10-Q 1 a08-29743_110q.htm 10-Q

Table of Contents

 

 

 

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 October 31, 2008

 

 

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 000-26209

 

 

Ditech Networks, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

 

94-2935531

(State or other jurisdiction of incorporation or
organization)

 

(I.R.S. Employer Identification Number)

 

825 East Middlefield Road

Mountain View, California 94043

(650) 623-1300

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

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 past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days.

 

YES  x   NO  o

 

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

 

Large accelerated filer  o

Accelerated filer  o

 

 

Non-accelerated filer  o

Smaller reporting company  x

(Do not check if a smaller reporting company)

 

 

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

 

As of November 30, 2008, 26,263,988 shares of the Registrant’s common stock were outstanding.

 

 

 



Table of Contents

 

Ditech Networks, Inc.

FORM 10-Q for the Quarter Ended October 31, 2008

 

INDEX

 

 

 

 

Page

 

 

 

 

Part I.

Financial Information

 

 

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

 

 

Condensed Consolidated Statements of Operations for the three and six months ended October 31, 2008 and October 31, 2007

 

3

 

 

 

 

 

Condensed Consolidated Balance Sheets at October 31, 2008 and April 30, 2008

 

4

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the six months ended October 31, 2008 and October 31, 2007

 

5

 

 

 

 

 

Notes to Condensed Consolidated Financial Statements

 

6

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

17

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

34

 

 

 

 

Item 4.

Controls and Procedures

 

35

 

 

 

 

Item 4T

Controls and Procedures

 

35

 

 

 

 

Part II.

Other Information

 

 

 

 

 

 

Item 1.

Legal Proceedings

 

36

 

 

 

 

Item 1A.

Risk Factors

 

36

 

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

 

37

 

 

 

 

Item 3.

Defaults Upon Senior Securities

 

37

 

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

37

 

 

 

 

Item 5.

Other Information

 

37

 

 

 

 

Item 6.

Exhibits

 

37

 

 

 

 

 

Signature

 

38

 

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Table of Contents

 

PART I. FINANCIAL INFORMATION

 

ITEM I. Financial Statements

 

Ditech Networks, Inc.

Condensed Consolidated Statements of Operations

 

(in thousands, except per share data)

 

(unaudited)

 

 

 

Three months ended
October 31,

 

Six months ended
October 31,

 

 

 

2008

 

2007

 

2008

 

2007

 

Revenue

 

 

 

 

 

 

 

 

 

Product revenue

 

$

2,515

 

$

5,103

 

$

5,334

 

$

17,714

 

Service revenue

 

1,607

 

1,534

 

3,320

 

2,945

 

Total revenue

 

4,122

 

6,637

 

8,654

 

20,659

 

 

 

 

 

 

 

 

 

 

 

Cost of goods sold

 

 

 

 

 

 

 

 

 

Product revenue

 

1,936

 

4,142

 

4,036

 

8,508

 

Service revenue

 

193

 

269

 

463

 

586

 

Total cost of goods sold(1)

 

2,129

 

4,411

 

4,499

 

9,094

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

1,993

 

2,226

 

4,155

 

11,565

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing (1)

 

3,061

 

5,185

 

6,626

 

10,477

 

Research and development (1)

 

3,422

 

5,394

 

6,849

 

10,445

 

General and administrative (1)

 

2,100

 

2,861

 

4,155

 

5,359

 

Amortization of purchased intangible assets

 

24

 

246

 

49

 

492

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

8,607

 

13,686

 

17,679

 

26,773

 

 

 

 

 

 

 

 

 

 

 

Loss from operations

 

(6,614

)

(11,460

)

(13,524

)

(15,208

)

Other income, net

 

(253

)

1,515

 

(329

)

3,161

 

 

 

 

 

 

 

 

 

 

 

Loss before provision for (benefit from) income taxes

 

(6,867

)

(9,945

)

(13,853

)

(12,047

)

Provision for (benefit from) income taxes

 

97

 

(4,532

)

136

 

(5,631

)

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(6,964

)

$

(5,413

)

$

(13,989

)

$

(6,416

)

 

 

 

 

 

 

 

 

 

 

Per share data:

 

 

 

 

 

 

 

 

 

Basic and diluted:

 

 

 

 

 

 

 

 

 

Net loss

 

$

(0.27

)

$

(0.18

)

$

(0.54

)

$

(0.20

)

 

 

 

 

 

 

 

 

 

 

Weighted shares used in per share calculation:

 

 

 

 

 

 

 

 

 

Basic and diluted

 

26,060

 

30,533

 

26,048

 

31,727

 

 


 

(1) Stock-based compensation expense was allocated by function as follows:

 

 

 

 

Cost of goods sold

 

$

57

 

$

79

 

$

152

 

$

198

 

Sales and marketing

 

245

 

373

 

387

 

974

 

Research and development

 

144

 

276

 

374

 

723

 

General and administrative

 

280

 

560

 

508

 

760

 

 

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

 

3



Table of Contents

 

Ditech Networks, Inc.

Condensed Consolidated Balance Sheets

 

(in thousands, except per share data)

 

(unaudited)

 

 

 

October 31,
2008

 

April 30,
2008

 

 

 

 

 

 

 

Assets

 

 

 

 

 

Cash and cash equivalents

 

$

43,288

 

$

36,131

 

Short-term investments

 

2,520

 

14,400

 

Accounts receivable, net of allowance for doubtful accounts of $289 at October 31, 2008 and $315 at April 30, 2008

 

1,900

 

5,294

 

Inventories

 

13,720

 

13,692

 

Other current assets

 

1,048

 

665

 

 

 

 

 

 

 

Total current assets

 

62,476

 

70,182

 

 

 

 

 

 

 

Long-term investments

 

10,646

 

15,130

 

Property and equipment, net

 

4,570

 

5,493

 

Purchased intangibles, net

 

90

 

139

 

Other assets

 

186

 

186

 

 

 

 

 

 

 

Total assets

 

$

77,968

 

$

91,130

 

 

 

 

 

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Accounts payable

 

$

2,300

 

$

2,130

 

Accrued expenses

 

3,727

 

5,070

 

Deferred revenue

 

1,372

 

1,274

 

Income taxes payable

 

210

 

229

 

 

 

 

 

 

 

Total current liabilities

 

7,609

 

8,703

 

 

 

 

 

 

 

Long term accrued expenses

 

340

 

377

 

Total liabilities

 

7,949

 

9,080

 

 

 

 

 

 

 

Commitments and contingencies (Note 9)

 

 

 

 

 

 

 

 

 

 

 

Common stock, $0.001 par value: 200,000 shares authorized and 26,213 and 26,090 shares issued and outstanding at October 31, 2008 and April 30, 2008, respectively

 

26

 

26

 

Additional paid-in capital

 

264,803

 

263,254

 

Accumulated deficit

 

(194,639

)

(180,650

)

Accumulated other comprehensive loss

 

(171

)

(580

)

 

 

 

 

 

 

Total stockholders’ equity

 

70,019

 

82,050

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

77,968

 

$

91,130

 

 

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

 

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Ditech Networks, Inc.

Condensed Consolidated Statements of Cash Flows

 

(in thousands)

 

(unaudited)

 

 

 

Six months ended October 31,

 

 

 

2008

 

2007

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(13,989

)

$

(6,416

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

1,205

 

1,284

 

Impairment loss on investments

 

1,367

 

 

Deferred income taxes

 

 

(5,667

)

(Gain)/loss on disposal of property and equipment

 

14

 

(14

)

Stock-based compensation expense

 

1,415

 

2,654

 

Amortization of purchased intangibles

 

49

 

492

 

Payment of employee-investor portion of convertible debenture

 

 

(605

)

Amortization of employee-investor portion of convertible debentures

 

 

50

 

Other

 

 

2

 

Changes in assets and liabilities:

 

 

 

 

 

Accounts receivable

 

3,394

 

7,115

 

Inventories

 

(28

)

(5,273

)

Other current assets

 

(383

)

82

 

Income taxes

 

(19

)

(385

)

Accounts payable

 

170

 

(777

)

Accrued expenses and other

 

(1,380

)

134

 

Deferred revenue

 

98

 

(2,492

)

 

 

 

 

 

 

Net cash used in operating activities

 

(8,087

)

(9,816

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

(296

)

(1,551

)

Purchases of available for sale investments

 

 

(13,636

)

Sales and maturities of available for sale investments

 

15,406

 

53,899

 

Acquisition of Jasomi Networks, Inc., net of cash received

 

 

(3,786

)

Decrease in other assets

 

 

(3

)

 

 

 

 

 

 

Net cash provided by investing activities

 

15,110

 

34,923

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Repurchase of common stock

 

 

(40,999

)

Proceeds from employee stock plan issuances

 

134

 

981

 

 

 

 

 

 

 

Net cash provided by (used in) financing activities

 

134

 

(40,018

)

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

7,157

 

(14,911

)

Cash and cash equivalents, beginning of period

 

36,131

 

34,074

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

43,288

 

$

19,163

 

 

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

 

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Table of Contents

 

DITECH NETWORKS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

(unaudited)

 

 1.            DESCRIPTION OF BUSINESS

 

Ditech Networks, Inc. (the “Company”) designs, develops and markets telecommunications equipment for use in wireline, wireless, satellite and IP telecommunications networks.  The Company’s products enhance and monitor voice quality and provide security in the delivery of voice services.  The Company has established a direct sales force that sells its products in the U.S. and internationally. In addition, the Company is expanding its use of value added resellers and distributors in an effort to broaden its sales channels, primarily in the Company’s international markets.

 

2.            SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated. The accompanying condensed consolidated financial statements as of October 31, 2008, and for the three and six month periods ended October 31, 2008 and 2007, together with the related notes, are unaudited but include all adjustments (consisting only of normal recurring adjustments) which, in the opinion of management, are necessary for the fair statement, in all material respects, of the financial position and the operating results and cash flows for the interim date and periods presented. The April 30, 2008 condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Results for the interim period ended October 31, 2008 are not necessarily indicative of results for the entire fiscal year or future periods. These condensed consolidated financial statements should be read in conjunction with the financial statements and related notes thereto for the year ended April 30, 2008, included in the Company’s Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 10, 2008, file number 000-26209.

 

Computation of Income (Loss) per Share

 

Basic loss per share is calculated based on the weighted average number of shares of common stock outstanding during the three and six-month periods ended October 31, 2008 and 2007. Diluted loss per share for the three and six month periods ended October 31, 2008 and 2007 is calculated excluding the effects of all common stock equivalents, as their effect would be anti-dilutive.  For the three and six-month periods ended October 31, 2008, common stock equivalents, primarily options, totaling approximately 6,558,000 shares and 6,678,000 shares, respectively, were excluded from the calculation of diluted loss per share, as their impact would be anti-dilutive. For the three and six month periods ended October 31, 2007, common stock equivalents, primarily options, totaling approximately 7,262,000 shares and 7,169,000 shares, respectively, were excluded from the calculation of diluted earnings per share, as their impact would be anti-dilutive.

 

A reconciliation of the numerator and denominator used in the calculation of the historical basic and diluted net loss per share follows (in thousands, except per share amounts):

 

 

 

Three months ended

 

Six months ended

 

 

 

October 31,

 

October 31,

 

 

 

2008

 

2007

 

2008

 

2007

 

Net loss per share, basic and diluted:

 

 

 

 

 

 

 

 

 

Net loss

 

$

(6,964

)

$

(5,413

)

$

(13,989

)

$

(6,416

)

 

 

 

 

 

 

 

 

 

 

Basic:

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding

 

26,129

 

30,747

 

26,133

 

31,945

 

Less restricted stock included in weighted shares outstanding subject to vesting

 

(69

)

(214

)

(85

)

(218

)

Shares used in calculation of basic loss per share amounts

 

26,060

 

30,533

 

26,048

 

31,727

 

 

 

 

 

 

 

 

 

 

 

Net loss per share

 

$

(0.27

)

$

(0.18

)

$

(0.54

)

$

(0.20

)

 

 

 

 

 

 

 

 

 

 

Diluted:

 

 

 

 

 

 

 

 

 

Shares used in calculation of basic per share amounts

 

26,060

 

30,533

 

26,048

 

31,727

 

Dilutive effect of stock plans

 

 

 

 

 

Shares used in calculation of diluted per share amounts

 

26,060

 

30,533

 

26,048

 

31,727

 

 

 

 

 

 

 

 

 

 

 

Net loss per share

 

$

(0.27

)

$

(0.18

)

$

(0.54

)

$

(0.20

)

 

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Table of Contents

 

Comprehensive Income (Loss)

 

For the three and six months ended October 31, 2008, comprehensive loss was $7.0 million and $13.6 million, respectively, and included the impact of unrealized gains and losses on available for sale investments.  For the three and six months ended October 31, 2007, comprehensive loss was $6.1 million and $7.1 million, respectively, and included the impact of unrealized gains and losses on available for sale investments, net of tax.

 

Accounting for Stock-Based Compensation

 

Stock-based compensation expense recognized during the period is based on the fair value of the actual awards vested or expected to vest. Stock-based compensation expense recognized in the Company’s condensed consolidated statements of operations for the three and six months ended October 31, 2008 and 2007 included compensation expense for stock-based payment awards granted prior to, but not yet vested as of, April 30, 2006, the date of adoption of SFAS 123R, based on the grant date fair value estimated in accordance with the provisions of SFAS 123, and compensation expense for the stock-based payment awards granted subsequent to April 30, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. In conjunction with the adoption of SFAS 123R, the Company changed its accounting policy of attributing the fair value of stock-based compensation to expense from the accelerated multiple-option approach provided by APB 25, as allowed under SFAS 123, to the straight-line single-option approach.  Compensation expense for all stock-based payment awards expected to vest that were granted on or prior to April 30, 2006 will continue to be recognized using the accelerated attribution method. Compensation expense for all stock-based payment awards expected to vest that were granted or modified subsequent to April 30, 2006 is recognized on a straight-line basis. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

 

There was no tax benefit from the exercise of stock options related to deductions in excess of compensation cost recognized in the first half of each of fiscal 2009 and 2008. Prior to the adoption of SFAS 123R, the Company presented all tax benefits of deductions resulting from the exercise of stock options as an operating cash flow, in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-15, Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option.  SFAS 123R requires the Company to reflect the tax savings resulting from tax deductions in excess of expense reflected in its financial statements as a financing cash flow.

 

Investments

 

Investment securities that have maturities of more than three months at the date of purchase but current maturities of less than one year, and auction rate securities which management typically has settled on 7, 28 or 35 day auction cycles, are considered short-term investments. Long-term investment securities include any investments with remaining maturities of one year or more and auction rate securities that have failed to settle since fiscal 2008, for which conditions leading to their failure at auction create uncertainty as to whether they will settle in the near-term. Short- and long-term investments consist of auction rates securities, which have underlying instruments that consist primarily of corporate notes and asset backed securities, and are rated AA or higher at the time of purchase. The Company’s investment securities are maintained at two major financial institutions, are classified as available-for-sale, and are recorded on the Condensed Consolidated Balance Sheets at fair value, with unrealized gains and losses included in accumulated other comprehensive income (loss), a component of stockholders’ equity, net of tax. If the Company sells its investments prior to their maturity, it may record a realized gain or loss in the period the sale took place. In the first half of fiscal 2009 and 2008, the Company realized no gains or losses on its investments.

 

The Company evaluates its investments periodically for possible other-than-temporary impairment by reviewing factors such as the length of time and the extent to which the fair value has been below cost-basis, the financial condition of the issuer and the Company’s ability to hold the investment for a period of time, which may be sufficient for anticipated recovery of the market value. To the extent that the historical cost of the available for sale security exceeds the estimated fair market value, and the decline in value is deemed to be other-than-temporary, an impairment charge is recorded in the Condensed Consolidated Statement of Operations. During the three and six months ended October 31, 2008, the Company recognized impairment losses of $0.8 million and $1.4 million, respectively.

 

Impairment of Long-lived Assets

 

The Company evaluates the recoverability of its long-lived assets on an annual basis in the fourth quarter, or more frequently if indicators of potential impairment arise.  The Company evaluates the recoverability of its amortizable purchased intangible assets based on an estimate of undiscounted future cash flows resulting from the use of the related asset group and its eventual disposition. The asset group represents the lowest level for which cash flows are largely independent of cash flows of other assets and liabilities. Measurement of an impairment loss for long-lived assets that the Company expects to hold and use is based on the difference between the fair value and carrying value of the asset.  Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.

 

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Table of Contents

 

Recent Accounting Pronouncements

 

In September 2006, the FASB issued Statement No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework and guidance regarding the methods for measuring fair value, and expands related disclosures about those measurements. In February 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13”, which amends SFAS 157 to exclude accounting pronouncements that address fair value measurements for purposes of lease classification or measurement under SFAS No. 13, “Accounting for Leases”.

 

In February 2008, the FASB issued FSP FAS 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS No. 157 until the first quarter of fiscal 2010 for all non-financial assets and non-financial liabilities, except for items that are recognized or discounted at fair value in the financial statements on a recurring basis (at least annually). SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company has adopted SFAS 157 for its financial assets effective May 1, 2008, which did not have a material impact on its results of operations, financial position or cash flows (see Note 3). The Company is currently assessing the impact that adoption of SFAS 157 for its non-financial assets and liabilities will have on its results of operations, financial position and cash flows, upon adoption in fiscal 2010.

 

In October 2008, the FASB issued FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active, which provides clarification on the application of SFAS 157 as it relates to financial assets that need to be valued but for which the market has become inactive.  The FSP was effective immediately on the date of its issuance and application of the FSP during the second quarter did not have a material impact on the Company’s results of operations, financial position or cash flows.

 

In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment to FAS 115 (“SFAS 159”). SFAS 159 allows entities to choose, at specified election dates, to measure eligible financial assets and liabilities at fair value in situations in which they are not otherwise required to be measured at fair value. If a company elects the fair value option for an eligible item, changes in that item’s fair value in subsequent reporting periods must be recognized in current earnings. SFAS 159 also establishes presentation and disclosure requirements designed to draw comparison between entities that elect different measurement attributes for similar assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company elected not to apply the fair value option of SFAS 159. As a result, adoption of SFAS 159 did not have a material impact on the Company’s results of operations, financial position and cash flows, upon adoption in fiscal 2009.

 

In December 2007, the FASB issued SFAS 141R, Business Combinations (“SFAS 141R”), replacing SFAS 141, “Business Combinations”. SFAS 141R revises existing accounting guidance for how an acquirer recognizes and measures in its financial statements the identifiable assets, liabilities, any noncontrolling interests, and the goodwill acquired. SFAS 141R is effective for fiscal years beginning after December 15, 2008. SFAS 141R will impact the accounting for business combinations completed by the Company on or after adoption in fiscal 2010.

 

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51 (“SFAS 160”). SFAS 160 requires all entities to report noncontrolling (minority) interests in subsidiaries as equity in the consolidated financial statements. Its intention is to eliminate the diversity in practice regarding the accounting for transactions between an entity and noncontrolling interests. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. Since the Company does not have any subsidiaries with noncontrolling interests, the Company does not expect this statement will have a material impact on its financial condition, results of operations and cash flows upon adoption in fiscal 2010.

 

In May 2008, the FASB issued Staff Position No. APB 14-1, Accounting for Convertible Debt Instruments that May be Settled in Cash Upon Conversion APB 14-1 requires that the liability and equity components of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) be separately accounted for in a manner that reflects an issuer’s nonconvertible debt borrowing rate. The resulting debt discount is amortized over the period the convertible debt is expected to be outstanding as additional non-cash interest expense. APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Retrospective application to all periods presented is required except for instruments that were not outstanding during any of the periods that will be presented in the annual financial statements for the period of adoption but were outstanding during an earlier period. The Company is currently evaluating the impact that adoption of this position could have on its financial condition, results of operations and cash flows, upon adoption in fiscal 2010.

 

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3.             BALANCE SHEET ACCOUNTS

 

Inventories

 

Inventories comprised (in thousands):

 

 

 

October 31,
2008

 

April 30,
2008

 

 

 

 

 

 

 

Raw materials

 

$

804

 

$

716

 

Work in progress

 

206

 

27

 

Finished goods

 

12,710

 

12,949

 

 

 

 

 

 

 

Total

 

$

13,720

 

$

13,692

 

 

Stock-based compensation included in inventories at October 31, 2008 and April 30, 2008 was $10,000 and $17,000, respectively.

 

Fair Value Measurements of Financial Assets and Liabilities

 

SFAS No. 157 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, SFAS No. 157 establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which requires the Company to develop its own assumptions. This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. On a recurring basis, the Company measures certain financial assets and liabilities at fair value, including its short-term and long-term investments.

 

When available, the Company uses quoted market prices to determine fair value of certain of its cash and cash equivalents including money market funds; such items are classified in Level 1 of the fair value hierarchy. As of October 31, 2008 the Company held auction rate securities with a par value of $18.8 million, which are included in short and long-term investments. At October 31, 2008, there were no active markets for these auction rate securities or comparable securities due to current market conditions. Therefore, until such a market becomes active, the Company is determining their fair value based on expected discounted cash flows. Such items are classified in Level 3 of the fair value hierarchy.

 

The following table presents for each of the fair value hierarchy levels, the assets and liabilities that are measured at fair value on a recurring basis as of October 31, 2008 (in thousands):

 

 

 

Fair Value

 

Level 1

 

Level 2

 

Level 3

 

 

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

Money market funds

 

$

40,042

 

$

40,042

 

$

 

$

 

Auction rate securities

 

13,166

 

 

 

13,166

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

53,208

 

$

40,042

 

$

 

$

13,166

 

 

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The following table presents the changes in the Level 3 fair value category for the three and six-month periods ended October 31, 2008 (in thousands):

 

 

 

 

 

Net Realized/Unrealized

 

 

 

 

 

 

 

 

 

 

 

Gains (Losses) included in

 

 

 

 

 

 

 

 

 

 

 

 

 

Other

 

Purchases, Sales,

 

Transfers in

 

 

 

 

 

August 1,

 

 

 

Comprehensive

 

Issuances and

 

and/or (out)

 

October 31,

 

 

 

2008

 

Earnings

 

Loss

 

(Settlements)

 

of Level 3

 

2008

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

Auction rate securities

 

$

21,030

 

(760

)

(24

)

(7,080

)

 

$

13,166

 

 

 

 

 

 

Net Realized/Unrealized

 

 

 

 

 

 

 

 

 

 

 

Gains (Losses) included in

 

 

 

 

 

 

 

 

 

 

 

 

 

Other

 

Purchases, Sales,

 

Transfers in

 

 

 

 

 

May 1,

 

 

 

Comprehensive

 

Issuances and

 

and/or (out)

 

October 31,

 

 

 

2008

 

Earnings

 

Loss

 

(Settlements)

 

of Level 3

 

2008

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

Auction rate securities

 

$

29,530

 

(1,367

)

409

 

(15,406

)

 

$

13,166

 

 

Accrued Expenses

 

Accrued expenses comprised (in thousands):

 

 

 

October 31,
2008

 

April 30,
2008

 

 

 

 

 

 

 

Accrued employee related

 

$

1,796

 

$

2,708

 

Accrued warranty

 

515

 

550

 

Accrued professional fees

 

125

 

485

 

Accrued restructuring costs

 

393

 

240

 

Other accrued expenses

 

898

 

1,087

 

 

 

 

 

 

 

Total

 

$

3,727

 

$

5,070

 

 

Warranties. The Company provides for future warranty costs upon shipment of its products. The specific terms and conditions of those warranties may vary depending upon the product sold, the customer and the country in which it does business. However, the Company’s warranties generally start from the shipment date and continue for a period of two to five years for the hardware element of the Company’s products and 90 days to one year for the software element.

 

Because the Company’s products are manufactured to a standardized specification and products are internally tested to these specifications prior to shipment, the Company historically has experienced minimal warranty costs. Factors that affect the Company’s warranty liability include the number of installed units, historical experience and management’s judgment regarding anticipated rates of warranty claims and cost per claim. The Company assesses the adequacy of its recorded warranty liabilities every quarter and makes adjustments to the liability, if necessary.

 

Changes in the warranty liability, which is included as a component of “Accrued expenses” on the Condensed Consolidated Balance Sheet, during the three and six-month periods ended October 31, 2008 and 2007 are as follows (in thousands):

 

 

 

Three months ended

 

Six months ended

 

 

 

October 31,

 

October 31,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Balance as of the beginning of the fiscal period

 

$

628

 

$

698

 

$

550

 

$

754

 

Provision for warranties issued during fiscal period

 

109

 

67

 

220

 

83

 

Warranty costs incurred during fiscal period

 

(53

)

(23

)

(86

)

(39

)

Other adjustments to the liability (including changes in estimates for pre-existing warranties) during fiscal period

 

(169

)

 

(169

)

(56

)

 

 

 

 

 

 

 

 

 

 

Balance as of October 31

 

$

515

 

$

742

 

$

515

 

$

742

 

 

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4.             PURCHASED INTANGIBLES

 

On June 30, 2005, the Company acquired Jasomi Networks, (Jasomi”). The carrying value of intangible assets acquired in the Jasomi business combination was as follows (in thousands):

 

 

 

October 31, 2008

 

 

 

Gross
Value

 

Accumulated
Amortization

 

Impairment

 

Net Value

 

Purchased Intangible Assets

 

 

 

 

 

 

 

 

 

Core technology

 

$

2,900

 

$

(2,090

)

$

(763

)

$

47

 

Customer relationships

 

1,100

 

(635

)

(429

)

36

 

Trade name and trademarks

 

200

 

(115

)

(78

)

7

 

Total

 

$

4,200

 

$

(2,840

)

$

(1,270

)

$

90

 

 

 

 

April 30, 2008

 

 

 

Gross
Value

 

Accumulated
Amortization

 

Impairment

 

Net Value

 

Purchased Intangible Assets

 

 

 

 

 

 

 

 

 

Core technology

 

$

2,900

 

$

(2,054

)

$

(763

)

$

83

 

Customer relationships

 

1,100

 

(624

)

(429

)

47

 

Trade name and trademarks

 

200

 

(113

)

(78

)

9

 

Total

 

$

4,200

 

$

(2,791

)

$

(1,270

)

$

139

 

 

In the three months ended October 31, 2008 and 2007, the Company recorded $24,000 and $246,000, respectively, of amortization of Jasomi acquisition-related intangible assets. In the six months ended October 31, 2008 and 2007, the Company recorded $49,000 and $492,000, respectively, of amortization of Jasomi acquisition-related intangible assets.

 

Estimated future amortization expense of purchased intangible assets as of October 31, 2008 is as follows (in thousands):

 

 

 

Years ended April 30,

 

 

 

 

 

2009 (six months)

 

$

48

 

2010

 

38

 

2011

 

4

 

 

 

$

90

 

 

5.             RESTRUCTURING

 

At the beginning of the second quarter of fiscal 2009, the Company undertook a reduction in force in an attempt to reduce its operating expenses. The reduction of force totaled approximately 15% of the Company’s workforce.  As a result of the reductions in headcount over the last twelve months, the Company determined that it no longer needs approximately 20% of its Mountain View headquarters and has undertaken to sublease that space for some or all of the remainder of the lease term.  As a result of these actions, the Company recorded a charge in the second quarter of fiscal 2009 totaling approximately $0.9 million.  Of this amount, $0.6 million was related to severance and benefits for the impacted employees and the balance of $0.3 million was related to the estimated loss from subleasing the space vacated in September 2008.  All individuals impacted by the reduction in headcount have been notified of the termination of their employment as of October 31, 2008. As of October 31, 2008, $0.5 million or 86% of the $0.6 million total severance related costs had been paid.  The remaining severance related costs, which primarily relate to outplacement services and COBRA, will be paid over the next twelve months.

 

At the end of the second quarter of fiscal 2008, the Company undertook a restructuring of certain of its operations in an effort to streamline its operations and reduce costs. The restructuring included a reduction in the workforce of approximately 23% and the closure of its research operations in Canada. As a result of these actions the Company recorded a restructuring charge of approximately $1.3 million attributable to severance benefits paid and accrued and costs associated with the closure of the Canadian office, including $250,000 attributable to the loss on abandonment of the Canadian facility lease and losses on assets abandoned at that location.  Of the $1.3 million total restructuring charge, $1.0 million was attributable to severance and related benefits. In the second quarter of fiscal 2009, approximately $24,000 of estimated outplacement benefit accrual related to this reduction in force expired unused and was reversed back to the same financial lines to which it was originally recorded.  All individuals impacted by the reduction in headcount were notified of the termination of their employment as of October 31, 2007.

 

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Reduction in force costs for the three and six-month periods ended October 31, 2008 and 2007 were as follows (in thousands):

 

 

 

Three months ended
October 31,

 

Six months ended
October 31,

 

 

 

2008

 

2007

 

2008

 

2007

 

Cost of Sales

 

$

31

 

$

65

 

$

31

 

$

65

 

Sales and marketing

 

234

 

230

 

234

 

230

 

Research and development

 

243

 

894

 

243

 

894

 

General and administrative

 

374

 

524

 

374

 

524

 

Total

 

$

882

 

$

1,713

 

$

882

 

$

1,713

 

 

6.            STOCKHOLDERS’ EQUITY

 

Employee Equity Plans

 

The Company utilizes a combination of Employee Stock Purchase, Stock Option and Restricted Stock plans as a means to provide equity ownership in the Company for its employees. In addition, the Company has a Non-employee Directors Stock Option Plan.  In the six months ended October 31, 2008, 63,788 shares of common stock were issued under the Employee Stock Purchase Plan (“ESPP”) and 260,171 shares remain available for issuance under that plan as of October 31, 2008.

 

Activity under the stock option and restricted stock plans was as follows (in thousands, except life and exercise price amounts):

 

 

 

 

 

Outstanding Options

 

 

 

Shares Available
For Grant(1)

 

Number
of Shares

 

Weighted Average
Exercise Price

 

Balances, April 30, 2008

 

2,180

 

7,060

 

$

7.13

 

Restricted stock and restricted stock units issued

 

(94

)

 

 

 

 

Restricted stock and restricted stock units forfeited

 

43

 

 

 

 

 

Options granted

 

(657

)

657

 

$

1.84

 

Options exercised

 

 

(10

)

$

0.57

 

Options forfeited

 

290

 

(290

)

$

4.61

 

Options expired

 

1,000

 

(1,000

)

$

8.18

 

 

 

 

 

 

 

 

 

Balances, October 31, 2008

 

2,762

 

6,417

 

$

6.55

 

 


(1) Shares available for grant include shares from the 2005 New Recruit Stock Plan and the 2006 Equity Incentive Plan that may be issued as either stock options, restricted stock or restricted stock units. Shares issued under the 2006 Equity Incentive Plan as stock bonus awards, stock purchase awards, stock unit awards, or other stock awards in which the issue price is less than the fair market value on the date of grant of the award count as the issuance of 1.3 shares for each share of common stock issued pursuant to these awards for purposes of the share reserve.

 

The aggregate intrinsic value of stock options exercised in the first six months of fiscal 2009 and 2008 was $15,000 and $428,000, respectively.

 

The summary of options vested, exercisable and expected to vest at October 31, 2008 comprised (in thousands, except term and exercise price):

 

 

 

Number of
Shares

 

Weighted
Average
Exercise Price

 

Aggregate
Intrinsic
Value

 

Weighted
Average
Remaining
Contractual
Term

 

Fully vested and expected to vest options

 

6,103

 

$

6.71

 

$

22

 

4.98

 

Options exercisable

 

4,444

 

$

7.79

 

$

22

 

3.19

 

 

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The summary of unvested restricted stock awards for the first six months of fiscal 2009 comprised (in thousands, except life):

 

 

 

Number of
Shares

 

Weighted Average
Grant Date Fair
Value

 

Nonvested restricted stock, April 30, 2008

 

124

 

$

6.98

 

Restricted stock issued

 

72

 

$

2.30

 

Restricted stock vested

 

(22

)

$

7.11

 

Restricted stock forfeited

 

(33

)

$

6.47

 

 

 

 

 

 

 

Nonvested restricted stock, October 31, 2008

 

141

 

$

4.69

 

 

The aggregate intrinsic value of vested and expected to vest restricted stock units, which had a weighted average remaining contractual term of 1.1 years, was $6,000 at October 31, 2008. For the six months ended October 31, 2008 and 2007, the total fair value of restricted shares that vested was $0.2 million and $0.3 million, respectively.

 

As of October 31, 2008, there was approximately $4.0 million of total unrecognized compensation cost related to stock options and restricted stock/RSUs that is expected to be recognized over a weighted-average period of 2.5 years for options and 2.1 years for restricted stock and restricted stock units.

 

The key assumptions used in the fair value model and the resulting estimates of weighted-average fair value per share used to record stock-based compensation in the three and six-month periods ended October 31, 2008 and 2007 under SFAS 123R for options granted and for employee stock purchases under the ESPP, during these periods are as follows:

 

 

 

Three months ended
October 31,

 

Six months ended
October 31,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Stock options:

 

 

 

 

 

 

 

 

 

Dividend yield(1)

 

 

 

 

 

Volatility factor(2)

 

0.65

 

0.64

 

0.63

 

0.64

 

Risk-free interest rate(3)

 

2.7

%

4.2

%

3.1

%

4.3

%

Expected life (years)(4)

 

4.6

 

4.8

 

4.6

 

4.8

 

Weighted average fair value of options granted during the period

 

$

0.74

 

$

2.84

 

$

0.98

 

$

3.01

 

 

 

 

 

 

 

 

 

 

 

Employee stock purchase plan:(5)

 

 

 

 

 

 

 

 

 

Dividend yield(1)

 

 

 

 

 

Volatility factor(2)

 

0.71

 

0.41

 

0.71

 

0.41

 

Risk-free interest rate(3)

 

1.4

%

5.0

%

1.4

%

5.0

%

Expected life (years)(4)

 

0.5

 

0.5

 

0.5

 

0.5

 

Weighted average fair value of employee stock purchases during the period

 

$

0.81

 

$

2.11

 

$

0.81

 

$

2.11

 

 

 

 

 

 

 

 

 

 

 

Restricted stock and restricted stock units:

 

 

 

 

 

 

 

 

 

Weighted average fair value of restricted stock and RSUs granted during the period

 

$

2.30

 

$

5.17

 

$

2.30

 

$

6.73

 

 


(1) The Company has no history or expectation of paying dividends on its common stock.

 

(2) The Company estimates the volatility of its common stock at the date of grant based on the historic volatility of its common stock for a term consistent with the expected life of the awards affected at the time of grant.

 

(3) The risk-free interest rate is based on the U.S. Treasury yield for a term consistent with the expected life of the awards in affect at the time of grant.

 

(4) The expected life of stock options granted under the Stock Option Plans is based on historical exercise patterns, which the Company believes are representative of future behavior. The expected life of grants under the ESPP represents the amount of time remaining in the 12-month offering window.

 

(5) Assumptions for the Purchase Plan relate to the most recent enrollment period. Enrollment is currently permitted in May and November of each year.

 

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7.            BORROWING AGREEMENT

 

 In the first quarter of fiscal 2009, the Company renewed its $2.0 million operating line of credit with its bank.  The renewed line of credit, which expires on July 31, 2009, carries the same basic terms and financial covenants related to minimum effective tangible net worth and cash and cash equivalent and short-term investment balances as the original line of credit.  As of October 31, 2008, the Company had no borrowings outstanding under the line of credit but was not in compliance with the loan covenant related to minimum tangible net worth.  The Company is beginning discussions with the bank to modify the covenant and obtain a waiver of the current non-compliance.

 

8.            INCOME TAXES

 

Effective May 1, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, Accounting for Uncertainties in Income Taxes — An Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The liability for uncertain tax positions, if recognized, will decrease the Company’s tax expense. The Company does not anticipate that the amount of liability for uncertain tax positions existing at October 31, 2008 will change significantly within the next 12 months.  Interest and penalties related to the liability for uncertain tax positions are included in provision for income taxes.

 

The Company files income tax returns in the U.S. and various state and foreign jurisdictions. The tax years since fiscal 1998 are subject to examination by the Internal Revenue Service and certain state tax authorities due to the Company’s net operating loss and/or tax credit carry forwards generated in those years. The Company is currently under audit by one state jurisdiction in which it operates for its fiscal 2005 filing but is not under examination by any other tax jurisdictions.

 

The Company recorded a tax provision of $97,000 and $136,000, respectively, for the three and six months ended October 31, 2008 resulting in an effective tax rate of approximately 1%.  The effective tax rate for the three and six months ended October 31, 2008 reflected the effects of a full valuation allowance against the Company’s net deferred tax assets principally from the federal and state net operating loss and tax credit carry forwards created in fiscal 2009 because of uncertainty as to the recoverability of those items due to the Company’s continuing operating losses. The tax provision for the three and six months ended October 31, 2008 is attributable to certain state and foreign jurisdictions in which the Company operates.

 

The Company recorded a tax benefit of $4.5 million and $5.6 million, respectively, for the three and six months ended October 31, 2007 resulting in an effective tax rate of (46)% and (47)%, respectively. The effective tax rate for the three and six months ended October 31, 2007 reflected the favorable impact associated with federal and California operating losses and research credits partially offset by the Company’s inability to deduct for tax purposes: (1) stock-based compensation expense associated with (i) most non-U.S. employees and (ii) incentive stock option grants; and (2) amortization of debentures associated with the Jasomi acquisition that are payable to employee-investors.

 

9.            COMMITMENTS AND CONTINGENCIES

 

Legal Proceedings

 

Beginning on June 14, 2005, several purported class action lawsuits were filed in the United States District Court for the Northern District of California, purportedly on behalf of a class of investors who purchased Ditech’s stock between August 25, 2004 and May 26, 2005. The complaints allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Ditech and its Chief Executive Officer and Chief Financial Officer in connection with alleged misrepresentations concerning VQA orders and the potential effect on Ditech of the merger between Sprint and Nextel, seeking monetary damages. All of the lawsuits were consolidated into a single action entitled In re Ditech Communications Corp. Securities Litigation, No. C 05-02406-JSW, and a consolidated amended complaint was filed on February 2, 2006. The defendants moved to dismiss the complaint, and by order dated August 10, 2006, the court granted the defendants’ motion and dismissed the complaint with leave to amend. The plaintiffs filed their Second Amended Complaint on September 11, 2006. The defendants again moved to dismiss, and by order dated March 22, 2007, the court dismissed the Second Amended Complaint with leave to amend. The plaintiffs filed their Third Amended Complaint on April 23, 2007. On May 14, 2007, the defendants again moved to dismiss. By order dated October 11, 2007, the court dismissed the third amended complaint with prejudice. On November 8, 2007, the plaintiffs filed a notice of appeal to the Ninth U.S. Circuit Court of Appeals. The appeal has been fully briefed. No date for oral argument of the appeal has been set.

 

On August 23, 2006, August 25, 2006, and November 3, 2006, three actions were filed in United States District Court for the Northern District of California (Case Nos. C06-05157, C06-05242, and C06-6877) purportedly as derivative actions on behalf of the Company against certain of the Company’s current and former officers and directors alleging that between 1999 and 2001 certain stock option grants were backdated; that these options were not properly accounted for; and that as a result false and misleading financial statements were filed. These three actions have been consolidated under case number C06-05157. On December 1, 2006, a fourth derivative complaint making similar allegations against many of the same defendants was filed in California Superior Court for the County of Santa Clara (Case No.106-CV-075695). On April 19, 2007, the California Superior Court granted the Company’s motion to stay the state court action pending the outcome of the federal consolidated actions.

 

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The defendants named in the derivative actions are Timothy Montgomery, Gregory Avis, Edwin Harper, William Hasler, Andrei Manoliu, David Sugishita, William Tamblyn, Caglan Aras, Toni Bellin, Robert DeVincenzi, James Grady, Lee House, Serge Stepanoff, Gary Testa, Lowell Trangsrud, Kenneth Jones, Pong Lim, Glenda Dubsky, Ian Wright, and Peter Chung. These derivative complaints raise claims under Section 10(b) and 10b-5 of the Securities Exchange Act, Section 14(a) of the Securities Act, and California Corporations Code Section 25403, as well as common law claims for breach of fiduciary duty, unjust enrichment, waste of corporate assets, gross mismanagement, constructive fraud, and abuse of control. The plaintiffs seek remedies including money damages, disgorgement of profits, accounting, rescission, and punitive damages. With respect to the consolidated federal actions, the plaintiffs filed an amended consolidated complaint on March 2, 2007, adding new allegations regarding another stock option grant. On April 2, 2007, the Company moved to dismiss the amended complaint based on plaintiffs’ failure to make a demand on the board before bringing suit. On the same day, the individual defendants moved to dismiss the amended complaint for failure to state a claim. On July 16, 2007, the Court granted the individual defendants’ motion to dismiss without prejudice.  Plaintiffs filed a second amended complaint on September 21, 2007.  On November 30, 2007, defendants moved to dismiss plaintiffs’ second amended complaint for failure to make a demand on the board and for failure to state a claim.  On March 26, 2008, the Court granted the individual defendants’ motion to dismiss without prejudice, requiring that plaintiffs file any amended complaint by April 25, 2008.  Plaintiffs did not file an amended complaint.  As a result, on May 12, 2008, defendants moved to dismiss plaintiffs’ action with prejudice.  The parties agreed to postpone the hearing on defendants’ motion so that they could engage in mediation.  These actions are in their preliminary stages; no discovery has taken place and no trial date has been set.

 

The Company cannot predict the outcome of the lawsuits at this time and has made no provisions for potential losses from these lawsuits.

 

Lease Commitments

 

At October 31, 2008, future minimum payments under the Company’s current operating leases are as follows (in thousands):

 

 

 

Years ended April 30,

 

 

 

 

 

2009 (Six months)

 

$

515

 

2010

 

1,058

 

2011

 

1,094

 

2012

 

276

 

 

 

 

 

 

 

$

2,943

 

 

Guarantees and Indemnifications. As is customary in the Company’s industry and as required by law in the U.S. and certain other jurisdictions, certain of the Company’s contracts provide remedies to its customers, such as defense, settlement, or payment of judgment for intellectual property claims related to the use of the Company’s products. From time to time, the Company indemnifies customers against combinations of losses, expenses, or liabilities arising from various trigger events related to the sale and the use of the Company’s products and services. In addition, from time to time the Company also provides protection to customers against claims related to undiscovered liabilities, additional product liability or environmental obligations. In the Company’s experience, claims made under such indemnifications are rare.

 

As permitted or required under Delaware law and to the maximum extent allowable under that law, the Company has certain obligations to indemnify its current and former officers and directors for certain events or occurrences while the officer or director is, or was serving at the Company’s request in such capacity. These indemnification obligations are valid as long as the director or officer acted in good faith and in a manner that a person reasonably believed to be in or not opposed to the best interests of the Company, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his or her conduct was unlawful. The maximum potential amount of future payments the Company could be required to make under these indemnification obligations is unlimited; however, the Company has a director and officer insurance policy that limits the Company’s exposure and enables the Company to recover a portion of any future amounts paid. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnification obligations is minimal.

 

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10.         REPORTABLE SEGMENTS AND GEOGRAPHIC INFORMATION

 

The Company currently operates in a single segment - voice quality products.

 

The Company’s revenue from external customers by geographic region, based on shipment destination, was as follows (in thousands):

 

 

 

Three months ended October 31,

 

Six months ended October 31,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

USA

 

$

1,912

 

$

3,218

 

$

5,047

 

$

14,584

 

Middle East/Africa

 

727

 

1,343

 

1,319

 

2,337

 

Canada

 

381

 

395

 

475

 

1,747

 

Far East

 

906

 

1,366

 

1,297

 

1,467

 

Other

 

196

 

315

 

516

 

524

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

4,122

 

$

6,637

 

$

8,654

 

$

20,659

 

 

Sales for the three months ended October 31, 2008 included three customers that represented greater than 10% of total revenue (27%, 21 and 11%).  Sales for the six months ended October 31, 2008 included three customers that represented greater than 10% of total revenue (29% 10% and 10%).  Sales for the three months ended October 31, 2007 included four customers that represented greater than 10% of total revenue (23%, 20%, 12% and 10%).   Sales for the six months ended October 31, 2007 included three customers that represented greater than 10% of total revenue (43%, 18% and 11%).  As of October 31, 2008, the Company had four customers that represented greater than 10% of accounts receivable (43%, 24%, 14% and 11%).  At April 30, 2008, three customers represented greater than 10% of accounts receivable (46%, 16% and 13%).

 

The Company maintained substantially all of its property and equipment in the United States at October 31, 2008 and April 30, 2008.

 

11.                               SUBSEQUENT EVENT

 

In November 2008, the Company completed a further reduction in force in its continuing effort to more closely align its cost structure with current revenue levels.  The reduction in force impacted approximately 15 employees and contractors or approximately 13% of the Company’s workforce immediately prior to the reduction.  The costs of the reduction in force, which are expected to total less than $0.5 million, will be reported as part of the Company’s third quarter fiscal 2009 operating results.

 

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

 

The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and Notes thereto for the year ended April 30, 2008, included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 10, 2008. The discussion in this Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, such as statements of our future financial operating results, plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed here. See “Future Growth and Operating Results Subject to Risk” at the end of this Item 2 for factors that could cause future results to differ materially.

 

Overview

 

We design, develop and market telecommunications equipment for use in enhancing voice quality and canceling echo in voice calls over wireline, wireless and internet protocol (IP) telecommunications networks. Our products monitor and enhance voice quality and provide security in the delivery of voice services. Since entering the voice processing market, we have continued to refine our echo cancellation products to meet the needs of the ever-changing telecommunications marketplace. Our more recent TDM-based product introductions have leveraged the processing capacity of our newer hardware platforms to offer not only echo cancellation but also enhanced Voice Quality Assurance (“VQA”) features including noise reduction, acoustic echo cancellation, voice level control and noise compensation through enhanced voice intelligibility.  Our most recent product introduction offers all the voice capabilities of our TDM-based products along with codec transcoding to meet the new challenges faced by carriers deploying VoIP technologies.

 

Since becoming a public company in June 1999, our financial success has been primarily predicated on the macroeconomic environment of U.S. wireline and, more recently, wireless carriers as well as our success in selling to the larger carriers. Since the beginning of calendar year 2004, large North American telecommunications service providers have been engaged in merger and acquisition activity. This activity largely drove a decline in our fiscal 2006 revenue as one of our two largest fiscal 2005 U.S. customers was and continues to be involved in post-merger integration and, consequently, orders from that customer since the first quarter of fiscal 2006 have been nominal. Over the last several quarters, not only have we continued to see changing strategies related to voice quality impacting the timing and amount of potential domestic and international customer demand, but we have also experienced delays in purchasing decisions due to the interplay of budget constraints with the strategic nature of their voice quality deployment and their transition to third generation cellular technology (“3G”) networks.

 

We believe that the current market conditions around the world could create further delays in purchasing decisions both as carriers tighten their capital investment activity due to internal budget constraints and as tighter credit hampers their ability to borrow to facilitate network expansion and/or upgrades.

 

Despite the previously mentioned delays due to budget and uncertainty around network architecture, we continue to believe that in the United States our continued focus on voice quality in the competitive wireless services landscape and the continued expansion of wireless networks will be key factors in adding new customers and driving opportunities for revenue growth. The development of our VQA feature set, which was originally targeted at the international Global System for Mobile Communications (“GSM”) market, has seen growing importance in the domestic market as well. We continue to focus sales and marketing efforts on international and domestic mobile carriers who might best apply our VQA solution. We have continued to invest in customer trials domestically and internationally in an attempt to better avail ourselves of these opportunities as they arise. Despite these efforts, we have experienced mixed results as we remain dependant on the buying patterns of a small, yet more diverse, group of large customers.

 

We expect additional long-term opportunities for growth will occur in voice over internet protocol, or “VoIP,” based network deployments as there appears to be a growing trend of service providers transitioning from traditional circuit-switched network infrastructure to VoIP. As such, since the beginning of fiscal 2005 we have directed, and expect to continue to direct, the majority of our R&D spending towards the development of our Packet Voice Processor, a platform targeting VoIP-based network deployments.  The Packet Voice Processor introduces cost-effective voice format transcoding capabilities combined with our VQA technology to improve call quality and clarity by eliminating acoustic echo and voice level imbalances and reducing packet loss, delay and jitter. Although fiscal 2008 marked the first period in which revenue from the Packet Voice Processor exceeded 10% of total revenue, ordering patterns are still volatile leading to spikes in the timing and amount of revenue from this product.  In addition to the PVP development efforts, we have begun focusing on the creation of licensed versions of our core technology for use in other elements within communications networks, such as Bluetooth headsets.

 

Acquisition History.    In the last five fiscal years, we have completed one acquisition. In June 2005, we acquired Jasomi, which developed and sold session border controllers that enable VoIP calls to traverse the network address translation, or “NAT,” and protect networks from external attacks by admitting only authorized sessions, ensuring that reliable VoIP service can be provided to them. Consideration for the acquisition totaled approximately $21.8 million.  We additionally issued shares of Ditech restricted stock to new employees hired as part of the acquisition.

 

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Our Customer Base.    Historically, the majority of our sales have been to customers in the United States. These customers accounted for approximately 58% of our revenue in the first six months of fiscal 2009 and 63% and 71% of our revenue in fiscal 2008 and 2007, respectively. However, sales to some of our U.S. customers may result in our products purchased by these customers eventually being deployed internationally, especially in the case of any original equipment manufacturer that distributes overseas. To date, the vast majority of our international sales have been export sales and denominated in U.S. dollars. We expect that as we expand shipments of certain of our voice processing products, which are targeted at GSM networks, international revenue will become a larger percentage of our overall revenue.

 

Our revenue historically has come from a small number of customers. Our largest customer accounted for approximately 29% of our revenue in the first half of fiscal 2009 and 35% of our total revenue in fiscal 2008. Our five largest customers accounted for approximately 62% of our revenue in the first half of fiscal 2009 and 68% and 88% of our revenue in fiscal 2008 and 2007, respectively. Consequently, the loss of any one of our largest customers, without an offsetting increase in revenue from existing or new customers, would have a negative and substantial effect on our business. This customer concentration risk was evidenced in fiscal 2006 and again over the last eighteen months as sudden delays and/or declines in purchases by our large customers resulted in significant declines in our overall revenues and ultimately resulted in net losses for those periods.

 

Critical Accounting Policies and Estimates.  The preparation of our financial statements requires us to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosures. We evaluate these estimates on an ongoing basis, including those related to our revenues, allowance for bad debts, provisions for inventories, warranties and recovery of deferred income taxes receivable. Estimates are based on our historical experience and other assumptions that we consider reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual future results may differ from these estimates in the event that facts and circumstances vary from our expectations. If and when adjustments are required to reflect material differences arising between our ongoing estimates and the ultimate actual results, our future results of operations will be affected. We believe that the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our consolidated financial statements.

 

Revenue Recognition—In applying our revenue recognition and allowance for doubtful accounts policies that are described in our Annual Report on Form 10-K filed on July 10, 2008, the level of judgment is generally relatively limited, as the vast majority of our revenue has been generated by a handful of relatively long-standing customer relationships. These customers are some of the largest wire-line and wireless carriers in the United States and our relationships with them are documented in contracts, which clearly highlight potential revenue recognition issues, such as passage of title and risk of loss. As of October 31, 2008, we had deferred $3.0 million of revenue.  However, only to the extent that we have received cash for a given deferred revenue transaction is the deferred revenue recorded on the Condensed Consolidated Balance Sheet.  Of the $3.0 million of revenue deferred as of October 31, 2008, approximately $1.8 million was associated with installations and other product related deferrals and $1.2 million was associated with maintenance contracts.  In dealing with the remaining smaller customers, we closely evaluate the credit risk of these customers. In those cases where credit risk is deemed to be high, we either mitigate the risk by having the customer post a letter of credit, which we can draw against on a specified date, to effectively provide reasonable assurance of collection, or we defer the revenue until customer payment is received.

 

Investments— We consider investment securities that have maturities of more than three months at the date of purchase but remaining maturities of less than one year, and auction rate securities, which we have historically settled on 7, 28 or 35 day auction cycles, as short-term investments. However, when auction rate securities fail to settle at auction, which occurred in fiscal 2008, and conditions leading to their failure to auction create uncertainty as to whether they will settle in the near-term, we classify them as long-term consistent with the contractual term of the underlying security. Long-term investment securities include any investments with remaining maturities of one year or more and auction rate securities for which we are unable to estimate when they will settle. Short-term and long-term investments consist primarily of corporate notes and asset backed securities. We have classified our investments as available-for-sale securities in the accompanying consolidated financial statements. We carry available-for-sale securities at fair value, and report unrealized gains and losses as a separate component of stockholders’ equity. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities, if any, are included in other income, net based on specific identification. We include interest on securities classified as available-for-sale in total other income. See also the discussion in “Liquidity and Capital Resources” and Item 3 for additional information on auction rate securities.

 

Inventory Valuation Allowances— In conjunction with our ongoing analysis of inventory valuation, we constantly monitor projected demand on a product by product basis. Based on these projections we evaluate the levels of write-downs required for inventory on hand and inventory on order from our contract manufacturers. Although we believe we have been reasonably successful in identifying write-downs in a timely manner, sudden changes in buying patterns from our customers, either due to a shift in product interest and/or a complete pull back from their expected order levels has resulted in the recognition of larger than anticipated write-downs. For example, we recorded an inventory write-down for excess levels of inventory of $5.1 million in fiscal 2008. There were no sales of previously written-down inventory during the three and six-month periods ended October 31, 2008 and 2007.

 

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Cost of Warranty— At the time that we recognize revenue, we accrue for the estimated costs of the warranty we offer on our products. We currently offer warranties on the hardware elements of our products ranging from one to five years and warranties on the software elements of our products ranging from 90 days to one year.  The warranty generally provides that we will repair or replace any defective product and provide software bug fixes within the term of the warranty. Our accrual for the estimated warranty is based on our historical experience and expectations of future conditions. To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, we may revise our estimated warranty accrual to reflect these additional exposures.  This would result in a decrease in gross profits. As of October 31, 2008, we had recorded $0.5 million of accruals related to estimated future warranty costs.  See Note 3 of the Notes to the Condensed Consolidated Financial Statements.

 

Impairment of Long-lived Assets— We continually monitor events and changes in circumstances that could indicate that carrying amounts of long-lived assets, including intangible assets, may not be recoverable. When such events or changes in circumstances arise, we assess the recoverability of our long-lived assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. If the total of the undiscounted future cash flows is less than the carry amount of the assets in question, we recognize an impairment loss based on the excess of the carrying amount over the fair value of the assets. We evaluate the recoverability of our amortizable purchased intangible assets based on an estimate of the undiscounted cash flows resulting from the use of the related asset group and its eventual disposition. The asset group represents the lowest level for which cash flows are largely independent of cash flows of other assets and liabilities. We report long-lived assets to be disposed of at the lower of carrying amount or fair value less costs to sell.

 

Accounting for Stock-based Compensation —Stock-based compensation cost is estimated at the grant date based on the award’s fair value as calculated by the Black-Scholes-Merton (“Black-Scholes”) option-pricing model and is recognized as expense, net of estimated forfeitures, ratably over the requisite service period.  Given our employee stock options have certain characteristics that are significantly different from traded options and, because changes in the subjective assumptions can materially affect the estimated value, in our opinion the existing valuation models may not provide an accurate measure of the fair value of our employee stock options.  Although we determine the fair value of employee stock options in accordance with SFAS 123R and SAB 107 using the Black-Scholes option-pricing model, that value may not be indicative of the fair value observed between a willing buyer and a willing seller in a market transaction.

 

The Black-Scholes model requires various highly judgmental assumptions including expected option life and volatility. If any of the assumptions used in the Black-Scholes model or the estimated forfeiture rate changes significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

 

Accounting for Income Taxes — Amounts recorded for income taxes, both current and deferred, are based on estimates of the tax consequences of our operations in the various tax jurisdictions in which we operate. Our deferred taxes are the result of temporary differences resulting from differing treatment of items such as valuation allowances for bad debts and inventory, for tax and accounting purposes. As part of our ongoing assessment of the recoverability of our deferred tax assets, on a quarterly basis we review the expiration dates of our net operating loss and research credit carry forwards. In addition, we complete a study on the impact of Section 382 of the Internal Revenue Code on at least a semi-annual basis to determine whether a change in ownership may limit the value of our net operating loss carry forwards. We determined that a full valuation allowance against all of our deferred tax assets beginning as of April 30, 2008 was required. We have considered all evidence, positive and negative, pursuant to SFAS 109, Accounting for Income Taxes, and believe that based on our recent operating losses and uncertainty about the magnitude and timing of future operating profits, it is no longer more likely than not that our deferred tax assets will be realized.

 

Effective May 1, 2007, we adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, Accounting for Uncertainties in Income Taxes—An Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition of tax benefits, classification on the balance sheet, interest and penalties, accounting in interim periods, disclosure, and transition. We have classified interest and penalties as a component of tax expense. As a result of the implementation of FIN 48 effective May 1, 2007, we recognized a $0.4 million decrease in the liability for unrecognized tax benefits, which was accounted for as a decrease in the May 1, 2007 balance of accumulated deficit. We do not expect a significant change to the liability for uncertain tax positions over the next 12 months.

 

The effective tax rate was approximately 1% and (46)% for the three months ended October 31, 2008 and 2007, respectively. The effective tax rate for the six months ended October 31, 2008 and 2007 was approximately 1% and (47)%, respectively.  In general, our effective tax rates differ from the statutory rate primarily due to stock-based compensation, research and experimentation tax credits, state taxes and the tax impact of foreign operations. However beginning with the fourth quarter of fiscal 2008, the effective tax rate was also significantly impacted by the establishment of a valuation allowance against our net deferred tax asset position.  As a result, the effective tax rate reflects the tax consequences of certain of the smaller state and foreign jurisdictions in which we report limited profits.

 

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We have completed the two year audit of our federal tax returns for fiscal 2004 and 2005 with no material findings and have begun an audit by one of the state jurisdictions in which we do business for our fiscal 2005 filing. Other than the one state previously noted, we are currently not under audit for any other years or in any other jurisdictions. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

 

Recent Accounting Pronouncements   In September 2006, the FASB issued Statement No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework and guidance regarding the methods for measuring fair value, and expands related disclosures about those measurements. In February 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13”, which amends SFAS 157 to exclude accounting pronouncements that address fair value measurements for purposes of lease classification or measurement under SFAS No. 13, “Accounting for Leases”.

 

In February 2008, the FASB also issued FSP FAS 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS No. 157 until the first quarter of fiscal 2010 for all non-financial assets and non-financial liabilities, except for items that are recognized or discounted at fair value in the financial statements on a recurring basis (at least annually). SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. There was no material impact from our adoption of SFAS No. 157 relative to our financial assets and liabilities effective May 1, 2008.  We are currently assessing the impact that SFAS 157 will have on our non-financial assets and liabilities, on our results of operations, financial position and cash flows, upon adoption beginning in fiscal 2010.

 

In October 2008, the FASB issued FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active, which provides clarification on the application of SFAS 157 as it relates to financial assets that need to be valued but for which the market has become inactive.  The FSP was effective immediately on the date of its issuance and application of the FSP during the second quarter did not have a material impact on our results of operations, financial position or cash flows.

 

In February 2007, the FASB issued Statement No. 159,The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment to FAS 115 (“SFAS 159”). SFAS 159 allows entities to choose, at specified election dates, to measure eligible financial assets and liabilities at fair value in situations in which they are not otherwise required to be measured at fair value. If a company elects the fair value option for an eligible item, changes in that item’s fair value in subsequent reporting periods must be recognized in current earnings. SFAS 159 also establishes presentation and disclosure requirements designed to draw comparison between entities that elect different measurement attributes for similar assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We did not elect to apply the fair value option under SFAS 159 upon adoption on May 1, 2008.  As such, the application of the standard did not have a material impact on our results of operations, financial position and cash flows.

 

In December 2007, the FASB issued SFAS 141R, Business Combinations (“SFAS 141R”), replacing SFAS 141, “Business Combinations”. SFAS 141R revises existing accounting guidance for how an acquirer recognizes and measures in its financial statements the identifiable assets, liabilities, any noncontrolling interests, and the goodwill acquired. SFAS 141R is effective for fiscal years beginning after December 15, 2008. The adoption of SFAS 141R will impact the accounting for business combinations completed by us on or after adoption in fiscal 2010.

 

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51. SFAS No. 160 requires all entities to report noncontrolling (minority) interests in subsidiaries as equity in the consolidated financial statements. Its intention is to eliminate the diversity in practice regarding the accounting for transactions between an entity and noncontrolling interests. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. Since we do not have any subsidiaries with noncontrolling interests, we do not expect this statement will have a material impact on our financial condition, results of operations and cash flows upon adoption in fiscal 2010.

 

In May 2008, the FASB issued Staff Position No. APB 14-1, Accounting for Convertible Debt Instruments that May be Settled in Cash Upon Conversion. APB 14-1 requires that the liability and equity components of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) be separately accounted for in a manner that reflects an issuer’s nonconvertible debt borrowing rate. The resulting debt discount is amortized over the period the convertible debt is expected to be outstanding as additional non-cash interest expense. APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Retrospective application to all periods presented is required except for instruments that were not outstanding during any of the periods that will be presented in the annual financial statements for the period of adoption but were outstanding during an earlier period. We are currently evaluating the impact of the adoption of this position could have on our financial condition, results of operations and cash flows.

 

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RESULTS OF OPERATIONS

 

The following table sets forth, for the periods indicated, the components of the results of operations, as reflected in our statement of operations, as a percentage of sales.

 

 

 

Three months ended October 31,

 

Six months ended October 31,

 

 

 

2008

 

2007

 

2008

 

2007

 

Revenue

 

100.0

%

100.0

%

100.0

%

100.0

%

Cost of goods sold

 

51.7

 

66.5

 

52.0

 

44.0

 

Gross Profit

 

48.3

 

33.5

 

48.0

 

56.0

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing

 

74.3

 

78.1

 

76.6

 

50.7

 

Research and development

 

83.0

 

81.3

 

79.1

 

50.6

 

General and administrative

 

50.9

 

43.1

 

48.0

 

25.9

 

Amortization of purchased intangibles

 

0.6

 

3.7

 

0.6

 

2.4

 

Total operating expenses

 

208.8

 

206.2

 

204.3

 

129.6

 

Loss from operations

 

(160.5

)

(172.7

)

(156.3

)

(73.6

)

Other income, net

 

(6.1

)

22.9

 

(3.8

)

15.3

 

Loss before provision for (benefit from) income taxes

 

(166.6

)

(149.8

)

(160.1

)

(58.3

)

Provision for (benefit from) income taxes

 

2.4

 

(68.4

)

1.5

 

(27.3

)

Net loss

 

(169.0

)%

(81.4

)%

(161.6

)%

(31.0

)%

 

THREE AND SIX MONTHS ENDED OCTOBER 31, 2008 AND 2007.

 

Revenue.

 

 

 

Three months ended October 31,

 

Six months ended October 31,

 

Change From Prior Year

 

$s in thousands

 

2008

 

2007

 

2008

 

2007

 

3 Month
Period

 

6 Month
Period

 

Revenue

 

$

4,122

 

$

6,637

 

$

8,654

 

$

20,659

 

$

(2,515

)

$

(12,005

)

 

The decrease in revenue during the three and six months ended October 31, 2008 compared to the same periods in fiscal 2008 was largely due to a decrease in revenue from our largest domestic customer, Verizon, as well as declines in the overall purchases from the next four largest customers in fiscal 2008, without an increase in other domestic and international business to offset these declines.  In the aggregate, our top five customers in fiscal 2009 accounted for $3.1 million and $5.4 million, respectively, of revenue in the three and six months ended October 31, 2008 as opposed to the top five customers in the same periods of fiscal 2008, which accounted for $4.9 million and $16.8 million, respectively.

 

Our largest customer in both fiscal 2009 and 2008, Verizon, accounted for approximately $1.1 million and $2.5 million, respectively, of our revenue during the three and six months ended October 31, 2008 as compared to $1.5 million and $8.9 million, respectively, during the corresponding periods of fiscal 2008.  This decline in revenue, both in real terms and as a percentage of revenue, appears to be largely due to Verizon shifting focus away from their traditional wireless network deployments, where our product has historically been installed, to newer 3G networks. The mix of customers that represent our next four largest customers has changed year over year but is reflective of a growing trend of our international business becoming a larger percentage of our revenue base mostly due to the decline in our domestic revenues exceeding the rate of decline we have experienced internationally and our VoIP product offering beginning to take hold, primarily domestically.  Two customers, other than Verizon, accounted for over 10% of our revenue for the three and six month periods ended October 31, 2009 and 2008.

 

Although we have experienced a consistent number of customers representing greater than 10% of our revenues during the first half of fiscal 2009 and 2008, the overall dollar magnitude of the revenue from these customers continues to trend down as buying decisions continue to be slow to materialize and are generally for more conservative amounts than buying patterns experienced in fiscal 2006 and 2007.  We believe that this protracted buying process and the smaller ordering levels are a function of tighter capital spending budgets and tighter credit markets, as well as uncertainty in the technical direction that companies are looking to take.  This indecision around future network design appears to have made carriers leery to invest heavily in legacy circuit switched technology due to the risk of stranding investments upon conversion to VoIP.  However on the VoIP side, we are experiencing carriers moving into the VoIP space in a more conservative manner than was expected by industry analysts, resulting in deployments at a fraction of the size which we are accustomed to seeing for circuit switched network deployments.  Although our initial VoIP product design was designed for large scale deployments and therefore was not easily adaptable to meet the smaller scale deployments that most carriers wanted to undertake, we have recently completed development of a smaller scale version of PVP product, which we hope will more closely meet current market demands.

 

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Geographically, our domestic revenue for the three months ended October 31, 2008 totaled 46% of total worldwide revenue as compared to 48% realized for the three months ended October 31, 2007.  Our domestic revenue for the six months ended October 31, 2008 was 58% of worldwide revenue as compared to 71% for the comparable period in fiscal 2008.  The decrease in the domestic portion of our revenue both in real terms and as a percentage of total revenue was primarily driven by the decline in Verizon purchasing activity.  Our international revenue has primarily been dependent on our success in selling VQA. Although we continue to believe that there are meaningful international revenue opportunities, we continue to experience slower than anticipated purchasing cycles from our existing and prospective international customers, which has resulted in volatility in the level of international revenue from quarter to quarter.  We plan to continue to invest in our international infrastructure and in customer trials to attempt to capture the international revenue opportunities that exist for us.  However, we expect that sales of our TDM-based BVP-Flex and QVP products will continue to represent the majority of our revenue in the foreseeable future.    We expect revenue in the third quarter of fiscal 2009 to remain relatively consistent with the quarterly levels experienced in the first half of fiscal 2009.

 

Cost of Goods Sold and Gross Profit.

 

 

 

Three months ended October 31,

 

Six months ended October 31,

 

Change From Prior Year

 

$s in thousands

 

2008

 

2007

 

2008

 

2007

 

3 Month
Period

 

6 Month
Period

 

Cost of goods sold

 

$

2,129

 

$

4,411

 

$

4,499

 

$

9,094

 

$

(2,282

)

$

(4,595

)

Gross profit

 

1,993

 

2,226

 

4,155

 

11,565

 

(233

)

(7,410

)

Gross margin%

 

48.3

%

33.5

%

48.0

%

56.0

%

14.8

%pts

(8.0

)%pts

 

Cost of goods sold consists of direct material costs, personnel costs for test, configuration and quality assurance, costs of licensed technology incorporated into our products, post-sales installation costs, provisions for inventory and warranty expenses and other indirect costs. The decrease in cost of goods sold was primarily driven by the decrease in business volume during the three and six months ended October 31, 2008 as compared to the three and six months ended October 31, 2007.  Our analysis of gross profit below discusses the other factors driving changes in cost of goods sold.

 

Our gross margin percentage increased during the three months ended October 31, 2008, as compared to the comparable period in fiscal 2008, primarily as a result of reduced manufacturing and service overhead costs, which are allocated to cost of sales, attributable to the reductions in force that occurred at the end of the second quarter of fiscal 2008 and again at the beginning of the second quarter of fiscal 2009.   These favorable trends in spending were partially offset by our under absorbed manufacturing overhead costs representing a larger percentage of our revenues.  This was due to reductions in production and purchasing levels in fiscal 2009 that led to increased amounts of under absorbed overhead and to the fiscal 2009 decline in revenue causing the under absorption to become a larger percentage of our revenues.  The favorable movement in manufacturing and service allocations during the second quarter of fiscal 2009 was also partially offset by increases in our provisions for excess inventory and warranty provision in the first quarter of fiscal 2009 as compared to fiscal 2008.

 

Our gross margin percentage decreased during the six months ended October 31, 2008, as compared to the comparable period in fiscal 2008, primarily largely due to our under absorbed manufacturing overhead costs representing a larger percentage of our revenues and increased provisions for excess inventory and warranty costs during the first half of fiscal 2009.  These factors that lead to declines in our gross margin percentage were only partially offset by the reductions in manufacturing and service allocations to cost of sales.

 

All other things being equal, we expect that if our revenue levels increase, gross margin percentages should increase slightly from the current levels as the continued under absorption of manufacturing overheads will become a smaller percentage of a larger revenue base, resulting in improved margins.  However, we could experience further pricing pressures as we expand the distribution of our products internationally through value-added resellers and distributors, which could cause our gross margins to decrease.

 

Sales and Marketing.

 

 

 

Three months ended October 31,

 

Six months ended October 31,

 

Change From Prior Year

 

$s in thousands

 

2008

 

2007

 

2008

 

2007

 

3 Month
Period

 

6 Month
Period

 

Sales & Marketing Expense

 

$

3,061

 

$

5,185

 

$

6,626

 

$

10,477

 

$

(2,124

)

$

(3,851

)

% of Revenue

 

74.3

%

78.1

%

76.6

%

50.7

%

(3.8

)%pts

25.9

%pts

 

Sales and marketing expenses primarily consist of personnel costs, including commissions and costs associated with customer service, travel, trade shows and outside consulting services.  The decrease in sales and marketing expense in the three and six month periods ending October 31, 2008, as compared to the corresponding periods in fiscal 2008 was largely due to the impacts of the reduction in force that occurred at the end of second quarter of fiscal 2008 and subsequent attrition in the sale and marketing organizations and the reduction in force completed at the beginning of the second quarter of fiscal 2009.  The resulting reduction in headcount had a direct impact on both base pay and variable compensation, which experienced a combined reduction of $1.4 million and $2.5 million during the three and six months periods, respectively.  The reduction in headcount also impacted travel and related expenses which experienced a $0.5 million and $0.7 million decrease during the three and six month periods, respectively and also resulted in a reduction in stock compensation for the during the six months ended October 31, 2008 of approximately $0.6 million.  Lastly sales and marketing spending declined by $0.1 million and $0.3 million during the three and six months periods, respectively due to tighter cost control through the adoption of a more focused marketing communications program.  We expect sales and marketing expenses to decrease in the third quarter of fiscal 2009 as we realize the full benefits from reduction in force that was completed in the second quarter of fiscal 2009.

 

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Table of Contents

 

Research and Development.

 

 

 

Three months ended October 31,

 

Six months ended October 31,

 

Change From Prior Year

 

$s in thousands

 

2008

 

2007

 

2008

 

2007

 

3 Month
Period

 

6 Month
Period

 

Research & Development Expense

 

$

3,422

 

$

5,394

 

$

6,849

 

$

10,445

 

$

(1,972

)

$

(3,596

)

% of Revenue

 

83.0

%

81.3

%

79.1

%

50.6

%

1.7

%pts

28.5

%pts

 

Research and development expenses primarily consist of personnel costs, contract consultants, materials and supplies used in the development of voice processing products. The decrease in expense during the three and six month periods ended October 31, 2008 as compared to the corresponding periods in fiscal 2008 was largely driven by the reduction in force that occurred at the end of the second quarter of fiscal 2008 and subsequent attrition and the reduction in force that occurred at the beginning of the second quarter of fiscal 2009.  As a result of the reduction and the related closure of our Canadian research operations, we experienced a decline in payroll and related expenses totaling $1.1 million and $2.2 million during the three and six months ended October 31, 2008, respectively.  Due to the fiscal 2008 reduction in force impacting a larger number of employees in the engineering area than the reduction in force in the second quarter of fiscal 2009, we experienced a $0.7 million reduction in termination and office closure costs in both the three and six months ended October 31, 2008.  We also experienced a $0.1 million and $0.3 million decline in stock-based compensation attributable to employees in the research and development organization during the three and six months ended October 31, 2008, respectively.  See the discussion in the Stock-based Compensation section below.   Lastly, in the six months ended October 31, 2008 we also experienced a $0.2 million decline in spending related to consumed materials associated with a reduction in the level of prototype material purchases due to the stage of development of our products.  We expect research and development expenses to decrease in the third quarter of fiscal 2009 as we realize the full benefits from reduction in force that was completed in the second quarter of fiscal 2009.

 

General and Administrative.

 

 

 

Three months ended October 31,

 

Six months ended October 31,

 

Change From Prior Year

 

$s in thousands

 

2008

 

2007

 

2008

 

2007

 

3 Month
Period

 

6 Month
Period

 

General & Administrative Expense

 

$

2,100

 

$

2,861

 

$

4,155

 

$

5,359

 

$

(761

)

$

(1,204

)

% of Revenue

 

50.9

%

43.1

%

48.0

%

25.9

%

7.8

%pts

22.1

%pts

 

 General and administrative expenses primarily consist of personnel costs for corporate officers, finance and human resources personnel, as well as insurance, legal, accounting and consulting costs.  The decrease in general and administrative expense during the three and six months ended October 31, 2008 was largely due to a decrease in special charges attributable to the separation package for the departing CEO in fiscal 2008.  As a result, general and administrative spending declined by $0.7 million for both the three and six months ended October 31, 2008.  The decline during the three and six months ended October 31, 2008 also reflected the decrease in recruiting costs of approximately $0.1 million and $0.3 million, respectively, associated with the search for a new CEO after our CEO announced his retirement in the first quarter of fiscal 2008.  Finally, the decline in spending also was impacted by a decline in spending on professional services of $0.2 million for the six months ended October 31, 2008 due largely to the incremental costs incurred in the first quarter of fiscal 2008 associated with the adoption of FIN 48.  We expect general and administrative expenses to decrease modestly in the third quarter of fiscal 2009 due to the seasonal nature of our spending on audit and tax services.

 

Stock-based Compensation.

 

Stock-based compensation expense recognized under SFAS 123R in fiscal 2009 and 2008 was as follows:

 

 

 

Three months ended
October 31,

 

Six months ended
October 31,

 

$s in thousands

 

2008

 

2007

 

2008

 

2007

 

Cost of Sales

 

$

57

 

$

79

 

$

152

 

$

198

 

Sales and marketing

 

245

 

373

 

387

 

974

 

Research and development

 

144

 

276

 

374

 

723

 

General and administrative

 

280

 

560

 

508

 

760

 

Total

 

$

726

 

$

1,288

 

$

1,421

 

$

2,655

 

 

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Table of Contents

 

The decline in stock based compensation for the three and six months ended October 31, 2008 is due to two key factors.  First and foremost is the reduction in options outstanding and therefore stock compensation linked to the reductions in force that occurred since the end of the second quarter of fiscal 2008.  The second key element of the decline is linked to the timing of option grants that are subject to accounting under SFAS 123R. As compensation related to older options, which were granted at higher fair values per share due to the stock price at the time of grant, become fully amortized, they are being replaced by newer option grants which are being issued at lower fair values due largely to the decline in our stock price.   We expect to continue to experience a declining level of expense related to stock compensation.

 

Amortization of purchased intangible assets.

 

 

 

Three months
ended October 31,

 

Six months
ended October 31,

 

Change From Prior Year

 

$s in thousands

 

2008

 

2007

 

2008

 

2007

 

3 Month
Period

 

6 Month
Period

 

Amortization of purchased intangible assets

 

$

24

 

$

246

 

$

49

 

$

492

 

$

(222

)

$

(443

)

% of Revenue

 

0.6

%

3.7

%

0.6

%

2.4

%

(3.1

)%pts

(1.8

)%pts

 

Purchased intangible assets relate to our acquisition of Jasomi in fiscal 2006 and are being amortized to operating expense over their estimated useful lives which range from four to five years.  The decline in amortization is largely due to the $1.3 million impairment charge that was recognized at the end of fiscal 2008.

 

Reduction in Force and Related Charges.

 

 

 

Three months ended
October 31,

 

Six months ended
October 31,

 

$s in thousands

 

2008

 

2007

 

2008

 

2007

 

Cost of Sales

 

$

31