10-Q 1 form10q.htm PROCERA NETWORKS INC 10-Q 3-31-2013 form10q.htm


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

FORM 10-Q
 
(Mark one)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended March 31, 2013
or

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from  _ to _  .
 
Commission File Number: 000-49862
 

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

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

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

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

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o   No þ
 
As of May 7, 2013, the registrant had 20,547,549 shares of its common stock, par value $0.001, outstanding.



 
 

 
 
FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2013
INDEX
 
 
Page
PART I. FINANCIAL INFORMATION
 
       
 
Item 1.
Consolidated Financial Statements
 
       
   
3
       
   
4
       
   
5
       
   
6
       
   
7
       
 
Item 2.
19
       
 
Item 3.
25
       
 
Item 4.
26
       
PART II. OTHER INFORMATION
 
       
 
Item 1.
27
       
 
Item 1A.
27
       
 
Item 2.
40
       
 
Item 3.
40
       
 
Item 4.
41
       
 
Item 5.
41
       
 
Item 6.
41
       
42
 
 
 


PART I. FINANCIAL INFORMATION

Item 1.
Consolidated Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except par value)
 
   
March 31,
   
December 31,
 
   
2013
   
2012
 
   
(unaudited)
   
(note)
 
ASSETS
           
Current Assets:
           
Cash and cash equivalents
 
$
16,536
   
$
30,933
 
Short-term investments
   
99,684
     
100,762
 
Accounts receivable, net
   
12,895
     
16,603
 
Inventories, net
   
12,294
     
11,240
 
Prepaid expenses and other
   
7,995
     
2,012
 
Total current assets
   
149,404
     
161,550
 
                 
Property and equipment, net
   
5,593
     
4,474
 
Intangible assets, net
   
7,782
     
 
Goodwill
   
13,241
     
960
 
Deferred tax asset
   
368
     
 
Other non-current assets
   
55
     
54
 
Total assets
 
$
176,443
   
$
167,038
 
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
 
$
5,046
   
$
5,453
 
Deferred revenue
   
7,150
     
6,953
 
Accrued liabilities
   
4,236
     
4,949
 
Total current liabilities
   
16,432
     
17,355
 
                 
Non-current liabilities:
               
Deferred revenue
   
2,574
     
2,878
 
Deferred tax liability
   
2,100
     
 
Total liabilities
   
21,106
     
20,233
 
                 
Commitments and contingencies (Note 12)
   
     
 
                 
                 
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; 20,548 and 19,696 shares issued and outstanding at March 31, 2013 and December 31, 2012, respectively
   
21
     
20
 
Additional paid-in capital
   
215,816
     
199,793
 
Accumulated other comprehensive loss
   
(851
)
   
(76
)
Accumulated deficit
   
(59,649
)
   
(52,932
)
Total stockholders’ equity
   
155,337
     
146,805
 
Total liabilities and stockholders’ equity
 
$
176,443
   
$
167,038
 
 
Note: Amounts have been derived from the December 31, 2012 audited consolidated financial statements.
 
See accompanying notes to condensed consolidated financial statements.

 
3

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

   
Three Months Ended
March 31,
 
   
2013
   
2012
 
             
Sales:
           
Product sales
 
$
10,411
   
$
9,829
 
Support sales
   
3,760
     
2,503
 
Total net sales
   
14,171
     
12,332
 
Cost of sales:
               
Product cost of sales
   
6,087
     
3,447
 
Support cost of sales
   
715
     
222
 
Total cost of sales
   
6,802
     
3,669
 
                 
Gross profit
   
7,369
     
8,663
 
                 
Operating expenses:
               
Research and development
   
4,401
     
1,691
 
Sales and marketing
   
6,621
     
4,006
 
General and administrative
   
3,637
     
2,360
 
Total operating expenses
   
14,659
     
8,057
 
                 
Income (loss) from operations
   
(7,290
)
   
606
 
Interest and other income (expense), net
   
(50
)
   
1
 
                 
Income (loss) before income taxes
   
(7,340
)
   
607
 
Income tax provision (benefit)
   
(623
)
   
28
 
Net income (loss)
 
$
(6,717
)
 
$
579
 
                 
Net income (loss) per share:
               
Basic
 
$
(0.34
)
 
$
0.04
 
Diluted
 
$
(0.34
)
 
$
0.04
 
                 
Shares used in computing net income (loss) per share:
               
Basic
   
19,931
     
14,547
 
Diluted
   
19,931
     
15,064
 
 
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,
 
   
2013
   
2012
 
             
Net income (loss)
 
$
(6,717
)
 
$
579
 
                 
Other comprehensive income, net of tax:
               
Unrealized gain (loss) on short-term investments
   
(19
)
   
(1
)
Foreign currency translation adjustments
   
(756
)
   
134
 
Other comprehensive income (loss)
   
(775
)
   
133
 
                 
Comprehensive income (loss)
 
$
(7,492
)
 
$
712
 
 
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,
 
   
2013
   
2012
 
Cash flows from operating activities:
           
Net income (loss)
 
$
(6,717
)
 
$
579
 
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
               
Depreciation
   
431
     
133
 
Amortization of intangible assets
   
376
     
 
Stock-based compensation expense:
               
Stock options
   
1,323
     
583
 
Restricted stock awards
   
275
     
128
 
Amortization of premium on investments
   
306
     
68
 
Provision for bad debts
   
     
6
 
Provision for excess and obsolete inventory
   
89
     
83
 
Changes in deferred taxes
   
(719
)
   
 
Changes in current assets and liabilities:
               
Accounts receivable
   
4,234
     
3,185
 
Inventories
   
(1,149
)
   
(838
)
Prepaid expenses and other current assets
   
1,843
     
(198
)
Deferred compensation advanced to escrow
   
(2,701
)
   
 
Accounts payable
   
(517
   
200
 
Accrued liabilities
   
(1,009
)
   
(254
)
Deferred revenue
   
(645
)
   
(28
)
Net cash provided by (used in) operating activities
   
(4,580
)
   
3,647
 
                 
Cash flows from investing activities:
               
Purchase of Vineyard Networks, net of cash received
   
(8,962
)
   
 
Purchase of property and equipment
   
(1,274
)
   
(645
)
Purchase of short-term investments
   
(26,125
)
   
(4,538
)
Sales of short-term investments
   
6,212
     
2,002
 
Maturities of short-term investments
   
20,735
     
2,750
 
Net cash used in investing activities
   
(9,414
)
   
(431
)
                 
Cash flows from financing activities:
               
Proceeds from issuance of common stock
   
     
835
 
Proceeds from exercise of stock options
   
114
     
 
Payments on notes payable
   
(497
)
   
 
Net cash provided by (used in) financing activities
   
(383
)
   
835
 
                 
Effect of exchange rates on cash and cash equivalents
   
(20
   
40
 
                 
Net increase (decrease) in cash and cash equivalents
   
(14,397
)
   
4,091
 
                 
Cash and cash equivalents, beginning of period
   
30,933
     
23,900
 
                 
Cash and cash equivalents, end of period
 
$
16,536
   
$
27,991
 
                 
Non-cash investing and financing activities:
               
Issuance of common stock in connection with Vineyard acquisition
 
$
11,140
   
$
 
 
See accompanying notes to condensed consolidated financial statements.
 
 
6

 
Notes to Condensed Consolidated Financial Statements
(unaudited)

1.
DESCRIPTION OF BUSINESS

Procera Networks, Inc. (“Procera” or the “Company”), is a leading provider of Intelligent Policy Enforcement (“IPE”), solutions based on Deep Packet Inspection technology, that enable mobile and broadband network operators and entities managing private networks including higher education institutions, businesses and government entities (collectively referred to as network operators) to gain enhanced visibility into, and control of, their networks and to create and deploy new services for their end user subscribers.  The Company sells its products through its direct sales force, resellers, distributors and system integrators in the Americas, Asia Pacific and Europe.
 
Procera was incorporated in 2002 and its common stock currently trades on the Nasdaq Global Select Market under the trading symbol “PKT”. Prior to December 29, 2011, the Company’s common stock traded on the NYSE Amex Equities exchange under the same trading symbol.

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 (“SEC”) applicable to interim financial information.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations.  However, 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, 2013, or any other future period. The consolidated balance sheet at December 31, 2012 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by United States generally accepted accounting principles (“U.S. GAAP”) for complete financial statements. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in Procera’s Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 15, 2013.
 
The consolidated financial statements present the accounts of Procera and its wholly-owned subsidiaries.  All significant inter-company balances and transactions have been eliminated.

During the quarter ended March 31, 2013, the Company identified immaterial errors in the consolidated financial statements for the year ended December 31, 2012, related to the recognition of revenue from a sale to a value added reseller, the accounting for inventory, and general and administrative fee accruals. Based on a quantitative and qualitative analysis of the errors as required by authoritative guidance, management concluded that the errors had no material impact on any of the Company’s previously issued financial statements, are immaterial to the Company’s results for the first quarter of 2013 and expected full year results, and had no material effect on the trend of financial results.

As a result of immaterial errors discussed above, the unaudited condensed consolidated financial statements for the first quarter of 2013 reflect the following immaterial adjustments related to prior periods: the reversal of a revenue deal resulting in a reduction of $0.6 million of revenue and a reduction of $0.2 million of cost of sales; inventory charges resulting in an increase of $0.4 million in cost of sales, and additional general and administrative costs of $43,000.
 
Significant Accounting Policies

The accounting and reporting policies of the Company conform to U.S. GAAP and to the practices within the telecommunications industry.  There have been no significant changes in the Company's significant accounting policies during the three months ended March 31, 2013 compared to what was previously disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2012.
 
Recent Accounting Pronouncements

In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income,” (“ASU 2013-02”). ASU 2013-02 finalizes the requirements of ASU 2011-05 that ASU 2011-12 deferred, clarifying how to report the effect of significant reclassifications out of accumulated other comprehensive income. ASU 2013-02 is to be applied prospectively. The adoption of this standard only impacted the presentation format of the Company’s condensed consolidated financial statements.
 
 
7

 
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, 2013 and December 31, 2012 (in thousands):

   
March 31, 2013
 
   
Amortized
   
Gross Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
Money market funds
 
$
6,524
   
$
   
$
   
$
6,524
 
Commercial paper
   
11,186
     
     
     
11,186
 
U.S. agency securities
   
57,509
     
16
     
     
57,525
 
Corporate bonds
   
30,987
     
     
(14
)
   
30,973
 
Total investments
 
$
106,206
   
$
16
   
$
(14
)
 
$
106,208
 
                                 
Reported as:
                               
Cash equivalents
 
$
6,524
   
$
   
$
   
$
6,524
 
Short-term investments
   
99,682
     
16
     
(14
)
   
99,684
 
Total investments
 
$
106,206
   
$
16
   
$
(14
)
 
$
106,208
 

   
December 31, 2012
 
   
Amortized
   
Gross Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
Money market funds
 
$
13,505
   
$
-
   
$
-
   
$
13,505
 
Commercial paper
   
9,696
     
-
     
-
     
9,696
 
U.S. agency securities
   
51,276
     
18
     
-
     
51,294
 
  Corporate bonds
   
34,751
     
5
     
(5
)
   
34,751
 
U.S. Government bonds
   
5,019
     
2
     
-
     
5,021
 
Total investments
 
$
114,247
   
$
25
   
$
(5
)
 
$
114,267
 
                                 
Reported as:
                               
Cash equivalents
 
$
13,505
   
$
-
   
$
-
   
$
13,505
 
Short-term investments
   
100,742
     
25
     
(5
)
   
100,762
 
Total
 
$
114,247
   
$
25
   
$
(5
)
 
$
114,267
 
 
As of March 31, 2013, 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 less than one year.  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, 2013.

The Company did not incur any material realized gains or losses in the three months ended March 31, 2013 and 2012.  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.
 
 
8

 
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.
 
The following is a summary of cash equivalents and short-term investments by type of instruments as of March 31, 2013 and December 31, 2012 measured at fair value on a recurring basis (in thousands):

   
March 31, 2013
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Money market funds
 
$
6,524
   
$
   
$
   
$
6,524
 
Commercial paper
   
     
11,186
     
     
11,186
 
U.S. agency securities
   
     
57,525
     
     
57,525
 
Corporate bonds
   
     
30,973
     
     
30,973
 
Total assets measured at fair value
 
$
6,524
   
$
99,684
   
$
   
$
106,208
 
 
   
December 31, 2012
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Money market funds
 
$
13,505
   
$
-
   
$
-
   
$
13,505
 
Commercial paper
   
-
     
9,696
     
-
     
9,696
 
U.S. agency securities
   
-
     
56,315
     
-
     
56,315
 
Corporate bonds
   
-
     
34,751
     
-
     
34,751
 
Total assets measured at fair value
 
$
13,505
   
$
100,762
   
$
-
   
$
114,267
 

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

During the three months ended March 31, 2013 and 2012, the Company did not have any transfers between Level 1 and Level 2 fair value instruments.

5.
ACQUISITIONS

On January 9, 2013, the Company completed its acquisition of Vineyard Networks Inc. (“Vineyard”), a privately held developer of Layer 7 Deep Packet Inspection (“DPI”) and application classification technology located in Kelowna, Canada. Vineyard’s integrated DPI and application classification technology provides enterprise and service provider networking infrastructure vendors with these capabilities through its integrated software suite, primarily through a variety of subscription based original equipment manufacturer and partner agreements. This acquisition complements the Company’s hardware and application software-based IPE and DPI solutions, expands the way it sells solutions to customers, and increases the Company’s customer base, previously comprised primarily of network operators, thereby allowing the Company to provide complementary technology and solutions to a greater number of customers.

For the three months ended March 31, 2013, Vineyard contributed approximately $0.4 million in revenue and $0.5 million in net loss.
 
The total purchase price was $20.9 million, consisting of $9.8 million cash consideration and $11.1 million in the Company’s common stock in exchange for 100% of the outstanding securities of Vineyard. Of the consideration paid, $2.0 million and $1.9 million in cash and stock, respectively, will be held in escrow for a period of 18 or 36 months from the closing of the acquisition and will be released subject to resolution of certain contingencies. In addition to the purchase consideration, the Company has recorded deferred compensation of $5.9 million, consisting of approximately $2.7 million in cash consideration and $3.2 million in the Company’s common stock, related to retention agreements with Vineyard’s three founders, which will be disbursed from the escrow account after one year of continuous employment with the Company.  The Company recognized $1.4 million in compensation costs for the three months ended March 31, 2013.

 
9

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

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

Assets acquired
     
Cash
  $ 822  
Accounts receivable, trade
    525  
Other current assets
    2,095  
Identifiable intangible assets
    8,460  
Goodwill (1)
    12,751  
Other assets
    303  
Total assets acquired
    24,956  
Liabilities assumed
       
Accounts payable and other accrued liabilities
    420  
Deferred revenue
    555  
Notes payable
    511  
Deferred tax liability
    2,546  
Total liabilities assumed
    4,032  
Net assets acquired
  $ 20,924  

(1)
None of the goodwill recognized is expected to be deductible for income tax purposes.

Intangible Assets Acquired

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

   
Estimated Useful Life
(In Years)
   
Amount
 
Developed technology
  5     $ 5,910  
Customer relationships
  5       2,550  
    Total
        $ 8,460  

Acquired technology consists of existing research and development projects at the time of the acquisition that have reached technological feasibility. No in process research and development was included in acquired intangibles as of March 31, 2013.

Pro Forma Financial Information
 
The following tables summarize the supplemental condensed consolidated statements of operations information on an unaudited pro forma basis as if the acquisition of Vineyard occurred on January 1, 2012 and include adjustments that were directly attributable to the foregoing transactions or were not expected to have a continuing impact on the Company. The pro forma results are for illustrative purposes only for the applicable period and do not purport to be indicative of the actual results that would have occurred had the transactions been completed as of the beginning of the period, nor are they indicative of results of operations that may occur in the future (in thousands, except per share amounts):

   
Three Months Ended
 
   
March 31,
 
   
2013
   
2012
 
             
Pro forma revenues
 
$
14,636
   
$
12,620
 
Pro forma net loss
   
(3,751
)
   
(1,752
)
Basic and diluted loss per share
 
$
(0.19
)
 
$
(0.12
)
 
 
10

 
The pro forma financial information reflects acquisition-related expenses incurred, pro forma adjustments for the additional amortization associated with finite-lived intangible assets acquired, deferred compensation costs related to the retention of certain Vineyard employees, the change in stock compensation expense as a result of the exercise of stock options immediately prior to closing of the Vineyard transaction, stock compensation related to the stock options granted to Vineyard employees, and the related tax expense. The weighted average common shares also reflect the issuance of 517,696 shares in January 2012.

These adjustments are as follows (in thousands, except per share data):
 
   
Three Months Ended
 
   
March 31,
 
   
2013
   
2012
 
             
Acquisition-related expenses
 
$
(1,006
 
$
-
 
Intangible amortization
   
36
     
414
 
Net change in stock compensation expense
   
(636
   
927
 
Increase (decrease) in deferred compensation expense
   
(1,342
)
   
1,468
 
Increase in weighted average common shares outstanding for shares issued and not already included in the weighted average common shares outstanding
   
46
     
518
 
 
6.
GOODWILL AND INTANGIBLE ASSETS

Changes in the carrying value of goodwill for the three months ended March 31, 2013 were as follows (in thousands):

   
Three Months Ended
 
   
March 31,
 
   
2013
 
Balance, December 31, 2012
  $ 960  
Additions from Vineyard acquisition
    12,751  
Translation adjustments
    (470 )
Balance, March 31, 2013
  $ 13,241  
 
Intangible assets other than goodwill are amortized on a straight-line basis over the following estimated remaining useful lives.

The following table is a summary of acquired intangible assets with remaining net book values at March 31, 2013 (in thousands, except weighted average remaining life):

   
Gross
Carrying
Value
   
Accumulated
Amortization
   
Net
Carrying
Value
   
Weighted Average Remaining Life
 
Developed technology
  $ 5,699     $ (262 )   $ 5,437       4.76  
Customer relationships
    2,459       (114 )     2,345       4.76  
Balance at March 31, 2013
  $ 8,158     $ (376 )   $ 7,782          

The Company had no acquired intangible assets with remaining book values at December 31, 2012.

For the three months ended March 31, 2013, amortization expense of $0.3 million related to developed technology was recorded in product cost of sales and amortization expense of $0.1 million related to customer relationships was recorded in operating expense.
 
The changes in the carrying value of acquired intangible assets during the three months ended March 31, 2012 were as follows (in thousands):

   
Gross
Carrying
Value
   
Accumulated
Amortization
   
Net
Carrying
Value
 
Balance at December 31, 2012
  $     $     $  
Additions
    8,460       (376 )     8,084  
Translation adjustments
    (302 )           (302 )
Balance at March 31, 2013
  $ 8,158     $ (376 )   $ 7,782  

 
11


The following table presents the estimated future amortization of intangible assets as of March 31, 2013 (in thousands):

Fiscal Year
 
Amortization
 
2013 (remaining nine months)
  $ 1,220  
2014
    1,632  
2015
    1,632  
2016
    1,632  
2017
    1,632  
Thereafter
    34  
Total
  $ 7,782  

7.
CERTAIN FINANCIAL STATEMENT INFORMATION
 
Accounts receivable:

Accounts receivables at March 31, 2013 and December 31, 2012 consisted of the following (in thousands):

   
March 31,
2013
   
December 31,
2012
 
Accounts receivable
 
$
13,031
   
$
16,699
 
Less: allowance for doubtful accounts
   
(136
)
   
(96
)
Total
 
$
12,895
   
$
16,603
 
   
Inventories:
 
Inventories are stated at the lower of cost, which approximates actual costs on a first in, first out basis, or market. Inventories at March 31, 2013 and December 31, 2012 consisted of the following (in thousands):

   
March 31,
2013
   
December 31,
2012
 
Finished goods
 
$
12,140
   
$
10,886
 
Raw materials
   
154
     
354
 
Inventories, net
 
$
12,294
   
$
11,240
 
 
Accrued Liabilities:

Accrued liabilities at March 31, 2013 and December 31, 2012 consisted of the following (in thousands):

   
March 31,
2013
   
December 31,
2012
 
Payroll and related
 
$
2,073
   
$
2,166
 
Sales commissions
   
713
     
1,112
 
Warranty
   
330
     
406
 
Audit and legal services
   
236
     
368
 
Other
   
884
     
897
 
Total accrued liabilities
 
$
4,236
   
$
4,949
 
 
Warranty Reserve

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

 
12

 
The following table summarizes warranty reserve activity during the three months ended March 31, 2013 and 2012 (in thousands):

   
Three Months Ended
March 31,
 
   
2013
   
2012
 
Warranty accrual, beginning of period
 
$
406
   
$
565
 
Changes in liability for pre-existing warranties
   
(38
   
 
Deductions for warranty claims processed during the period
   
(38
)
   
(64
Warranty accrual, end of period
 
$
330
   
$
501
 
 
Accumulated Other Comprehensive Income (Loss):
 
The components of accumulated other comprehensive income (loss) at March 31, 2013 and December 31, 2012, and the reclassifications out of accumulated other comprehensive income (loss) for the three months ended March 31, 2013, net of taxes, were as follows (in thousands):

   
Foreign Currency Translation Adjustments
   
Net Unrealized Gain (Loss) on Short-Term Investments
   
Total
 
Accumulated other comprehensive income (loss) as of December 31, 2012
  $ (96 )   $ 20     $ (76 )
Other comprehensive income (loss), net of tax
    (756 )     (19 )     (775 )
Accumulated other comprehensive income (loss) as of March 31, 2013
  $ (852 )   $ 1     $ (851 )
 
The Company did not have any amounts reclassified from accumulated other comprehensive income (loss) for the three months ended March 31, 2013.  The Company did not have any other-than-temporary gain or loss reflected in accumulated other comprehensive income (loss) as of March 31, 2013 and December 31, 2012.

8.
STOCKHOLDERS’ EQUITY
 
Common Stock Transactions

On January 9, 2013, the Company issued 825,060 unregistered shares with a value of approximately $14.7 million (gross value), pursuant to the Company’s acquisition of Vineyard related to purchase consideration in exchange for one hundred percent 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 agreement, approximately 518,000 shares were transferred to the former Vineyard shareholders at closing, with the remainder being held in escrow for a period of 18 or 36 months from the closing of the acquisition.

On April 25, 2012, the Company completed a registered offering of 4.5 million shares of common stock.  The shares were sold to the public at $21.00 per share for an aggregate gross sales price of $94.5 million.  The Company received net proceeds of approximately $88.0 million after deducting underwriting commissions and other offering expenses.
 
Equity Incentive Plan and Stock Option Activity

The Company‘s 2007 Equity Incentive Plan, as amended (the “Plan”), provides for the grant of stock options and restricted stock awards RSAs to eligible employees, consultants, and non-employee directors of the Company.  As of March 31, 2013, 359,210 shares of the Company’s common stock were available for future grant under the Plan.  On January 9, 2013, the Company granted to certain former Vineyard employees who became employees of the Company upon closing options to purchase an aggregate of 412,000 shares of the Company’s common stock.  These options were granted outside of the Plan as inducements material to such employees joining the Company.

The following table summarizes the Company’s stock option activity for the three months ended March 31, 2013 and 2012 (in thousands, except per share data):

   
Three Months Ended March 31,
 
   
2013
   
2012
 
   
Options
   
Weighted
Average
Exercise
Price
   
Options
   
Weighted
Average
Exercise
Price
 
Outstanding at the beginning of the period
   
1,332
   
$
14.65
     
1,198
   
$
10.35
 
Granted
   
467
     
17.22
     
65
     
19.16
 
Exercised
   
(13
)
   
7.85
     
(78
)
   
10.36
 
Cancelled
   
(52
)
   
19.33
     
(24
)
   
11.39
 
Outstanding at the end of the period
   
1,734
   
$
15.55
     
1,161
   
$
10.87
 
Vested and expected to vest at the end of the period
   
1,590
   
$
15.30
     
1,114
   
$
10.79
 
Exercisable at the end of the period
   
631
   
$
11.76
     
689
   
$
10.42
 

 
13

 
As of March 31, 2013, the aggregate intrinsic value of options outstanding, options vested and expected to vest and options exercisable was $2.2 million, $2.2 million and $1.7 million, respectively. As of March 31, 2013, the weighted average remaining contractual life of options outstanding, options vested and expected to vest and options exercisable was 8.43 years, 8.33 years and 6.67 years, respectively. The total intrinsic value of options exercised during the three months ended March 31, 2013 and 2012 was $0.1 million and $0.7 million, 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, 2013 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
   
Weighted
Average
Exercise Price
   
Number of
Shares
   
Weighted
Average
Exercise Price
 
$ 4.30 –  $ 5.80      
223
     
6.73
   
$
5.07
     
169
   
$
5.06
 
  6.00 –   9.72      
152
     
5.68
     
7.62
     
133
     
7.46
 
  9.93  –   14.49      
245
     
10.24
     
13.39
     
165
     
13.90
 
  14.50  –   33.50      
1,114
     
8.77
     
19.21
     
164
     
20.01
 
$ 4.30 – $ 33.50      
1,734
     
8.40
   
$
15.55
     
631
   
$
11.76
 
 
The following table summarizes the Company’s RSA activity for the three months ended March 31, 2013 and 2012 (in thousands, except per share data):

   
Three Months Ended March 31,
 
   
2013
   
2012
 
   
Awards
   
Weighted
Average
Grant Date
Fair Value
   
Awards
   
Weighted
Average
Grant Date
Fair Value
 
Unvested outstanding at the beginning of the period
   
253
   
$
15.79
     
136
   
$
9.24
 
Granted
   
7
     
13.27
     
3
     
15.64
 
Vested
   
(6
)
   
19.40
     
(10
)
   
6.40
 
Unvested outstanding at the end of the period
   
254
   
$
15.64
     
129
   
$
9.61
 

The weighted average remaining contractual term for the RSAs outstanding as of March 31, 2013 was 2.99 years. As of March 31, 2013, the aggregate pre-tax intrinsic value of RSAs outstanding was $2.8 million.
 
9.
NET INCOME (LOSS) PER SHARE

Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted net income per share reflects the potential dilution that could occur from common shares issuable upon the exercise of outstanding stock options or warrants and the vesting of RSAs, which are reflected in diluted earnings per share by application of the treasury stock method.  Under the treasury stock method, the amount that the employee must pay for exercising stock options or warrants, the amount of stock-based compensation cost for future services that the Company has not yet recognized, and the amount of tax benefit that would be recorded in additional paid-in capital upon exercise are assumed to be used to repurchase shares.
 
 
14


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

   
Three Months Ended
March 31,
 
   
2013
   
2012
 
Numerator:
               
Net income (loss)
 
$
(6,717
)
 
$
579
 
                 
Denominator:
               
Weighted average common shares - basic
   
19,931
     
14,547
 
Dilutive effect of employee equity incentive plans
   
     
483
 
Dilutive effect of warrants
   
     
34
 
Weighted average common shares - diluted
   
19,931
     
15,064
 
                 
Net income (loss) per share:
               
Basic
 
$
(0.34
 
$
0.04
 
Diluted
 
$
(0.34
 
$
0.04
 
                 
Anti-dilutive securities:
               
Options and restricted stock
   
1,107
     
260
 
Warrants
   
     
20
 
Total anti-dilutive securities
   
1,107
     
280
 

10.
STOCK-BASED COMPENSATION

The following table summarizes employee stock-based compensation expense, net of income tax, as it relates to the Company’s statement of operations for the three months ended March 31, 2013 and 2012 (in thousands):

   
Three Months Ended
March 31,
 
   
2013
   
2012
 
Cost of sales
 
$
112
   
$
34
 
Research and development
   
500
     
97
 
Sales and marketing
   
587
     
322
 
General and administrative
   
399
     
258
 
Total stock-based compensation expense
 
$
1,598
   
$
711
 
 
Stock-based compensation in the three months ended March 31, 2013 includes a one-time $660,000 charge associated with the acceleration of Vineyard option grants at the closing of the acquisition. 
 
No income tax benefits were recognized in the three months ended March 31, 2013 and 2012 due to current period operating loss carry-forwards available to offset income in the previous three month period.  No stock-based compensation has been capitalized in inventory due to the immateriality of such amounts.

As of March 31, 2013, total unrecognized compensation cost related to unvested stock options was $9.9 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 3.50 years, and total unrecognized compensation cost related to non-vested RSAs was $2.8 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 2.99 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 RSA is calculated based upon the closing stock price of the Company’s common stock on the date of the grant. The expense for stock-based awards is recognized over the requisite service period using the straight-line attribution approach.

The following assumptions were used in determining the fair value of stock options granted during the three months ended March 31, 2013 and 2012:

   
Three Months Ended
March 31,
   
2013
   
2012
 
Expected term (years)
   
4.75
     
4.80
 
Expected volatility
   
78.1
%
   
72.0
%
Risk-free interest rate
   
0.85
%
   
1.02
%
Expected dividend yield
   
%
   
%
 
 
15

 
The weighted average grant date fair value of options granted during the three months ended March 31, 2013 and 2012 was $10.18 and $9.54, 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.

11.
RELATED PARTY TRANSACTIONS

On July 19, 2010, the Company entered into a Master OEM Purchase and Sales Agreement (the “OEM Agreement”) with GENBAND US LLC and GENBAND Ireland Ltd. (collectively, “GENBAND”), pursuant to which GENBAND may purchase any of the Company’s existing software and hardware products, as well as procure licenses and services related to such products from the Company.  Pursuant to the OEM Agreement, the Company’s Board of Directors supported the election of Mark Pugerude, Chief Strategy Officer of GENBAND, as a director of the Company beginning in fiscal 2012 through the Company’s 2012 Annual Meeting of Stockholders on August 27, 2012, and B.G. Kumar, Executive Vice President and President of the Networking and Applications Product Unit of GENBAND, as a director of the Company beginning on the Company’s 2012 Annual Meeting of Stockholders on August 27, 2012.  Mr. Kumar’s service on the Company’s Board of Directors will end on the date of the Company’s 2013 Annual Meeting of Stockholders.

During the three months ended March 31, 2013 and 2012, the Company recognized revenue of approximately $0.1 million and $0.4 million, respectively, on sales to GENBAND.  At March 31, 2013 and December 31, 2012, the Company had accounts receivable of approximately $0.2 million and $38,000, respectively, from GENBAND.

As outlined in Note 15 - Subsequent Events, effective April 15, 2013, Procera and GENBAND terminated the OEM Agreement, and the letter agreement, dated July 19, 2010, between the Company and GENBAND US LLC.

12.
COMMITMENTS AND CONTINGENCIES
 
Legal

The Company is periodically involved in legal actions and claims that arise as a result of events that occur in the normal course of operations. The Company does not believe that any of its legal actions and claims will have, individually or in the aggregate, a material adverse effect on the Company’s financial position or results of operations.
 
Operating Leases
 
The Company leases its operating and office facilities for various terms under long-term, non-cancelable operating lease agreements. The leases expire at various dates through 2016 and provide for renewal options ranging from month-to-month to three year terms. In the normal course of business, it is expected that these leases will be renewed or replaced by leases on other properties. The leases provide for increases in future minimum annual rental payments based on defined increases which are generally meant to correlate with the Consumer Price Index, subject to certain minimum increases. Also, the agreements generally require the Company to pay executory costs (real estate taxes, insurance and repairs).

As of March 31, 2013, future minimum lease payments due under operating leases are as follows (in thousands):
 
  
Fiscal years ending December 31,
     
2013 (remaining)
 
504
 
2014
   
540
 
2015
   
407
 
2016
   
326
 
2017
   
249
 
Total minimum lease payments
 
$
2,026
 
 
Secured Line of Credit

On December 10, 2009, the Company entered into a two-year loan and security agreement for a secured line of credit facility (“Secured Credit Facility”), for short-term working capital purposes with Silicon Valley Bank.  On February 3, 2012, the Secured Credit Facility was amended and restated (the “Amended Secured Credit Facility”), to increase the secured line of credit facility from $2.0 million to $10.0 million and to provide for borrowings through February 2, 2014. Pursuant to the Amended Secured Credit Facility, borrowings bear interest at the prime rate plus 1%, but not less than 4.25% on an annual basis.  The Company will pay Silicon Valley Bank a $35,000 commitment fee in each of the two years under the agreement. The Amended Secured Credit Facility is secured by substantially all of the Company’s assets.  The terms of the Amended Secured Credit Facility include a financial covenant requiring a minimum company liquidity ratio and restrictions on the Company’s ability to incur certain additional indebtedness, pay dividends, create or permit liens on assets or engage in mergers, consolidations or dispositions.  The Amended Secured Credit Facility may be terminated at any time by the Company during the term of the agreement, to take effect three business days after the Company provides written notice to Silicon Valley Bank. In connection with such termination, the Company would be obligated to pay Silicon Valley Bank a $50,000 termination fee. The Company was in compliance with the financial covenants as of March 31, 2013.  At March 31, 2013 and December 31, 2012, the Company had no outstanding balance under the Amended Secured Credit Facility.
 
 
16

 
Concentrations
 
For the three months ended March 31, 2013, revenue from Cox Communications, Inc. represented 22% of net revenue and revenue from Shaw Communications, Inc. represented 17% of net revenue, with no other single customer representing more than 10% of net revenue.  For the three months ended March 31, 2012, revenue from Shaw Communications, Inc. and Cox Communications, Inc. represented 21% and 20% of net revenue, respectively. Revenue from a third customer represented 12% of net revenues for the three months ended March 31, 2012, with no other single customer representing more than 10% of net revenue.
 
At March 31, 2013, accounts receivable from two customers represented 17% and 15%, respectively, of total accounts receivable, with no other single customer accounting for more than 10% of the accounts receivable balance. At December 31, 2012, accounts receivable from three customers represented 14%, 12% and 12%, respectively, of total accounts receivable with no other single customer accounting for more than 10% of the accounts receivable balance.  As of March 31, 2013 and December 31, 2012, approximately 69% and 72%, 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, 2013 and 2012, the Company has not been required to make any payments resulting from infringement claims asserted against customers and has not recorded any related reserves.
 
13.
INCOME TAXES
 
The Company's effective tax rate was 8% for the three months ended March 31, 2013 and 5% for the three months ended March 31, 2012.  For the three months ended March 31, 2013, the Company recorded an income tax benefit of $623,000 on a loss before provision for income taxes of $7.3 million.  For the three months ended March 31, 2012, the Company recorded an income tax provision of $28,000 on an income before provision for income taxes of $0.6 million. The effective tax rate for the three months ended March 31, 2013 differs from the federal statutory tax rate as a result of the income tax benefit related to the release of Vineyard’s pre-existing income tax valuation allowance, the amortization of the acquired intangibles, state taxes, earnings taxed in foreign jurisdictions and the anticipated tax expense in the U.S. that was offset by the utilization of federal tax attributes.
 
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, 2013, the Company had no accrued interest or penalties related to uncertain tax positions.   The federal returns for the years ended 2009 through the current period and most state returns for the years ended 2008 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 other foreign jurisdictions including Australia and Sweden beginning in 2006 through the current period.

At March 31, 2013, the Company had $193,000 of unrecognized tax benefits, a total of $158,000 which would affect the Company’s effective tax rate if recognized. The Company does not anticipate that the total unrecognized tax benefits will change significantly over the next twelve months.
 
14.
SEGMENT INFORMATION

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

 
17

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

   
Three Months Ended
 
   
March 31,
 
   
2013
   
2012
 
Net sales:
           
Americas
 
$
8,412
   
$
7,624
 
Europe, Middle East and Africa
   
3,862
     
3,084
 
Asia Pacific
   
1,897
     
1,624
 
Total
 
$
14,171
   
$
12,332
 
 
The following are summaries of long-lived assets by geographical region (in thousands):

   
March 31,
2013
   
December 31,
2012
 
Long-lived assets:
           
Americas
 
$
1,915
   
$
1,750
 
Europe
   
3,673
     
2,719
 
Australia
   
5
     
5
 
Total
 
$
5,593
   
$
4,474
 

15.
SUBSEQUENT EVENTS

Effective April 15, 2013, (i) Procera and GENBAND terminated the OEM Agreement, and (ii) Procera and GENBAND US LLC terminated the letter agreement, dated July 19, 2010 between the parties (the “Letter Agreement”). Under the OEM Agreement, GENBAND affiliates were permitted to purchase Procera’s software and hardware products, as well as procure licenses and services related to such products from Procera, all on specified pricing terms. In addition, GENBAND was authorized to sell Procera products under the Procera or GENBAND name and branding either as a complete solution or as integrated with hardware procured by GENBAND in accordance with either Procera’s or GENBAND’s specifications. Under the OEM Agreement, GENBAND also had a source code license to Procera product software and was permitted to create and sell derivative products, subject to payment of agreed-upon royalties. Under the Letter Agreement, Procera agreed to advise GENBAND of the receipt of certain acquisition proposals related to Procera and GENBAND had the right to nominate an individual for appointment and election to Procera’s board of directors.

The termination of the OEM Agreement and the Letter Agreement was effected pursuant to the execution of a transition agreement between Procera and GENBAND. The transition agreement permits GENBAND to continue to perform its functions for existing customers, as provided under the OEM Agreement, for the remainder of the current service term, and further provides that Procera will continue to provide support or maintenance to GENBAND’s existing customers under or in connection with the OEM Agreement and for which GENBAND previously submitted a purchase order. Under the transition agreement, Procera and GENBAND also agreed to promptly enter into a reseller arrangement.

 
18

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

The following is a discussion of our results of operations and current financial position. This discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this report and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 15, 2013.

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

Cautionary Note Regarding Forward-Looking Statements

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

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

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

We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. We also provide 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.

Overview

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

 
19

 
Our IPE products are part of the high-growth market for mobile packet and broadband core products.  The market for IPE products was expected to reach $601.7 million in 2012 and is expected to grow to $1.8 billion in 2016, a 2011–2016 compounded annual growth rate of 30.4%.  Our bundled products deliver a solution that is a key element of the mobile packet and broadband core ecosystems.  Our solutions are often integrated with additional elements in the mobile packet and broadband core including Policy Management and Charging functions, and are compliant with the widely adopted 3rd Generation Partnership Program (“3GPP”) standard.  In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, network operators are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers.  We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products.

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

We face competition from suppliers of standalone and integrated IPE and deep packet inspection (“DPI”) products including Allot Communications Ltd., Tektronix (acquired Arbor Networks), Blue Coat Systems, Brocade Communications Systems, Cisco Systems, Inc., Citrix Systems (acquired Bytemobile), SAIC (acquired Cloudshield Technologies), Ericsson, F5 Networks, Huawei Technologies Company, and Sandvine Corporation.  Some of our competitors supply platform products with different degrees of DPI functionality, such as switch/routers, routers, session border controllers and VoIP switches.  Some of our competitors are also our customer.

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

On January 9, 2013, we completed our acquisition of Vineyard Networks, Inc. (“Vineyard”), a privately held developer of Layer 7 Deep Packet Inspection (DPI) and application classification technology located in Kelowna, Canada. Vineyard’s integrated DPI and application classification technology provides enterprise and service provider networking infrastructure vendors with these capabilities through its integrated software suite, primarily through a variety of subscription based Original Equipment Manufacturer and Partner agreements. This acquisition complements our hardware and application based software based IPE and DPI solutions, as well as expanding the way we sell solutions to customers, and therefore expanding our customer base, previously comprised primarily of network operators, allowing us to provide complementary technology and solutions to a greater number of customers.

We were incorporated in 2002 and became a public company in October 2003.  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

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

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

 
20

 
These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 15, 2013.

Results of Operations

Comparison of Three Months Ended March 31, 2013 and 2012
 
Revenue
 
Revenue for the three months ended March 31, 2013 and 2012 was as follows (in thousands, except percentages):
 
   
Three Months Ended
       
   
March 31,
       
   
2013
   
2012
   
Increase
 
Net product revenue
 
$
10,411
   
$
9,829
     
6
%
Net support revenue
   
3,760
     
2,503
     
50
%
Total revenue
 
$
14,171
   
$
12,332
     
15
%

Our revenue is derived from two sources: 1) product revenue, which includes sales of our hardware appliances bundled with software licenses, separate software licenses or 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 twelve months.

Total revenue in the three months ended March 31, 2013 was $14.2 million, an increase of 15% compared with $12.3 million in the three months ended March 31, 2012, and reflected a 6% increase in product revenue and a 50% increase in support revenue.  The increase in product revenue in 2013 compared to the first quarter of 2012 reflected follow-on orders from existing customers and included increased sales to our newer network operator customers, including mobile service providers, fixed line service providers, and cable multiple system operators; and we continued to add new higher education customers.  The increase in product revenue also continued to reflect increased sales of our mid-range PL8000 series products. Vineyard contributed $0.2 million in product and $0.2 million in support revenue for the three months ended March 31, 2013. The increase in support revenue in 2013 compared to the first quarter of 2012 reflected the continued expansion of the installed base of our product to which we have sold ongoing support services. In the three months ended March 31, 2013, sales to two customers, Cox Communications, Inc. and Shaw Communications, Inc., represented 22% and 17% of total net revenues, respectively. In the three months ended March 31, 2012, sales to three customers, Shaw Communications, Inc., Cox Communications, Inc. and a third customer, represented 21%, 20% and 12% of total net revenues, respectively.

Sales to customers located in the Americas as a percentage of total revenues were 59% and 62% for the three months ended March 31, 2013 and 2012, respectively.

We believe that our revenue will continue to grow in each of the remaining quarters of the fiscal year ending December 31, 2013, as compared with the fiscal year ended December 31, 2012.
 
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, 2013 and 2012 (in thousands, except percentages):

   
Three Months Ended
       
   
March 31,
       
   
2013
   
2012
   
Increase
 
Product costs
 
$
6,087
   
$
3,447
     
77
%
Percent of net product revenue
   
58
%
   
35
%
       
                         
Support costs
   
715
     
222
     
222
%
Percent of net support revenue
   
19
%
   
9
%
       
                         
Total costs of sales
 
$
6,802
   
$
3,669
     
85
%
Percent of total net revenue
   
48
%
   
30
%
       

 
21

 
Total cost of sales in the three months ended March 31, 2013 increased by $3.1 million compared to the three months ended March 31, 2012, and increased as a percentage of revenue by 18 percentage points.  The increase in cost of sales in 2013 primarily reflected higher material costs associated with increased product sales and higher support costs for increased customer support and professional services personnel. The increase also reflected $0.3 million of amortization of developed technology intangible assets acquired as part of the Vineyard acquisition in January 2013.  The increase in cost of sales as a percentage of revenue primarily reflected a higher proportion of hardware sales in the first quarter of 2013. Stock-based compensation recorded to cost of sales in the three months ended March 31, 2013 and 2012 was $0.1 million and $34,000, respectively.
 
Gross Profit
 
Gross profit for the three months ended March 31, 2013 and 2012 was as follows (in thousands, except percentages):
 
   
Three Months Ended
       
   
March 31,
       
   
2013
   
2012
   
Increase/
(Decrease)
 
Total gross profit
 
$
7,369
   
$
8,663
     
(15)
%
Total gross margin
   
52
%
   
70
%
       

Our total gross profit margin for the three months ended March 31, 2013 decreased by 18 percentage points to 52% compared to 70% for the three months ended March 31, 2012.  The decrease resulted from a higher proportion of hardware sales in the first quarter of 2013, higher support and service costs and amortization of acquired intangible assets. We expect our gross profit margin to increase in each of the remaining quarters of the fiscal year ending December 31, 2013, as compared with the first quarter of 2013.
 
Operating Expense
 
Operating expenses for the three months ended March 31, 2013 and 2012 was as follows (in thousands, except percentages):

   
Three Months Ended
         
   
March 31,
         
   
2013
   
2012
   
Increase
 
Research and development
 
$
4,401
   
$
1,691
     
160
 %
Sales and marketing
   
6,621
     
4,006
     
65
 %
General and administrative
   
3,637
     
2,360
     
54
 %
Total
 
$
14,659
   
$
8,057
     
82
 %
 
In the first three months of 2013, our total operating expenses increased to support the scale of our operations as we have hired additional employees in each function of our company, invested in testing equipment for the development of our products, invested in infrastructure, and increased the use of outside services, including legal, audit and accounting services. Additionally, our costs have increased due to the integration of Vineyard personnel and related operating costs.

We anticipate that this trend will continue in subsequent periods and that total operating expenses for the remainder of the year ending December 31, 2013 will exceed those incurred in the year ended December 31, 2012.

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.

   
Three Months Ended
       
   
March 31,
       
   
2013
   
2012
   
Increase
 
   
($ in thousands)
       
Research and development
 
$
4,401
   
$
1,691
     
160
%
As a percentage of total net revenue
   
31
%
   
14
%
       

Research and development expenses for the three months ended March 31, 2013 increased by $2.7 million compared to the three months ended March 31, 2012 as a result of increased research and development personnel and the corresponding additional employee compensation costs, including the addition of Vineyard personnel, and amortization of deferred compensation of $0.7 million associated with the Vineyard acquisition. The additional personnel are expected to allow us to enhance our core product features and functionality in order to support new sales and to achieve follow-on sales to our current customers.  Stock-based compensation recorded to research and development expenses in the three months ended March 31, 2013 and 2012 was $0.5 million and $0.1 million, respectively.
 
 
22

 
Sales and Marketing

Sales and marketing expenses primarily include personnel costs, sales commissions and marketing expenses, such as trade shows, channel development and literature.

   
Three Months Ended
       
   
March 31,
       
   
2013
   
2012
   
Increase
 
   
($ in thousands)
       
Sales and marketing
 
$
6,621
   
$
4,006
     
65
%
As a percentage of total net revenue
   
47
%
   
32
%
       
 
Sales and marketing expenses for the three months ended March 31, 2013 increased by $2.6 million compared to the three months ended March 31, 2012.  The increase reflected the addition of sales and marketing personnel during 2012 and in the three months ended March 31, 2013, and the corresponding higher compensation costs and higher commission costs as a result of the increase in revenue. The increase also reflected the amortization of deferred compensation of $0.7 million and the amortization of acquired intangible assets of $0.1 million associated with the Vineyard acquisition. Stock-based compensation recorded to sales and marketing expenses in the three months ended March 31, 2013 and 2012 was $0.6 million and $0.3 million, respectively.
 
General and Administrative

General and administrative expenses consist primarily of personnel and facilities costs related to our executive, finance functions and service fees for professional services.  Professional services include costs for legal advice and services, accounting and tax professionals, independent auditors and investor relations.

   
Three Months Ended
       
   
March 31,
       
   
2013
   
2012
   
Increase
 
   
($ in thousands)
       
General and administrative
  $ 3,637     $ 2,360       54  %
As a percentage of total net revenue
    26 %     19 %        

General and administrative expenses for the three months ended March 31, 2013 increased by $1.3 million compared to the three months ended March 31, 2012, reflecting increased accounting and human resource personnel related costs, legal and audit fees, and increased use of contractors and outside services. The increase also reflected $1.0 million in business development costs for legal, accounting and investment banking fees associated with the Vineyard acquisition, compared to $0.6 million in business development costs in the three months ended March 31, 2012 associated with potential mergers, acquisitions and partnership agreements. Stock-based compensation recorded to general and administrative expense in the three months ended March 31, 2013 and 2012 was $0.4 million and $0.3 million, respectively.
 
Interest and Other Income (Expense), Net
 
   
Three Months Ended
 
   
March 31,
 
   
2013
   
2012
 
   
($ in thousands)
 
Interest and other income (expense), net
 
$
(50
)
 
$
1
 
 
Interest and other income (expense) decreased in the three months ended March 31, 2013 compared to the three months ended March 31, 2012 mainly due to higher foreign currency transaction losses from our foreign subsidiaries in the first three months of 2013 versus 2012.
 
Provision for Income Taxes
 
   
Three Months Ended
 
   
March 31,
 
   
2013
   
2012
 
   
($ in thousands)
 
Provision (benefit) for income taxes
 
$
(623
)
 
$
28
 
 
 
23

 
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 benefit for the three months ended March 31, 2013 primarily reflects the following Vineyard acquisition related items: reversal of Vineyard’s pre-existing income tax valuation allowance upon acquisition, amortization of intangible assets acquired, and the tax impact of book/tax differences on deferred revenue.

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 ASC 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.
 
Adjustment to Previously Announced Preliminary Quarterly Results
 
On May 2, 2013, we filed a Current Report on Form 8-K, which contained a press release announcing our financial results for the quarter ended March 31, 2013.  In the press release, we reported stock-based compensation expense of approximately $938,000 for the quarter ended March 31, 2013.  Subsequent to the issuance of our press release, we determined we needed to record a one-time stock compensation charge of approximately $660,000 related to the acceleration of unvested stock options to purchase common shares of Vineyard Networks Inc. in connection with our acquisition of Vineyard on January 9, 2013.  The additional expense was allocated as follows: $52,000 for cost of sales, $297,000 for research and development, $267,000 for sales and marketing and $44,000 for general and administrative.  As a result, the Condensed Consolidated Statements of Operations for the three months ended March 31, 2013 contained in our press release has been adjusted to increase stock-based compensation expense to $1.598 million for the three months ended March 31, 2013.
 
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,
 
   
2013
   
2012
 
   
($ in thousands)
 
Net cash (used in) provided by operating activities
 
$
(4,580
 
$
3,647
 
Net cash used in investing activities
   
(9,414
)
   
(431
)
Net cash provided by (used in) financing activities
   
(383
   
835
 
Effect of exchange rate changes on cash and cash equivalents
   
(20
   
40
 
Net increase in cash and cash equivalents
 
$
(14,397
 
$
4,091
 
 
During the three months ended March 31, 2013, we utilized $4.6 million in cash from operating activities as compared to generating $3.6 million for the three months ended March 31, 2012.  Cash used by operating activities during the three months ended March 31, 2013 primarily consisted of our net loss of $6.7 million and non-cash charges of $2.8 million. Non-cash charges consisted primarily of stock-based compensation of $1.6 million, amortization of intangible assets of $0.4 million, amortization of premium on investments of $0.3 million and depreciation expense of $0.4 million. Working capital sources of cash consisted primarily of a decrease in accounts receivable of $4.2 million due to strong collections. Working capital uses of cash consisted primarily of an advance payment to escrow of $2.7 million recorded as deferred compensation related to retention agreements with Vineyard’s three founders which are payable after one year of continuous employment with the Company, and an increase in inventory of $1.1 million, resulting from material purchases in anticipation of future sales. Cash provided by operating activities during the three months ended March 31, 2012 primarily consisted of our net income of $0.6 million, non-cash charges of $1.0 million and net working capital sources of cash of $2.1 million. Non-cash charges consisted primarily of stock-based compensation of $0.7 million and depreciation expense of $0.1 million. Working capital sources of cash consisted primarily of a decrease in accounts receivable of $3.2 million due to strong collections. Working capital use of cash consisted primarily of an increase in inventory of $0.8 million, resulting from material purchases in anticipation of future sales.

Net cash used in investing activities of $9.4 million during the three months ended March 31, 2013 consisted of net cash consideration associated with the acquisition of Vineyard of $9.0 million, and purchases of lab and testing equipment for use in research and development of $1.3 million, partially offset by proceeds from net sales and maturities of short-term investments of $0.8 million. Net cash used in investing activities of $0.4 million during the three months ended March 31, 2012 consisted of purchases of lab and testing equipment for use in research and development of $0.6 million, partially offset by proceeds from net sales and maturities of short-term investments of $0.2 million.

Net cash used in financing activities of $0.4 million during the three months ended March 31, 2013 consisted of the repayment of debt acquired from Vineyard of $0.5 million, offset by proceeds from the exercise of stock options of $0.1 million.  Net cash provided by financing activities of $0.8 million during the three months ended March 31, 2012 reflected proceeds from the exercise of stock options and warrants.  

Our cash, cash equivalents and short-term investments at March 31, 2013 consisted of bank deposits with third party financial institutions, money market funds, U.S. agency securities, certificates of deposit, 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 an effective maturity of less than one year.  All investments are classified as available for sale.

 
24

 
In January 2013, we acquired Vineyard Networks, Inc. in Kelowna, Canada. The aggregate total consideration of approximately $20.9 million consisted of $9.8 million in cash and 825,060 shares of our common stock.

On December 10, 2009, we entered into a two-year loan and security agreement for a secured credit facility of $2.0 million for short-term working capital purposes with Silicon Valley Bank. Borrowings under the facility bore interest at the prime rate plus 1%, but not less than 5% per annum. On February 3, 2012, the agreement was amended and restated to increase the credit facility from $2.0 million to $10.0 million for an additional two-year period beginning on that date. Borrowings under the amended credit facility bear interest at the prime rate plus 1%, but not less than 4.25% on an annual basis. At March 31, 2013, we had no borrowings outstanding under this credit facility.

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 twelve 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, 2013, 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 and Sweden that extend through 2016. The details of these contractual obligations are further explained in Note 12 of the Notes to Condensed Consolidated Financial Statements.

We use third-party contract manufacturers 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 manufacturers 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 manufacturers in accordance with our forecasts. In addition, we issue purchase orders to our third-party manufacturers that may not be cancelable at any time.  As of March 31, 2013, we had open non-cancelable purchase orders amounting to approximately $12.3 million, primarily with our third-party contract manufacturers.

Item 3.    Quantitative and Qualitative Disclosures about Market Risk
 
Foreign Currency Risk

Our sales contracts are denominated predominantly in U.S. Dollars, Swedish Krona, Canadian Dollars, Australian Dollars and the Euro.  We incur operating expenses in U.S. Dollars, Swedish Krona, Canadian Dollars and Australian Dollars.  Therefore, we are subject to fluctuations in these foreign currency exchange rates. To date, exchange rate fluctuations have had minimal 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 $116.2 million at March 31, 2013.  Cash equivalents and short-term investments are composed of money market funds, U.S. agency securities, commercial paper, certificates of deposit 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.  All short-term investments 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, 2013, 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.

 
25

 
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) 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 are effective.
 
Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the period ended March 31, 2013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
 
26

 
PART II. OTHER INFORMATION

Item 1.    Legal Proceedings

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 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, 2012 filed with the Securities and Exchange Commission (the “SEC”) on March 15, 2013.

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 report 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 purchased 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.

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 represent 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.

 
27

 
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.

*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.

All 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.  We do not currently have plans or resources to develop additional product lines, and as a result, 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.

*Sales of our products to large broadband service providers often involve a lengthy 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.  Carriers, 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.

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.

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 if we cannot fulfill all of the orders and satisfy all the revenue recognition criteria under our accounting policies before the quarter ends.  In addition, if anticipated purchase orders are not finalized 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 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.

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.

 
28

 
*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 revenues 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.  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.

For the three months ended March 31, 2013, revenue from Cox Communications, Inc. represented 22% of net revenue and revenue from Shaw Communications, Inc. represented 17% of net revenue, with no other single customer representing more than 10% of net revenue.  For the three months ended March 31, 2012, revenue from Shaw Communications, Inc. and Cox Communications, Inc. represented 21% and 20% of net revenue, respectively. Revenue from a third customer represented 12% of net revenues for the three months ended March 31, 2012, with no other single customer representing more than 10% of net revenue.  The proportion of our revenues derived from a limited number of customers may be even higher in any future year or quarter.  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.

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.

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.

*Acquisitions may 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, a company based in British Columbia, Canada. We have integrated the employees of Vineyard Networks 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 and or technology we acquire into Procera, 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 our management and employees and increase our expenses.

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

 
29

 
 
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 results of operations and financial condition and, as a result, on the market price of our common stock.

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.  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.

*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.  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.

*We 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 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 (acquired Arbor Networks), Blue Coat Systems, Brocade Communications Systems, Cisco Systems, Inc., Citrix Systems (acquired Bytemobile), SAIC (acquired Cloudshield Technologies), Ericsson, F5 Networks, Huawei Technologies Company 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.  While we have enhanced our balance sheet by raising additional capital through a public sale of our common stock, it is possible that one or more prospective customers could raise similar concerns in the future.  Our competitors may 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 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.

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 (“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 functionally and features, our results of operations and financial condition may be adversely affected.

 
30

 
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.

*We have incurred losses in previous periods and may incur losses in future periods.

We had an accumulated deficit of $59.6 million as of March 31, 2013. We may incur losses from operations in future periodsThe profitability we achieved in the years ended December 31, 2012 and 2011 were the first in our history and may not be indicative of sustained profitability in future periods.  Any losses incurred in the future may result from increased costs related to continued investments in sales and marketing, product development and administrative expenses, and/or less than anticipated revenues.  Furthermore, if our revenue growth does not continue or is slower than anticipated, or our operating expenses exceed expectations, our results of operations and financial condition may be adversely affected.

*We may need to raise further capital, which could dilute or otherwise adversely affect your interest in our company.

We believe that our existing cash, cash equivalents and short term investments, along with the cash that we expect to generate from operations and any debt financing that management currently believes is available, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for the next twelve months.

A number of factors may negatively impact our level of cash availability and working capital requirements, including, without limitation:

 
lower than anticipated revenues;

 
higher than expected cost of goods sold or operating expenses;

 
our inability to liquidate short-term investments; or

 
the inability of our customers to pay for the goods and services ordered.

We believe that the ability to obtain equity and debt financing in the future will depend on our operating results, general economic conditions and global credit market conditions.  If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and such securities may have rights, preferences and privileges senior to those of our common stock.  There can be no assurance that additional financing will be available on terms favorable to us or at all.  If adequate funds are not available on acceptable terms, we may not be able to fund expansion, take advantage of unanticipated growth or acquisition opportunities, develop or enhance services or products or respond to competitive pressures.  In addition, we may be required to defer or cancel product development programs, lay-off employees and/or take other steps to reduce our operating expenses.  Our inability to raise additional financing or the terms of any financing we do raise could have a material adverse effect on our business, results of operations and financial condition.

 
31

 
*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.  We have recently hired new employees in many different positions and our growth expectations will require us to attract experienced personnel to augment our current staff.  We expect to recruit experienced professionals in such areas as software and hardware development, sales, technical support, product marketing and management.  We currently plan to expand our indirect channel partner program and we 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 Networks, and we now employ many former Vineyard Networks engineers and product developers at its location in British Columbia, 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 execu