  Because of the short weighted average maturity of our investment portfolio at March 31, 2015, we believe that the fair value of our investment portfolio would not be significantly impacted by either a hypothetical 100 basis point increase or decrease in market interest rates.  If hypothetical market interest rates increased by 100 basis points, we may incur $0.4 million of unrealized loss.  If hypothetical market interest rates decreased by 100 basis points, we may incur $0.2 million of unrealized gain.

Item 4.
Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We have adopted and maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that controls and procedures, no matter how well designed and operated, cannot provide absolute assurance of achieving the desired control objectives.

As required by Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that as of the end of the period covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the period ended March 31, 2015 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
32

PART II. OTHER INFORMATION

Item 1.
Legal Proceedings

The information set forth in Note 10 of the Notes to Condensed Consolidated Financial Statements under the caption “Litigation Relating to the Company’s Pending Merger with Francisco Partners” included in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.

We are at times involved in litigation and other legal claims in the ordinary course of business. When appropriate in management’s estimation, we may record reserves in our financial statements for pending litigation and other claims.  Although it is not possible to predict with certainty the outcome of litigation, we do not believe that any of the other current pending legal proceedings to which we are a party or to which any of our property is subject will have a material impact on our results of operations or financial condition.

Item 1A.
Risk Factors

We have marked with an asterisk (*) those risk factors below that reflect material changes from the risk factors included in our Annual Report on Form 10-K for the year ended December 31, 2014, filed with the Securities and Exchange Commission, or the SEC, on March 13, 2015.

You should carefully consider the risks described below, together with all of the other information included in this Quarterly Report on Form 10-Q, in considering our business and prospects.  Set forth below and elsewhere in this Quarterly Report on Form 10-Q and in other documents we file with the SEC are descriptions of the risks and uncertainties that could cause our actual results to differ materially from the results contemplated by the forward-looking statements contained in this report. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations.  Each of these risk factors could adversely affect our business, operating results and financial condition, as well as adversely affect the value of an investment in our common stock.

Risks Related to Our Business

We have a limited operating history on which to evaluate our Company.

The products we sell today are derived primarily from the products of the Netintact companies that we acquired in 2006. We are continually working to improve our operations on a combined basis.

Furthermore, we have only recently launched many of our products and services on a worldwide basis, and we are continuing to develop relationships with distribution partners and otherwise exploit sales channels in new markets.  Therefore, investors should consider the risks and uncertainties frequently encountered by companies in new and rapidly evolving markets, which include the following:

·
successfully introducing new products and entering new markets;
·
successfully servicing and upgrading new products once introduced;
·
increasing brand recognition;
·
developing strategic relationships and alliances;
·
managing expanding operations and sales channels;
·
successfully responding to competition; and
·
attracting, retaining and motivating qualified personnel.

If we are unable to address these risks and uncertainties, our results of operations and financial condition may be adversely affected.

Our actual operating results may differ significantly from our guidance and investor expectations.

From time to time, we may release guidance in our earnings releases, earnings conference calls or otherwise, regarding our future performance that represents our management’s estimates as of the time of release of the guidance.  Any such guidance, which will include forward-looking statements, will be based on projections prepared by our management.
 
33

Projections are based upon a number of assumptions and estimates that, while presented with numerical specificity, are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. These projections are also based upon specific assumptions with respect to future business decisions, some of which will change.  We may state possible outcomes as high and low ranges, which are intended to provide a sensitivity analysis as variables are changed but are not intended to indicate that actual results could not fall outside of the suggested ranges.  The principal reason why we may release guidance is to provide an opportunity for our management to discuss our business outlook with analysts and investors.  With or without our guidance, analysts and other investors may publish their own expectations regarding our business, financial performance and results of operations.  We do not accept any responsibility for any projections or reports published by any such third persons.

Guidance is necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the guidance furnished by us will not materialize or will vary significantly from actual results.  Accordingly, our guidance is only an estimate of what our management believes is realizable as of the time of release. Actual results will vary from our guidance, and the variations may be material.  If our actual performance does not meet or exceed our guidance or investor expectations, the trading price of our common stock may decline.

In addition, historically we have received, and in the future we may receive, a material portion of a quarter’s sales orders during the last two weeks of the quarter. Accordingly, there is a risk that our revenue may move from one quarter to the next, or not be realized at all, if we cannot fulfill all of the orders and satisfy all the revenue recognition criteria under our accounting policies before the quarter ends.  If completed purchase orders are not obtained in a timely manner, our products are not shipped on time, we fail to manage our inventory properly, we fail to release new products on schedule or we are unable to fulfill orders for any other reason, our revenue for that quarter could fall below our expectations or those of securities analysts and investors, which may result in a decline in our stock price.

Our PacketLogic family of products is our primary product line. A substantial majority of our current revenues and a significant portion of our future growth depend on our ability to continue its commercialization.

A substantial majority of our current revenues and much of our anticipated future growth depend on the development, introduction and market acceptance of new and enhanced products in our PacketLogic product line that address additional market requirements in a timely and cost-effective manner.  In the past, we have experienced delays in product development and such delays may occur in the future.  Our future growth will largely be determined by market acceptance and continued development of our PacketLogic product line.

If additional customers do not adopt, purchase and deploy our PacketLogic products, our revenues will not grow and may decline.  In addition, should our prospective customers fail to recognize, or our current customers lose confidence in, the value or effectiveness of our PacketLogic product line, the demand for our products and services will likely decline. Any significant price compression in our targeted markets as a result of newly introduced solutions could have a material adverse effect on our business.  Moreover, when we announce new products or product enhancements that have the potential to replace or shorten the life cycle of our existing products, customers may defer purchasing our existing products.  These actions could harm our operating results by unexpectedly decreasing sales and exposing us to greater risk of product obsolescence.

Marketing and sales of our products to large broadband service providers often involve a lengthy evaluation and sales cycle, which may cause our revenues to fluctuate from period to period and could result in us expending significant resources without making any sales.

Our sales cycles often are lengthy because our prospective customers generally follow complex procurement procedures and undertake significant testing to assess the performance of our products within their networks. As a result, we may invest significant time from initial contact with a prospective customer before that customer decides to purchase and incorporate our products in its network.  We may also expend significant resources attempting to persuade large broadband service providers to incorporate our products into their networks without any measure of success. Even after deciding to purchase our products, initial network deployment and acceptance testing of our products by a large broadband service provider may last several years.  Network operators, especially in North America, often require that products they purchase meet Network Equipment Building System, or NEBS, certification requirements, which relate to the reliability of telecommunications equipment.  While our PacketLogic products and future products are and are expected to continue to be designed to meet NEBS certification requirements, they may fail to do so, and any failure to meet NEBS certification requirements could have a material adverse impact on our ability to sell our products.
 
34

Due to our lengthy sales cycle, particularly to larger customers, and our revenue recognition practices, we expect our revenue may fluctuate significantly from period to period. In pursuing sales opportunities with larger enterprises, we expect that we will make fewer sales to larger entities, but that the magnitude of individual sales will be greater.  We may report substantial revenue growth in the period that we recognize the revenue from a large sale, which may not be repeated in an immediately subsequent period.  Because our revenues may fluctuate materially from period to period, the price of our common stock may decline. In addition, even after we have received commitments from a customer to purchase our products, in accordance with our revenue recognition practices, we may not be able to recognize and report the revenue from that purchase for months or years after the time of purchase. As a result, there could be significant delays in our receipt and recognition of revenue following sales orders for our products.

In addition, if a competitor succeeds in convincing a prospective customer to adopt that competitor’s product, it may be difficult for us to displace the competitor at a later time because of the cost, time, effort and perceived risk to network stability involved in changing to a different vendor’s products.  As a result, we may incur significant sales and marketing expenses without generating any sales.

We need to increase the functionality of our products and offer additional features in order to be competitive.

The market in which we operate is highly competitive and unless we continue to enhance the functionality of our products by adding additional features, our competitive position may deteriorate and the average selling prices for our products may decrease over time.  Such a decrease also could result from the introduction of competing products or from the standardization of Deep Packet Inspection, or DPI, technology.  To counter this trend, we endeavor to enhance our products by offering higher system speeds and additional performance features, such as additional protection functionality, supporting additional applications and enhanced reporting tools.  We may also need to reduce our per unit manufacturing costs at a rate equal to or faster than the rate at which selling prices may decline.  If we are unable to reduce these costs or to offer increased functionality and features, our results of operations and financial condition may be adversely affected.

If we fail to effectively manage our inventory, we could have excess inventory or experience inventory shortages, which could result in decreased revenue and gross margins and harm our business.

In determining the required quantities of our products to produce, we must make significant judgments and estimates based on inventory levels, market trends and other related factors. Because of the inherent nature of estimates, there could be significant differences between our estimates and the actual amounts of inventory we require. This could result in shortages if we fail to anticipate demand, or excess inventory and write-offs if we order more inventory than we need or if anticipated sales do not occur.

In addition, at any time, a significant amount of our inventory may be located off-site at customer locations while our customers evaluate and conduct trials of our products. If these trials do not result in sales of our products, we may need to take inventory charges or fully write-off such inventory. Additionally, inventory levels in excess of customer demand may result in inventory write-downs, and the sale of excess inventory at discounted prices could significantly impair our brand recognition and have an adverse effect on our business, results of operations or financial condition.

*A substantial portion of our revenues may be dependent on a small number of Tier 1 service providers that purchase in large quantities. If we are unable to maintain or replace our relationships with these customers, our revenues may fluctuate and our growth may be limited.

Since 2008, when we first sold our products to Tier 1 service providers, a significant portion of our revenue has come from a limited number of customers.  There can be no guarantee that we will be able to continue to achieve revenue growth from these customers because their capacity requirements have become or will become fulfilled.  Additionally, we cannot guarantee that any customer will place follow-on orders after fulfillment of current orders.  For this reason, we do not expect that any single customer will remain a significant customer from year to year, and we will need to attract new customers in order to sustain our revenues.  Moreover, our current customers may cancel orders or their agreements with us. Order cancellations could adversely affect our product sales and revenues and, therefore, harm our business and results of operations.
 
35

For the three months ended March 31, 2015, revenue from Itochu Techno-Solutions Corp. represented 14% of net revenue, British Telecommunications plc represented 13% of net revenue, and revenue from Shaw Communications, Inc. and one other customer each represented 11% of net revenue with no other single customer accounting for more than 10% of net revenue.  For the three months ended March 31, 2014, no customer accounted for more than 10% of net revenue.

In any future year or quarter, the proportion of our revenues derived from a limited number of customers may be higher than in prior periods.  If we cannot maintain or replace the customers that purchase large amounts of our products, or if they do not purchase products at the levels or at the times that we anticipate, our ability to maintain or grow our revenues will be adversely affected.

*Changes in customer or product mix, downward pressure on sales prices, changes in volume of orders and other factors could cause our gross margin percentage to fluctuate or decline in the future.

Our gross profit margins have fluctuated from period to period, and these fluctuations are expected to continue in the future. Within the last three years, our gross profit margin has fluctuated from 49% for the three months ended September 30, 2013 to 63% for the three months ended September 30, 2014. Factors that may cause our gross margins to fluctuate include customer and product mix, market acceptance of our new products, competitive pricing dynamics, geographic and/or market segment pricing strategies, decreases in average selling prices of our products, our ability to successfully develop new products and our ability to manage manufacturing, labor and materials costs. A higher proportion of hardware sales versus software and service revenue in any period generally results in a lower gross profit margin for that period. In addition, our industry has been characterized by declining product prices over time, and we are under continuous pressure to reduce our prices to increase or even maintain our market share. Forecasting our gross margins is difficult due to our lengthy sales cycle, particularly with respect to larger customers, and our revenue recognition practices. Because our gross profit margins may fluctuate materially from period to period, or decline over time, the price of our common stock may decline.

We operate in a highly competitive market and may be unable to compete effectively with competitors which are substantially larger and more established and have greater resources.

In our rapidly evolving and highly competitive market, we compete on the price as well as the performance of our products.  We expect competition to remain intense in the future.  Increased competition could result in reduced prices and gross margins for our products and loss of market share, and could require us to increase spending on research and development, sales and marketing and customer support, any of which could have a negative financial impact on our business.  We compete with Allot Communications Ltd., Tektronix, Inc. (acquired Arbor Networks), Blue Coat Systems, Inc., Brocade Communications Systems, Inc., Cisco Systems, Inc., Citrix Systems, Inc. (acquired Bytemobile), Science Applications International Corporation (acquired Cloudshield Technologies), Ericsson, F5 Networks, Inc., Huawei Technologies Co., Ltd. and Sandvine Corporation, as well as other companies which sell products incorporating competing technologies.  In addition, our products and technology compete with other types of products that offer monitoring capabilities, such as probes and related software.  We also face indirect competition from companies that offer broadband service providers increased bandwidth and infrastructure upgrades that increase the capacity of their networks, which may lessen or delay the need for bandwidth management solutions.

Most of our competitors are substantially larger than we are and have significantly greater name recognition and financial, sales and marketing, technical, manufacturing and other resources and more established distribution channels than we do.  In addition, some prospective customers have in the past advised us that their concerns about our financial condition disqualified us from competing successfully for their business.   It is possible that one or more prospective customers could raise similar concerns in the future.  We may not be able to compete successfully against our current or potential competitors as our competitors may, among other things, be able to respond more rapidly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can.  Furthermore, prospective customers often have expressed greater confidence in the product offerings of our competitors.   Additional competitors may enter our existing or future markets with solutions that may be less expensive, provide higher performance or provide additional features than our solutions.  Given the opportunities in the bandwidth management solutions market, we also expect that other companies may enter the market with alternative products and technologies, which could reduce the sales or market acceptance of our products and services, perpetuate intense price competition or make our products obsolete.  If any technology that is competing with ours is or becomes more reliable, higher performing, less expensive or has other advantages over our technology, then the demand for our products and services would decrease, which would harm our business.
 
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Competition for experienced and skilled personnel is intense and our inability to attract and retain qualified personnel could significantly damage our business.

Our future performance will depend to a significant extent on the ability of our management to operate effectively, both individually and as a group.  We are dependent on our ability to attract, retain and motivate high caliber key personnel.  Our growth expectations will require us to attract experienced personnel to augment our current staff.  We expect to continue to recruit experienced professionals in such areas as software and hardware development, sales, technical support, product marketing and management.  We may expand our indirect channel partner program in the future and we would need to attract qualified business partners to broaden these sales channels.  In our market, there is significant competition for qualified personnel and we may not be able to attract and retain such personnel.  Our business may suffer if we encounter material delays in hiring additional personnel.

Our performance is substantially dependent on the continued services and on the performance of our executive officers and other key employees, including our Chief Executive Officer, James Brear, and our Chief Technical Officer, Alexander Haväng.  The loss of the services of any of our executive officers or other key employees could materially and adversely affect our business.  In addition, our engineering department is based in Varberg, Sweden, and many of our engineers were formerly employees of Netintact, which we acquired in 2006.   In January 2013, we acquired Vineyard and we now employ many former Vineyard engineers and product developers in Kelowna, Canada.  We are continuing to develop plans to integrate the Canadian and Swedish engineering teams, and this integration effort may result in changes to current job responsibilities.  If some or all of our Sweden-based engineers or Canada-based engineers or product developers were no longer employed by us, our ability to develop new products and serve existing customers could be materially and adversely impacted, and our results of operations and financial condition could be negatively affected.

We believe we will need to attract, retain and motivate talented management and other highly skilled employees in order to execute on our business plan.  We may be unable to retain our key employees or attract, assimilate and retain other highly qualified employees in the future.  Competitors and others have in the past, and may in the future, attempt to recruit our employees.  In California, where we are headquartered, non-competition agreements with employees generally are unenforceable. As a result, if an employee based in California leaves our Company for any reason, he or she will generally be able to begin employment with one of our competitors or otherwise compete immediately against us.

We currently do not have key person insurance in place.  If we lose one of our key officers, we would need to attract, hire and retain an equally competent person to take his or her place.  There is no assurance that we would be able to find such an employee in a timely fashion.  If we fail to recruit an equally qualified replacement or incur a significant delay, our business plans may slow down.  We could fail to implement our strategy or lose sales and marketing and development momentum.

Mergers or other strategic transactions involving our competitors could weaken our competitive position, limit our growth prospects or reduce our revenues.

We believe that there may be consolidation in our industry, which could lead to increased price competition and other forms of competition. Increased competition may cause pricing pressure and loss of market share, either of which could have a material adverse effect on our business, may limit our growth prospects or reduce our revenues and margins.  Our competitors may establish or strengthen cooperative relationships with strategic partners or other parties.  Established companies may not only develop their own products but may also merge with or acquire our current competitors as a means of entering our markets.  New competitors or alliances among competitors may emerge and rapidly acquire significant market share.  Any of these circumstances could materially and adversely affect our business and operating results.

If we are unable to effectively manage our anticipated growth, we may experience operating inefficiencies and have difficulty meeting demand for our products.

We seek to manage our growth so as not to exceed our available capital resources.  If our customer base and market grow rapidly, we would need to expand to meet this demand.  This expansion could place a significant strain on our management, products and support operations, sales and marketing personnel and other resources, which could harm our business.
 
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If demand for our products and services grows rapidly, we may experience difficulties meeting the demand. For example, the installation and use of our products require customer training.  If we are unable to provide adequate training and support for our products, the implementation process will be longer and customer satisfaction may be lower.  In addition, we may not be able to exploit fully the growing market for our products and services, and our competitors may be better able to satisfy this demand.  We cannot assure you that our systems, procedures or controls will be adequate to support the anticipated growth in our operations.  The failure to meet the challenges presented by rapid customer and market expansion could cause us to miss sales opportunities and otherwise have a negative impact on our sales and profitability.

We may not be able to install management information and control systems in an efficient and timely manner, and our current or planned personnel, systems, procedures and controls may not be adequate to support our future operations.

A currently pending proxy contest could cause us to incur substantial costs, divert management's attention and resources, and have an adverse effect on our business.

On February 25, 2015, Tristan Partners L.P., a stockholder that, together with a group of affiliated stockholders, claims to collectively own approximately 1.5% of our outstanding common stock, nominated eight individuals for election to our Board of Directors at our 2015 Annual Meeting of Stockholders.  In addition, on February 26, 2015, Castle Union Partners, L.P., a stockholder that, together with a group of affiliated stockholders, claims to collectively own approximately 6.6% of our outstanding common stock, nominated five individuals for election to our Board of Directors at our 2015 Annual Meeting of Stockholders.

As a result of these pending proxy contests, our business could be adversely affected because responding to proxy contests and reacting to other proposals from stockholders can be costly and time-consuming, disrupt our operations and divert the attention of management and our employees.  We have retained the services of various professionals to advise us on these matters, including legal, financial and communications advisors, the costs of which may negatively impact our future financial results.  In addition, perceived uncertainties as to our future direction, strategy or leadership created as a consequence of these and any similar stockholder initiatives may result in the loss of potential business opportunities, harm our ability to attract new investors and business partners, and cause our common share price to experience periods of volatility or stagnation.  Moreover, if new individuals are elected to our Board of Directors with a specific agenda, it may adversely affect our ability to effectively and timely implement our current initiatives, retain and attract experienced executives and employees, and execute on our long-term strategy.

We have limited ability to protect our intellectual property and defend against claims, which may adversely affect our ability to compete.

We rely primarily on patent law, trademark law, copyright law, trade secret law and contractual rights to protect our intellectual property rights in our PacketLogic product line.  We cannot assure you that the actions we have taken will adequately protect our intellectual property rights or that other parties will not independently develop similar or competing products that do not infringe on our intellectual property rights.  We enter into confidentiality or license agreements with our employees, consultants and corporate partners, and take appropriate measures to control access to and distribution of our software, documentation and other proprietary information.  Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise misappropriate or use our products or technology.

In an effort to protect our unpatented proprietary technology, processes and know-how, we require our employees, consultants, collaborators and advisors to execute confidentiality agreements.  These agreements, however, may not provide us with adequate protection against improper use or disclosure of confidential information.  These agreements may be breached, and we may not become aware of, or have adequate remedies in the event of, any such breach.  In addition, in some situations, these agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants, collaborators or advisors have previous employment or consulting relationships.  Furthermore, others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets.  Additionally, in some cases, customers have the right to request access to our source code upon demand.  Some of our customers have obtained the source code for our products by exercising this right, and others may do so in the future. In addition, some of our customers have required us to deposit the source code of our products into a source code escrow.  The conditions triggering the release of the escrowed source code vary by customer, but include, among other things, breach of the applicable customer agreement, failure to provide required product support or maintenance, or if we are subject to a bankruptcy proceeding or otherwise fail to carry on our business in the ordinary course.  Disclosing the content of our source code may limit the intellectual property protection we can obtain or maintain for that source code or the products containing that source code and may facilitate intellectual property infringement claims against us.  It also could permit a customer to which source code is disclosed to support and maintain that software product without being required to purchase our support or maintenance services. Each of these could harm our business, results of operations and financial condition.
 
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Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and other intellectual property rights.  This type of litigation often is very costly and can continue for a lengthy period of time.  If we are found to infringe on the proprietary rights of others, or if we agree to settle any such claims, we could be compelled to pay damages or royalties and either obtain a license to those intellectual property rights or alter our products so that they no longer infringe upon such proprietary rights.  Any license could be very expensive to obtain or may not be available at all. Similarly, changing our products or processes to avoid any claims of infringement may be costly or impractical.  Litigation resulting from claims that we are infringing the proprietary rights of others, or litigation that we initiate to protect our intellectual property rights, could result in substantial costs and a diversion of resources from sales and/or development activities, and could have a material adverse effect on our results of operations and financial condition.

Furthermore, the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the U.S.  If we fail to apply for intellectual property protection or if we cannot adequately protect our intellectual property rights in these foreign countries, our competitors may be able to compete more effectively against us, which could have a material adverse effect on our results of operations and financial condition.

Acquisitions may divert management’s attention, increase expenses and disrupt or otherwise have a negative impact on our business.

We may seek to acquire or make investments in complementary businesses, products, services or technologies on an opportunistic basis when we believe they will assist us in executing our business strategy.  Growth through acquisitions has been a viable strategy used by other network control and management technology companies.  We acquired the Netintact entities in 2006, and its products have formed the core of our current product offering.  In January 2013, we acquired Vineyard Networks Inc., or Vineyard, a company based in Kelowna, Canada. We have integrated the employees of Vineyard into our organizational structure, and we are developing plans for further product and organizational integration, which will require both time and investment to accomplish. Any failure to properly integrate the personnel or technology we hire or acquire, including successfully maintaining cohesive technology development in distant locations, could have an adverse effect on us and our results of operations. Any future acquisitions that we may pursue could distract or divert the attention of our management and employees and cause us to incur various expenses related to identifying, investigating and pursuing suitable acquisitions, whether or not they are consummated.

Following any acquisition, the integration of the acquired business, product, service or technology is complex, time consuming and expensive, and may disrupt our business.  These challenges include the timely and efficient execution of a number of post-transaction integration activities, including:

·
integrating the operations and technologies of the two companies;
·
retaining and assimilating the key personnel of each company;
·
retaining existing customers of both companies and attracting additional customers;
·
leveraging our existing sales channels to sell new products into new markets;
·
developing an appropriate sales and marketing organization and sales channels to sell new products into new markets;
·
retaining strategic partners of each company and attracting new strategic partners; and
·
implementing and maintaining uniform standards, internal controls, processes, procedures, policies and information systems.

The process of integrating operations and technology could cause an interruption of, or loss of momentum in, our business and the loss of key personnel.  The diversion of management’s attention and any delays or difficulties encountered in connection with an acquisition and the integration of our operations and technology could have an adverse effect on our business, results of operations or financial condition.  Furthermore, the execution of these post-transaction integration activities will involve considerable risks and may not come to pass as we envision.  The inability to integrate the operations, technology and personnel of an acquired business with ours, or any significant delay in achieving integration, could have a material adverse effect on our results of operations and financial condition and, as a result, on the market price of our common stock.
 
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We may not achieve the desired benefits from our acquisitions, including the revenue and other synergies and growth that we anticipate from the acquisition in the timeframe that we originally expect, and the costs of achieving these benefits may be higher than what we originally had anticipated because of a number of risks, including, but not limited to, the possibility that the acquisition may not further our business strategy as we expected and the possibility that we may not be able to expand the reach and customer base for current and future products as expected.  For example, during the third quarter of fiscal year 2014, we recorded a partial impairment of the NAVL intangible assets and a full impairment of the NAVL reporting unit goodwill, which were acquired through our acquisition of Vineyard in January 2013.  As a result of these risks, our acquisitions may not immediately contribute to our earnings as expected, or at all, we may not achieve expected revenue synergies or realization of efficiencies related to the integration of the businesses when expected, or at all, and we may not achieve the other anticipated strategic and financial benefits of the acquisitions.

We are in the process of expanding our research and development group and implementing new strategic initiatives.  If we are not successful in implementing these initiatives, or if these initiatives do not result in the intended benefits, our operating results could suffer.

We have recently embarked upon several new 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 combined with software.  We will need to expend a significant amount of time and cost to develop and implement these initiatives, including adding key resources in research and development and marketing. Moreover, we may experience unanticipated difficulties or delays in implementing these initiatives, and we may not complete these initiatives on our expected timetable, if at all, or within our projected budget. Furthermore, there can be no assurance that these initiatives, once implemented, will improve our business or our financial performance, and we may incur expenses without the benefit of higher revenues. If we are unable to successfully implement these initiatives or fail to do so on a timely basis, or if these initiatives do not provide us with the intended benefits, our results of operations and financial condition will be adversely affected.

If our products contain undetected software or hardware errors or performance deficiencies, we could incur significant unexpected expenses, experience purchase order cancellations and lose sales.

Network products frequently contain undetected software or hardware errors, failures or bugs when new products or new versions or updates of existing products are released to the marketplace.  Because we frequently introduce new versions and updates to our product line, previously unaddressed errors in the accuracy or reliability of our products, or issues with their performance, may arise.  We expect that such errors or performance deficiencies will be found from time to time in the future in new or existing products, including the components incorporated therein, after the commencement of commercial shipments.  These problems may have a material adverse effect on our business by requiring us to incur significant warranty repair costs and support related replacement costs, diverting the attention of our engineering personnel from new product development efforts, delaying the recognition of revenue and causing potentially significant customer relations problems.

In addition, if our products are not accepted by customers due to software or hardware defects or performance deficiencies, orders contingent upon acceptance may be cancelled or deferred until we have remedied the defects, which could result in lost sales opportunities or delayed revenue recognition.  In this circumstance, or if warranty returns exceed the amount we have accrued for defect returns based on our historical experience, our results of operations and financial condition may be adversely affected.

Our products must properly interface with products from other vendors.  As a result, when problems occur in a computer or communications network, it may be difficult to identify the sources of these problems.  The occurrence of hardware and software errors, whether or not caused by our products, could result in the delay or loss of market acceptance of our products and any necessary revisions may cause us to incur significant expenses.  The occurrence of any such problems would likely have a material adverse effect on our results of operations and financial condition.
 
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