10-Q 1 sons9271310-q.htm 10-Q SONS 9.27.13 10-Q
 


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
(Mark One)
x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 27, 2013
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 001-34115
SONUS NETWORKS, INC.
(Exact name of Registrant as specified in its charter)
DELAWARE

04-3387074
(State or other jurisdiction of
incorporation or organization)

(I.R.S. Employer Identification No.)

4 Technology Park Drive, Westford, Massachusetts 01886
(Address of principal executive offices) (Zip code)

(978) 614-8100
(Registrant's telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes 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. (Check one):
Large accelerated filer o

Accelerated filer x

Non-accelerated filer o
 (Do not check if a smaller
reporting company)

Smaller reporting company o

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 October 18, 2013, there were 273,495,101 shares of the registrant's common stock, $0.001 par value, outstanding.
 



SONUS NETWORKS, INC.
FORM 10-Q
QUARTER ENDED SEPTEMBER 27, 2013
TABLE OF CONTENTS

Item
 
Page
 
PART I FINANCIAL INFORMATION
 
 
 
 
 
 
 
PART II OTHER INFORMATION
 
 
 



Cautionary Note Regarding Forward-Looking Statements
This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of the U.S. Private Securities Litigation Reform Act of 1995, which are subject to a number of risks and uncertainties. All statements other than statements of historical facts contained in this Quarterly Report on Form 10-Q, including statements regarding our future results of operations and financial position, business strategy, plans and objectives of management for future operations and plans for future product development and manufacturing are forward-looking statements. Without limiting the foregoing, the words "anticipates", "believes", "could", "estimates", "expects", "intends", "may", "plans", "seeks" and other similar language, whether in the negative or affirmative, are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. Forward-looking statements are based on our current expectations and assumptions regarding our business, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. We therefore caution you against relying on any of these forward-looking statements.
Important factors that could cause actual results to differ materially from those in these forward-looking statements are discussed in Part I, Items 2 and 3, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Quantitative and Qualitative Disclosures About Market Risk," respectively, and Part II, Item 1A, "Risk Factors," of this Quarterly Report on Form 10-Q. Also, any forward-looking statement made by us in this Quarterly Report on Form 10-Q speaks only as of the date on which this Quarterly Report on Form 10-Q was first filed. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.


3


PART I FINANCIAL INFORMATION


Item 1. Financial Statements
SONUS NETWORKS, INC.
Condensed Consolidated Balance Sheets
(in thousands, except share and per share data)
(unaudited)

 
September 27,
2013
 
December 31,
2012
Assets
Current assets:
 
 
 
Cash and cash equivalents
$
72,385

 
$
88,004

Marketable securities
128,177

 
161,905

Accounts receivable, net of allowance for doubtful accounts of $364 at September 27, 2013 and $0 at December 31, 2012
52,479

 
68,728

Inventory
22,058

 
25,614

Deferred income taxes
632

 
686

Other current assets
14,450

 
16,520

Total current assets
290,181

 
361,457

Property and equipment, net
18,756

 
23,767

Intangible assets, net
11,177

 
15,237

Goodwill
32,379

 
32,379

Investments
66,889

 
29,698

Deferred income taxes
954

 
1,011

Other assets
7,616

 
7,191

 
$
427,952

 
$
470,740

Liabilities and Stockholders' Equity
Current liabilities:
 
 
 
Accounts payable
$
16,001

 
$
10,643

Accrued expenses
25,967

 
26,212

Current portion of deferred revenue
36,556

 
37,094

Current portion of long-term liabilities
572

 
763

Total current liabilities
79,096

 
74,712

Deferred revenue
10,322

 
11,647

Deferred income taxes
790

 
249

Convertible subordinated note
2,380

 
2,380

Other long-term liabilities
4,689

 
5,706

Total liabilities
97,277

 
94,694

Commitments and contingencies (Note 16)

 

Stockholders' equity:
 
 
 
Preferred stock, $0.01 par value per share; 5,000,000 shares authorized, none issued and outstanding

 

Common stock, $0.001 par value per share; 600,000,000 shares authorized; 273,305,861 shares issued and outstanding at September 27, 2013; 280,963,298 shares issued and outstanding at December 31, 2012
273

 
281

Additional paid-in capital
1,299,029

 
1,321,385

Accumulated deficit
(974,764
)
 
(952,373
)
Accumulated other comprehensive income
6,137

 
6,753

Total stockholders' equity
330,675

 
376,046

 
$
427,952

 
$
470,740


See notes to the unaudited condensed consolidated financial statements.

4


SONUS NETWORKS, INC.
Condensed Consolidated Statements of Operations
(in thousands, except per share data)
(unaudited)
 
Three months ended
 
Nine months ended
 
September 27,
2013
 
September 28,
2012
 
September 27,
2013
 
September 28,
2012
Revenue:
 
 
 
 
 
 
 
Product
$
40,712

 
$
33,520

 
$
121,447

 
$
107,517

Service
27,387

 
23,529

 
79,133

 
71,481

Total revenue
68,099

 
57,049

 
200,580

 
178,998

Cost of revenue:
 
 
 
 
 
 
 
Product
15,415

 
11,768

 
42,844

 
31,988

Service
10,420

 
12,839

 
33,662

 
40,019

Total cost of revenue
25,835

 
24,607

 
76,506

 
72,007

Gross profit
42,264

 
32,442

 
124,074

 
106,991

Operating expenses:
 
 
 
 
 
 
 
Research and development
16,566

 
15,612

 
52,086

 
51,094

Sales and marketing
18,291

 
17,613

 
58,596

 
56,339

General and administrative
9,178

 
7,939

 
29,621

 
25,302

Acquisition-related

 
4,090

 

 
5,057

Restructuring
1,140

 
1,992

 
4,787

 
1,992

Total operating expenses
45,175

 
47,246

 
145,090

 
139,784

Loss from operations
(2,911
)
 
(14,804
)
 
(21,016
)
 
(32,793
)
Interest income, net
61

 
20

 
289

 
457

Other income (expense), net
(1
)
 
(2
)
 
2

 
(2
)
Loss before income taxes
(2,851
)
 
(14,786
)
 
(20,725
)
 
(32,338
)
Income tax provision
(922
)
 
(833
)
 
(1,666
)
 
(1,444
)
Net loss
$
(3,773
)
 
$
(15,619
)
 
$
(22,391
)
 
$
(33,782
)
Loss per share
 
 
 
 
 
 
 
Basic
$
(0.01
)
 
$
(0.06
)
 
$
(0.08
)
 
$
(0.12
)
Diluted
$
(0.01
)
 
$
(0.06
)
 
$
(0.08
)
 
$
(0.12
)
Shares used to compute loss per share:
 
 
 
 
 
 
 
Basic
279,209

 
280,145

 
281,041

 
279,854

Diluted
279,209

 
280,145

 
281,041

 
279,854


See notes to the unaudited condensed consolidated financial statements.


5


SONUS NETWORKS, INC.
Condensed Consolidated Statements of Comprehensive Loss
(in thousands)
(unaudited)

 
Three months ended
 
Nine months ended
 
September 27, 2013
 
September 28, 2012
 
September 27, 2013
 
September 28, 2012
Net loss
$
(3,773
)
 
$
(15,619
)
 
$
(22,391
)
 
$
(33,782
)
Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Foreign currency translation adjustments
(77
)
 
119

 
(532
)
 
(76
)
Unrealized gain (loss) on available-for sale marketable securities, net of tax
188

 
127

 
(84
)
 
24

Other comprehensive income (loss), net of tax
111

 
246

 
(616
)
 
(52
)
Comprehensive loss, net of tax
$
(3,662
)
 
$
(15,373
)
 
$
(23,007
)
 
$
(33,834
)

See notes to the unaudited condensed consolidated financial statements.


6


SONUS NETWORKS, INC.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
 
Nine months ended
 
September 27, 2013
 
September 28, 2012
Cash flows from operating activities:
 
 
 
Net loss
$
(22,391
)
 
$
(33,782
)
Adjustments to reconcile net loss to cash flows provided by (used in) operating activities:
 
 
 
Depreciation and amortization of property and equipment
9,591

 
9,081

Amortization of intangible assets
3,460

 
904

Impairment of intangible assets
600

 

Stock-based compensation
13,137

 
6,540

Loss on disposal of property and equipment
23

 
23

Deferred income taxes
541

 

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
15,744

 
13,020

Inventory
3,294

 
(3,868
)
Other operating assets
5,126

 
(4,998
)
Accounts payable
5,134

 
(1,753
)
Accrued expenses and other long-term liabilities
(2,061
)
 
(3,625
)
Deferred revenue
(1,664
)
 
(9,624
)
Net cash provided by (used in) operating activities
30,534

 
(28,082
)
Cash flows from investing activities:
 
 
 
Purchases of property and equipment
(4,498
)
 
(7,792
)
Business acquisition, net of cash acquired

 
(35,508
)
Purchases of marketable securities
(182,534
)
 
(139,917
)
Maturities of marketable securities
175,887

 
200,380

Net cash (used in) provided by investing activities
(11,145
)
 
17,163

Cash flows from financing activities:
 
 
 
Proceeds from sale of common stock in connection with employee stock purchase plan
1,888

 
1,693

Proceeds from exercise of stock options
2,393

 
151

Payment of tax withholding obligations related to net share settlements of restricted stock awards
(1,240
)
 
(169
)
Repurchase of common stock
(37,340
)
 

Principal payments of capital lease obligations
(91
)
 
(87
)
Settlement of redeemable convertible subordinated debentures

 
(23,704
)
Net cash used in financing activities
(34,390
)
 
(22,116
)
Effect of exchange rate changes on cash and cash equivalents
(618
)
 
192

Net decrease in cash and cash equivalents
(15,619
)
 
(32,843
)
Cash and cash equivalents, beginning of year
88,004

 
105,451

Cash and cash equivalents, end of period
$
72,385

 
$
72,608

Supplemental disclosure of cash flow information:
 
 
 
Interest paid
$
49

 
$
638

Income taxes paid
$
1,391

 
$
1,958

Income tax refunds received
$
117

 
$
42

Supplemental disclosure of non-cash investing activities:
 
 
 
Capital expenditures incurred, but not yet paid
$
467

 
$
861

Property and equipment acquired under operating lease
$

 
$
40

Business acquisition purchase consideration - assumed equity awards
$

 
$
892


See notes to the unaudited condensed consolidated financial statements.

7


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements
(unaudited)

(1) BASIS OF PRESENTATION
Business
Sonus Networks, Inc. (“Sonus” or the “Company”) was incorporated in 1997 and is a leading provider of networked solutions for communications service providers (e.g., telecommunications, wireless and cable service providers) and enterprises to help them advance, protect and unify their communications and improve collaboration. Sonus' products include session border controllers, Session Initiation Protocol ("SIP") session management servers, Voice over IP ("VoIP"), switches, SIP application servers, multiprotocol signaling gateways and network analytics tools. Sonus' solutions address the need for communications service providers and enterprises to seamlessly link and leverage multivendor, multiprotocol communications systems and applications across their networks, around the world and in a rapidly changing ecosystem of IP-enabled devices such as smartphones and tablets.

The Company's target customers comprise both communications service providers and enterprises utilizing both direct and indirect sales channels. Customers and prospective customers in the service provider space are traditional and emerging communications providers, including long distance carriers, local exchange carriers, Internet service providers, wireless operators, cable operators, international telephone companies and carriers that provide services to other carriers. Enterprise customers and target enterprise customers include financial institutions, retailers, state and local governments, and other multinational corporations. The Company collaborates with its customers to identify and develop new, advanced services and applications that can help to reduce costs, improve productivity and generate new revenue.

Basis of Presentation

In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring items, necessary for their fair presentation with accounting principles generally accepted in the United States of America ("GAAP") and with the rules and regulations of the U.S. Securities and Exchange Commission ("SEC").

Interim results are not necessarily indicative of results for a full year or any future interim period. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2012 ("Annual Report") filed with the SEC on March 6, 2013.

On August 24, 2012, the Company completed the acquisition of Network Equipment Technologies, Inc. (“NET”). The financial results of NET are included in the Company's condensed consolidated financial statements for the three and nine months ended September 27, 2013 and for the three and nine months ended September 28, 2012 for the period subsequent to August 24, 2012.

The Company reported acquisition-related expenses of approximately $967,000 as a component of general and administrative expenses in its Quarterly Report on Form 10-Q for the quarter ended June 29, 2012. The Company is now separately reporting this amount as acquisition-related expenses in the condensed statements of operations included herein.

Significant Accounting Policies

The Company's significant accounting policies are disclosed in Note 2 to the Consolidated Financial Statements included in the Company's Annual Report. There were no material changes to the significant accounting policies during the three or nine months ended September 27, 2013.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of Sonus and its wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated in consolidation.


8


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

Use of Estimates and Judgments

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Significant estimates and judgments relied upon in preparing these consolidated financial statements include accounting for business combinations, revenue recognition for multiple element arrangements, inventory valuations, assumptions used to determine the fair value of stock-based compensation, intangible assets and goodwill valuations, including impairments, legal contingencies and recoverability of Sonus' net deferred tax assets and the related valuation allowances. Sonus regularly assesses these estimates and records changes in estimates in the period in which they become known. Sonus bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results could differ from those estimates.

Fair Value of Financial Instruments

The carrying amounts of the Company's financial instruments, which include cash equivalents, marketable securities, investments, accounts receivable, accounts payable, convertible subordinated debt and other long-term liabilities, approximate their fair values.

Operating Segments

The Company operates in a single segment. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker in making decisions regarding resource allocation and assessing performance. To date, the chief operating decision maker has made such decisions and assessed performance at the company level, as one segment. The Company's chief operating decision maker is its President and Chief Executive Officer.

Recent Accounting Pronouncements

On July 18, 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2013-11, Presentation of a Liability for an Unrecognized Tax Benefit When a Net Operating Loss Carryforward or Tax Credit Carryforward Exists ("ASU 2013-11"), which provides guidance on financial statement presentation of an unrecognized tax benefit when a net operating loss ("NOL") carryforward, a similar tax loss or a tax credit carryforward exists. The FASB's objective in issuing ASU 2013-11 is to eliminate diversity in practice resulting from a lack of guidance on this topic in current GAAP. ASU 2013-11 requires that an entity present an unrecognized tax benefit, or a portion of an unrecognized tax benefit, in the financial statements as a reduction to a deferred tax asset for an NOL carryforward, a similar tax loss or a tax credit unless certain conditions exist. ASU 2013-11 is effective for the Company beginning January 1, 2014. The Company does not expect the adoption of ASU 2013-11 to have an impact on its consolidated financial statements, as the Company currently applies the methodology prescribed by ASU 2013-11.

On March 4, 2013, the FASB issued ASU 2013-05, Foreign Currency Matters (Topic 830) - Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity ("ASU 2013-05"), which indicates that the entire amount of a cumulative translation adjustment ("CTA") related to an entity's investment in a foreign entity should be released when there has been either: (a) a sale of a subsidiary or group of net assets within a foreign entity and the sale represents the substantially complete liquidation of the investment in a foreign entity; (b) the loss of a controlling financial interest in an investment in a foreign entity (i.e., the foreign entity is deconsolidated); or (c) the step acquisition of a foreign entity (i.e., when the accounting for an entity has changed from applying the equity method for an investment in a foreign entity to consolidating the foreign entity). ASU 2013-05 does not change the requirement to release a pro rata portion of the CTA of the foreign entity into earnings for a partial sale of an equity method investment in a foreign entity. ASU 2013-05 is effective for the Company beginning January 1, 2014, although early adoption is permitted. The Company does not expect the adoption of ASU 2013-05 to have a material impact on its consolidated financial statements.

On February 5, 2013, the FASB issued ASU 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income ("ASU 2013-02"), which requires entities to disclose changes in

9


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

accumulated other comprehensive income balances by component (i.e., unrealized gains or losses on available-for-sale securities or foreign-currency items) and significant items reclassified out of accumulated other comprehensive income by component either on the face of the income statement or as a separate footnote to the financial statements. ASU 2013-02 does not change the current requirements for interim financial statement reporting of comprehensive income. ASU 2013-02 became effective for the Company on January 1, 2013. The Company does not have significant items reclassified out of accumulated other comprehensive income and accordingly, the adoption of ASU 2013-02 did not impact the Company's condensed consolidated financial statements.


(2) ACQUISITION OF NET

On August 24, 2012 (the “NET Acquisition Date”), the Company acquired all of the outstanding common stock of NET for cash consideration of $41.5 million, or $1.35 per share of NET common stock. The acquisition was effected through a merger of a wholly-owned subsidiary of the Company into NET, with NET surviving the merger as a wholly-owned subsidiary of the Company. NET is a provider of networking equipment focused on secure real-time communications for Unified Communications ("UC"), SIP trunking, enterprise mobility and IP-based multi-service networking. The Company acquired NET to enhance its position as an enabler of cloud-based UC. The acquisition of NET expands the Company's portfolio of Session Border Controller (“SBC”) solutions for enterprise customers and brings engineering resources, broader channel capability and a broad U.S. federal government installed base to leverage into SIP-enabled platforms.

As of August 24, 2013, the valuation of acquired assets, identifiable intangible assets, uncertain tax liabilities and certain accrued liabilities had been finalized. Based on new information gathered about facts and circumstances that existed as of the NET Acquisition Date related to the valuation of certain acquired assets and assumed liabilities, the Company finalized its valuations of assets acquired and liabilities assumed. The Company recorded retrospective adjustments as of December 31, 2012, which resulted in a net decrease to goodwill of $1.4 million, a net increase to other current assets of $0.9 million and a net decrease to current liabilities of $0.5 million as set forth in the table below. The adjustments have been retrospectively applied to the December 31, 2012 balance sheet; however, these adjustments had no impact on either the condensed consolidated statements of operations or the condensed consolidated statements of cash flows.

During the second quarter of fiscal 2013, the Company made an election under Section 338(g) of the Internal Revenue Code to have the NET transaction treated as an asset acquisition (i.e., a taxable transaction) with the goodwill being deductible for tax purposes over 15 years.

A summary of the allocation of the purchase consideration for NET is as follows (in thousands):

Fair value of consideration transferred:
 
  Cash, net of cash acquired
$
35,508

  Fair value of equity awards assumed
892

    Fair value of total consideration
$
36,400

Fair value of assets acquired and liabilities assumed:
 
  Marketable securities
$
5,359

  Deferred income taxes
681

  Other current assets
13,388

  Property and equipment
4,694

  Noncurrent investments
10,167

  Intangible assets
16,810

  Goodwill
27,317

  Other noncurrent assets
1,843

  Current liabilities
(9,350
)
  Debt
(34,208
)
  Other long-term liabilities
(301
)
 
$
36,400



10


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

The valuation of the acquired intangible assets is inherently subjective and relies on significant unobservable inputs. The Company used an income approach to value the acquired customer relationships and developed technology intangible assets. The valuation for each of these intangible assets was based on estimated projections of expected cash flows to be generated by the assets, discounted to the present value at discount rates commensurate with perceived risk. The valuation assumptions take into consideration the Company's estimates of contract renewal, technology attrition and revenue growth projections. The Company is amortizing the identifiable intangible assets in relation to the expected cash flows from the individual intangible assets over their respective useful lives (see Note 6).

Pro Forma Results

The following unaudited pro forma information presents the condensed combined results of operations of the Company and NET for the three and nine months ended September 28, 2012 as if the acquisition of NET had been completed on January 1, 2011, with adjustments to give effect to pro forma events that are directly attributable to the acquisition. These pro forma adjustments include a reduction to historical NET revenue for the fair value adjustment related to assumed deferred revenue, an increase in amortization expense for the acquired identifiable intangible assets and decreases in historical NET interest expense and the Company's historical interest income reflecting the extinguishment of certain of NET's debt as a result of the acquisition. Subsequent to the filing of the Company's Quarterly Report on Form 10-Q for the quarter ended September 28, 2012, the Company refined the amounts and attribution of certain expenses related to the acquisition and the related purchase accounting and accordingly, the pro forma information below has been revised.

The unaudited pro forma results do not reflect any operating efficiencies or potential cost savings which may result from the consolidation of the operations of the Company and NET. Accordingly, these unaudited pro forma results are presented for illustrative purposes and are not intended to represent or be indicative of the actual results of operations of the combined companies that would have been achieved had the acquisition occurred as of January 1, 2011, nor are they intended to represent or be indicative of future results of operations (in thousands, except per share amount):
 
Three months ended
 
Nine months ended
 
September 28, 2012
 
September 28, 2012
Revenue
$
63,369

 
$
207,878

Net loss
$
(13,496
)
 
$
(48,765
)
Loss per share
$
(0.05
)
 
$
(0.17
)


Acquisition-Related Expenses

Acquisition-related expenses include those expenses related to the acquisition that would otherwise not have been incurred by the Company. These expenses include professional and services fees, such as legal, audit, consulting, paying agent and other fees, and expenses related to cash payments to former NET executives under their NET change of control agreements.

The components of acquisition-related costs included in the Company's results of operations for the three and nine months ended September 28, 2012 are as follows (in thousands):
 
Three months ended
 
Nine months ended
 
September 28, 2012
 
September 28, 2012
Professional and services fees
$
2,048

 
$
3,015

Change of control agreements
2,042

 
2,042

 
$
4,090

 
$
5,057



The Company did not record any acquisition-related expenses in either the three or nine months ended September 27, 2013.

11


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)



(3) EARNINGS (LOSS) PER SHARE
Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of shares outstanding during the period. For periods in which the Company reports net income, diluted net income per share is determined by using the weighted average number of common and dilutive common equivalent shares outstanding during the period unless the effect is antidilutive.

The calculations of shares used to compute basic and diluted loss per share are as follows (in thousands):

 
Three months ended
 
Nine months ended
 
September 27,
2013
 
September 28,
2012
 
September 27,
2013
 
September 28,
2012
Weighted average shares outstanding—basic
279,209

 
280,145

 
281,041

 
279,854

Potential dilutive common shares

 

 

 

Weighted average shares outstanding—diluted
279,209

 
280,145

 
281,041

 
279,854



Options to purchase the Company's common stock, unvested shares of restricted stock and unvested performance-based stock awards for which the performance conditions have been satisfied aggregating 35.9 million shares for the three and nine months ended September 27, 2013 have not been included in the computation of diluted loss per share because their effect would have been antidilutive. Options to purchase the Company's common stock and unvested shares of restricted stock aggregating 27.2 million shares for the three and nine months ended September 28, 2012 have not been included in the computation of diluted loss per share because their effect would have been antidilutive.

(4) CASH EQUIVALENTS, MARKETABLE SECURITIES AND INVESTMENTS

The Company invests in debt and equity instruments, primarily U.S. government-backed, municipal and corporate obligations, which management believes to be high quality (investment grade) credit instruments.

During the nine months ended September 27, 2013 and September 28, 2012, the Company did not sell any of its available-for-sale securities and accordingly, no such gains or losses were realized.

Marketable securities and investments with continuous unrealized losses for one year or greater at September 27, 2013 were nominal. Since the Company does not intend to sell these securities and does not believe it will be required to sell any securities before they recover in value, it does not believe these declines are other-than-temporary.

On a quarterly basis, the Company reviews its marketable securities and investments to determine if there have been any events that could create a credit impairment. The increase in unrealized losses in the current year period primarily relates to the recent increase in interest rates. However, since the Company's entire investment portfolio has investment grade ratings with no indication of credit loss, the Company believes it will recover the entire amortized cost basis of these securities and does not believe these unrealized losses are other-than-temporary. Accordingly, the Company does not believe that any impairment existed with its current holdings at September 27, 2013.

The amortized cost, gross unrealized gains and losses and fair value of the Company's marketable debt and equity securities and investments at September 27, 2013 and December 31, 2012 were comprised of the following (in thousands):


12


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

 
September 27, 2013
 
Amortized
cost
 
Unrealized
gains
 
Unrealized
losses
 
Fair
value
Cash equivalents
$
33,110

 
$

 
$

 
$
33,110

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
U.S. government agency notes
$
47,606

 
$
30

 
$

 
$
47,636

Corporate debt securities
65,241

 
24

 
(20
)
 
65,245

Commercial paper
11,240

 
4

 

 
11,244

Certificates of deposit
4,050

 
3

 
(1
)
 
4,052

 
$
128,137

 
$
61

 
$
(21
)
 
$
128,177

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
20,471

 
$
8

 
$
(3
)
 
$
20,476

Foreign government notes
1,250

 

 
(1
)
 
1,249

Corporate debt securities
45,188

 
16

 
(40
)
 
45,164

 
$
66,909

 
$
24

 
$
(44
)
 
$
66,889


 
December 31, 2012
 
Amortized
cost
 
Unrealized
gains
 
Unrealized
losses
 
Fair
value
Cash equivalents
$
69,389

 
$

 
$

 
$
69,389

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
U.S. government agency notes
$
53,646

 
$
22

 
$

 
$
53,668

Foreign government notes
2,000

 
1

 

 
2,001

Corporate debt securities
84,047

 
34

 
(5
)
 
84,076

Commercial paper
7,492

 
5

 

 
7,497

Certificates of deposit
14,650

 
13

 

 
14,663

 
$
161,835

 
$
75

 
$
(5
)
 
$
161,905

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
19,358

 
$
20

 
$

 
$
19,378

Corporate debt securities
10,306

 
20

 
(6
)
 
10,320

 
$
29,664

 
$
40

 
$
(6
)
 
$
29,698


The Company's available-for-sale debt securities that are classified as Investments in the condensed consolidated balance sheet mature after one year but within two years or less from the balance sheet date.

Fair Value Hierarchy

Fair value is the price 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 a liability. The three-tier fair value hierarchy is based on the level of independent, objective evidence surrounding the inputs used to measure fair value. A financial instrument's categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The fair value hierarchy is as follows:

Level 1. Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities.

Level 2. Level 2 applies to assets or liabilities for which there are inputs that are directly or indirectly observable in the marketplace, such as quoted prices for similar assets or liabilities in active markets or quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets).


13


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

Level 3. Level 3 applies to assets or liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities.

The following table shows the fair value of the Company's financial assets at September 27, 2013 and December 31, 2012. These financial assets are comprised of the Company's available-for-sale debt and equity securities and reported under the captions Cash and cash equivalents, Marketable securities and Investments in the consolidated balance sheets (in thousands):

 
 
 
Fair value measurements at
September 27, 2013 using:
 
Total carrying
value at
September 27,
2013
 
Quoted prices
in active
markets
(Level 1)
 
Significant other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Cash equivalents
$
33,110

 
$
33,110

 
$

 
$

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
U.S. government agency notes
$
47,636

 
$

 
$
47,636

 
$

Corporate debt securities
65,245

 

 
65,245

 

Commercial paper
11,244

 

 
11,244

 

Certificates of deposit
4,052

 

 
4,052

 

 
$
128,177

 
$

 
$
128,177

 
$

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
20,476

 
$

 
$
20,476

 
$

Foreign government notes
1,249

 

 
1,249

 

Corporate debt securities
45,164

 

 
45,164

 

 
$
66,889

 
$

 
$
66,889

 
$


 
 
 
Fair value measurements at
December 31, 2012 using:
 
Total carrying
value at
December 31,
2012
 
Quoted prices
in active
markets
(Level 1)
 
Significant other
observable
inputs
(Level 2)
 
Significant
unobservable
inputs
(Level 3)
Cash equivalents
$
69,389

 
$
68,389

 
$
1,000

 
$

 
 
 
 
 
 
 
 
Marketable securities
 
 
 
 
 
 
 
U.S. government agency notes
$
53,668

 
$

 
$
53,668

 
$

Foreign government notes
2,001

 

 
2,001

 

Corporate debt securities
84,076

 

 
84,076

 

Commercial paper
7,497

 

 
7,497

 

Certificates of deposit
14,663

 

 
14,663

 

 
$
161,905

 
$

 
$
161,905

 
$

Investments
 
 
 
 
 
 
 
U.S. government agency notes
$
19,378

 
$

 
$
19,378

 
$

Corporate debt securities
10,320

 

 
10,320

 

 
$
29,698

 
$

 
$
29,698

 
$



The Company's marketable securities and investments have been valued on the basis of valuations provided by third-party pricing services, as derived from such services' pricing models. Inputs to the models may include, but are not limited to, reported trades, executable bid and asked prices, broker/dealer quotations, prices or yields of securities with similar characteristics, benchmark curves or information pertaining to the issuer, as well as industry and economic events. The pricing

14


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

services may use a matrix approach, which considers information regarding securities with similar characteristics to determine the valuation for a security. The Company is ultimately responsible for the condensed consolidated financial statements and underlying estimates. Accordingly, the Company assesses the reasonableness of the valuations provided by the third-party pricing services by reviewing actual trade data, broker/dealer quotes and other similar data, which are obtained from quoted market prices or other sources.


(5) INVENTORY

Inventory consists of the following (in thousands):
 
September 27,
2013
 
December 31,
2012
On-hand final assemblies and finished goods inventories
$
18,895

 
$
22,009

Deferred cost of goods sold
5,420

 
5,704

 
24,315

 
27,713

Less current portion
(22,058
)
 
(25,614
)
Noncurrent portion (included in Other assets)
$
2,257

 
$
2,099


(6) INTANGIBLE ASSETS AND GOODWILL

The Company's intangible assets at September 27, 2013 and December 31, 2012 consist of the following (dollars in thousands):
September 27, 2013
Weighted average amortization period
(years)
 
Cost
 
Accumulated
amortization
 
Net
carrying value
Intellectual property
5.00
 
$
999

 
$
999

 
$

Developed technology
5.03
 
9,080

 
2,229

 
6,851

Customer relationships
5.30
 
6,140

 
2,280

 
3,860

Order backlog
0.33
 
860

 
860

 

Internal use software
3.00
 
730

 
264

 
466

 
4.35
 
$
17,809

 
$
6,632

 
$
11,177



December 31, 2012
Weighted average amortization period
(years)
 
Cost
 
Accumulated
amortization
 
Net
carrying value
Intellectual property
5.00
 
$
2,999

 
$
2,199

 
$
800

Developed technology
5.03
 
9,080

 
730

 
8,350

Customer relationships
5.30
 
6,140

 
702

 
5,438

Order backlog
0.33
 
860

 
860

 

Internal use software
3.00
 
730

 
81

 
649

 
4.35
 
$
19,809

 
$
4,572

 
$
15,237



Amortization expense for intangible assets for the three and nine months ended September 27, 2013 and September 28, 2012 was as follows (in thousands):

15


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

 
Three months ended
 
Nine months ended
 
Statement of operations classification
 
September 27, 2013
 
September 28, 2012
 
September 27, 2013
 
September 28, 2012
 
Intellectual property
$

 
$
100

 
$
200

 
$
300

 
Research and development
Developed technology
500

 
183

 
1,499

 
183

 
Cost of revenue - product
Customer relationships
526

 
175

 
1,578

 
175

 
Sales and marketing
Order backlog

 
216

 

 
216

 
Cost of revenue - product
Internal use software
61

 
30

 
183

 
30

 
Cost of revenue - product
 
$
1,087

 
$
704

 
$
3,460

 
$
904

 
 


In connection with the preparation of its financial statements for the second quarter of fiscal 2013, the Company reviewed its intangible assets and other long-lived assets for impairment indicators. The Company determined that a triggering event had occurred relative to one of its intellectual property intangible assets that had been acquired during fiscal 2010. During the three months ended June 28, 2013, the Company discontinued its development of this technology and determined that there were no alternative uses of the technology within either its existing or future product lines. Additionally, based on the age and resulting obsolescence of such technology, the Company concluded that the fair value was nominal based on a discounted cash flow model. As a result, the Company recorded an impairment charge of $0.6 million in the three months ended June 28, 2013 to write down the carrying value of the asset to zero. This expense is included as a component of research and development expense in the Company's condensed consolidated statements of operations for the nine months ended September 27, 2013. The nonrecurring fair value measurement of the impairment of the intellectual property was categorized in Level 3 of the fair value hierarchy.

Estimated future amortization expense for the Company's intangible assets at September 27, 2013 is as follows (in thousands):

Years ending December 31,
 
Remainder of 2013
$
1,087

2014
3,235

2015
2,367

2016
1,933

2017
1,900

Thereafter
655

 
$
11,177



Goodwill is recorded when the consideration for an acquisition exceeds the fair value of net tangible and identifiable intangible assets acquired. Other than the purchase price adjustments discussed in Note 2 and retrospectively recorded as of December 31, 2012, there were no changes to the carrying value of the Company's goodwill in the three or nine months ended September 27, 2013.

The changes in the carrying value of the Company's goodwill in the nine months ended September 28, 2012 were as follows (in thousands):


16


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

Balance at January 1, 2012:
 
  Goodwill
$
8,168

  Accumulated impairment losses
(3,106
)
 
5,062

Acquisition of NET
27,199

Balance at September 28, 2012
$
32,261



(7) ACCRUED EXPENSES
Accrued expenses consist of the following (in thousands):
 
September 27,
2013
 
December 31,
2012
Employee compensation and related costs
$
16,640

 
$
15,799

Other
9,327

 
10,413

 
$
25,967

 
$
26,212



(8) RESTRUCTURING ACCRUAL

On August 7, 2012, the Company announced that it had committed to a restructuring initiative to streamline operations and reduce operating costs by closing and consolidating certain facilities and reducing its worldwide workforce. In connection with this initiative, the Company recorded $4.8 million of restructuring expense in the nine months ended September 27, 2013, comprised of $4.5 million for severance and related costs in connection with reducing the Company's workforce and $0.3 million related to facilities. Of this amount, the Company recorded $1.2 million in the three months ended September 27, 2013 for severance and related costs; $1.7 million in the three months ended June 28, 2013, comprised of $1.4 million for severance and related costs and $0.3 million for facility costs; and $1.9 million in the three months ended March 29, 2013, primarily for severance and related costs. The Company had recorded $7.7 million of restructuring expense in the year ended December 31, 2012, of which $5.2 million remained accrued at December 31, 2012.

The table below summarizes the restructuring accrual activity for the nine months ended September 27, 2013 (in thousands):
 
Balance at
January 1,
2013
 
Initiatives
charged to
expense
 
Cash
payments
 
Balance at
September 27,
2013
Severance
$
1,135

 
$
4,478

 
$
(3,435
)
 
$
2,178

Facilities
4,100

 
309

 
(1,102
)
 
3,307

 
$
5,235

 
$
4,787

 
$
(4,537
)
 
$
5,485



The Company expects to complete the restructuring payments related to severance in the fourth quarter of fiscal 2014 and the payments related to facilities in fiscal 2016. The portion of restructuring payments due more than one year from the balance sheet date is included in Other long-term liabilities in the Company's condensed consolidated balance sheets. The long-term portions of accrued restructuring were $2.1 million at September 27, 2013 and $2.7 million at December 31, 2012. The Company expects to record restructuring expense of approximately $2 million in the fourth quarter of fiscal 2013.



17


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

(9) DEBT

The Company has determined that the estimated fair value of its $2.4 million of aggregate principal amount of outstanding debt due in 2014 equaled its carrying value at both September 27, 2013 and December 31, 2012. Although the debt can be publicly traded, there have been no trading transactions since 2010 and accordingly, the Company has categorized it in Level 2 within the fair value hierarchy.


(10) STOCKHOLDER RIGHTS PLAN

On June 21, 2013, the Company entered into an amendment to its stockholder rights agreement, as amended (the "Rights Plan"), to extend the expiration date of the rights in such Rights Plan from June 26, 2013 to June 26, 2015. The amendment was not in response to any acquisition proposal and no other amendments were made to the Rights Plan. The Rights Plan was originally adopted on June 26, 2008 and subsequently extended to June 26, 2013 on June 10, 2011.

Under the Rights Plan, preferred stock purchase rights (the "Rights") were distributed as a dividend at the rate of one Right per share of common stock held by stockholders of record as of the close of business on July 7, 2008. Each Right entitles the stockholder to purchase from the Company a unit consisting of one one-thousandth of a share (a "Unit") of preferred stock at a purchase price of $25.00, subject to adjustment.

The Rights generally will be exercisable only if a person or group acquires beneficial ownership of 15% or more of the Company's common stock (which includes for this purpose shares of common stock referenced in derivative transactions or securities), or commences or publicly announces a tender or exchange offer upon consummation of which they would beneficially own 15% or more of the Company's common stock. Subject to certain conditions, a person or group who beneficially owned 15% or more of the outstanding shares of the Company's common stock prior to the adoption of the Rights Plan did not cause the Rights to become exercisable upon adoption of the Rights Plan. Should the Rights become exercisable, the effect would be to dilute the ownership of the beneficial owner(s) who triggered the Rights, as that beneficial owner or group of owners would not receive the Units.

(11) COMMON STOCK REPURCHASES

On July 29, 2013, the Company announced that its Board of Directors had authorized a stock buyback program to repurchase up to $100 million of the Company's common stock from time to time on the open market or in privately negotiated transactions. The timing and amount of any shares repurchased will be determined by the Company's management based on its evaluation of market conditions and other factors. The Company may elect to implement a 10b5-1 repurchase program, which would permit shares to be repurchased when the Company might otherwise be precluded from doing so under insider trading laws. The buyback program may be suspended or discontinued at any time. The buyback program is being funded using the Company's working capital.

During both the three and nine months ended September 27, 2013, the Company spent $37.3 million, including transaction fees, to repurchase and retire 10.8 million shares of its common stock under the buyback program.


(12) STOCK-BASED COMPENSATION PLANS

The Company's 2007 Stock Incentive Plan, as amended, (the "2007 Plan"), provides for the award of options to purchase the Company's common stock ("stock options"), stock appreciation rights ("SARs"), restricted common stock ("restricted stock"), performance-based awards, restricted stock units ("RSUs") and other stock-based awards to employees, officers, directors (including those directors who are not employees or officers of the Company), consultants and advisors of the Company and its subsidiaries. At its June 12, 2013 annual meeting of stockholders, the Company's stockholders approved an amendment to the 2007 Plan, which increased the number of shares available for future grant by 21 million shares.

The Company's 2008 Stock Incentive Plan provides for the award of stock options, SARs, restricted stock, performance-based awards and RSUs to former employees of NET who subsequently became employees of Sonus and Sonus employees hired subsequent to the NET Acquisition Date.


18


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

In March 2013, 21 executives of the Company, including Raymond P. Dolan, the Company's President and Chief Executive Officer ("Mr. Dolan"), elected to receive bonuses with respect to fiscal 2013 (collectively, the "2013 Bonus"), if any are earned, in the form of shares of the Company's common stock (collectively, the "2013 Bonus Shares"). The 2013 Bonus Shares, if any are granted, will be granted on a date concurrent with the timing of normal 2013 bonus payouts and will be fully vested as of the date of grant, with the number of 2013 Bonus Shares calculated by dividing amounts equal to 1.5 times the respective 2013 Bonus amounts earned, as determined by the Compensation Committee of the Company's Board of Directors (the "Compensation Committee") by the closing price of the Company's common stock on the date of grant. The Company is recording stock-based compensation expense for the 2013 Bonus Shares commensurate with the expected achievement level represented by the Company's accrual for its company-wide cash bonus program, as the performance metrics for each are consistent. Because no shares have been granted in connection with the 2013 Bonus, there are no shares related to the 2013 Bonus reported in the restricted stock grant table below.

On February 15, 2013, Mr. Dolan elected to accept restricted shares of the Company's common stock in lieu of his base salary for the period from January 1, 2013 through December 31, 2013. Mr. Dolan had previously not received any salary payments from the Company for this period. On February 15, 2013, the Company granted Mr. Dolan 183,824 shares of restricted common stock (the "Salary Shares") having a total grant date fair value of $500,000, equal to Mr. Dolan's base salary for the year ending December 31, 2013. The number of shares was calculated by dividing Mr. Dolan's base salary for the year by $2.72, the closing price of the Company's common stock on the date of grant. The Salary Shares will vest on December 31, 2013. If Mr. Dolan's employment is terminated by Mr. Dolan with Good Reason (as defined in his employment agreement, as amended) or his employment is terminated by the Company without Cause (as defined in his employment agreement, as amended) before December 31, 2013, a pro rata portion of the Salary Shares will vest on the date of such termination. If Mr. Dolan terminates his employment without Good Reason or his employment is terminated by the Company for Cause before December 31, 2013, he will forfeit the Salary Shares. The Company is recording stock-based compensation expense related to the Salary Shares ratably for the period of January 1, 2013 through December 31, 2013. The Salary Shares are included in the amount reported as "Granted" in the restricted stock grant table below.

On February 14, 2013, the Compensation Committee determined that eight executives of the Company, excluding Mr. Dolan, would receive their bonuses with respect to fiscal 2012 in the form of restricted shares of the Company's common stock equal to 100% of their respective target bonus amounts for fiscal 2012 (collectively, the "Executive Bonus Shares"). The number of shares granted to each executive was calculated by dividing his/her target bonus amount by the closing price of the Company's common stock on February 15, 2013, the date of grant. The Executive Bonus Shares vested 50% on August 15, 2013 and the remaining 50% will vest on February 15, 2014, contingent upon each such executive's continued employment with the Company on the last vesting date. The Company had accrued for the cash payment of bonuses at the expected company-wide cash payout percentage amount at December 31, 2012, which amounts were less than the target bonus amounts for each individual. The Company is recording the unamortized expense related to the Executive Bonus Shares as stock-based compensation expense through February 15, 2014. These shares are reported as "Granted" in the restricted stock grant table below.

On August 7, 2012, Mr. Dolan elected to receive his fiscal year 2012 bonus, if earned, in the form of restricted shares of the Company's common stock (the “Dolan Bonus Shares”). On August 10, 2012, the Company granted Mr. Dolan 421,348 Dolan Bonus Shares, which equaled Mr. Dolan's potential 2012 bonus at the maximum level of achievement (150% of Mr. Dolan's annual base salary), divided by $1.78, the closing price of the Company's common stock on the date of grant. During fiscal 2012, the Company recorded stock-based compensation expense for the Dolan Bonus Shares commensurate with the expected achievement level represented by the Company's accrual for its company-wide cash bonus program, as the performance metrics for each were consistent. The Dolan Bonus Shares represented the performance-based stock award shares reported as “Unvested balance at January 1, 2013” in the performance-based stock awards table below. On February 14, 2013, the Compensation Committee determined that Mr. Dolan had earned 280,899 Dolan Bonus Shares, of which 50% vested on August 15, 2013 and the remaining 50% will vest on February 15, 2014, subject to Mr. Dolan's continued employment with the Company on the last vesting date. The Company is recording the unamortized expense related to the Dolan Bonus Shares, including incremental expense arising from the modification of this award, through February 15, 2014. Mr. Dolan forfeited the remaining 140,449 Dolan Bonus Shares on February 14, 2013, and these shares are reported as "Forfeited" in the performance-based stock awards table below.

Certain members of the Company's Board of Directors elected to receive their annual cash retainer in shares of the

19


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

Company's common stock in lieu of cash payments. Accordingly, the Company granted approximately 73,000 shares in the aggregate under the 2007 Plan to such members of the Board of Directors, of which approximately 40,000 shares were granted on February 15, 2013 and approximately 33,000 shares were granted on June 17, 2013. All such shares vested immediately. The shares are reported as both "Granted" and "Vested" in the restricted stock grants table below.

Stock Options

The activity related to the Company's outstanding stock options during the nine months ended September 27, 2013 is as follows:
 
Number of
Shares
 
Weighted
Average
Exercise Price
 
Weighted
Average
Remaining
Contractual Term
(years)
 
Aggregate
Intrinsic Value
(in thousands)
Outstanding at January 1, 2013
25,116,398

 
$
3.46

 
 
 
 
Granted
13,043,856

 
$
2.92

 
 
 
 
Exercised
(1,166,397
)
 
$
2.01

 
 
 
 
Forfeited
(1,398,660
)
 
$
2.62

 
 
 
 
Expired
(2,312,336
)
 
$
4.78

 
 
 
 
Outstanding at September 27, 2013
33,282,861

 
$
3.25

 
7.21
 
$
16,860

Vested or expected to vest at September 27, 2013
30,487,280

 
$
3.29

 
7.02
 
$
15,294

Exercisable at September 27, 2013
14,228,903

 
$
3.85

 
4.76
 
$
5,694



The grant date fair values of options to purchase common stock granted in the three and nine months ended September 27, 2013 were estimated using the Black-Scholes valuation model with the following assumptions:
 
Three months ended
 
Nine months ended
 
September 27,
2013
 
September 27,
2013
Risk-free interest rate
1.51% - 1.71%
 
0.82% - 1.71%
Expected dividends
 
Weighted average volatility
57.6%
 
63.2%
Expected life (years)
4.5
 
4.5 - 6.0


Additional information regarding the Company's stock options for the three and nine months ended September 27, 2013 is as follows:
 
Three months ended
 
Nine months ended
 
September 27,
2013
 
September 27,
2013
Weighted average grant date fair value of stock options granted
$
1.58

 
$
1.49

Total intrinsic value of stock options exercised (in thousands)
$
398

 
$
1,185

Cash received from the exercise of stock options (in thousands)
$
1,056

 
$
2,393



20


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

Restricted Stock Grants - Restricted Stock Awards and Restricted Stock Units

The Company's outstanding restricted stock grants consist of both restricted stock awards and RSUs. The activity related to the Company's unvested restricted stock grants for the nine months ended September 27, 2013 is as follows:
 
Shares
 
Weighted
Average
Grant Date
Fair Value
Unvested balance at January 1, 2013
617,203

 
$
2.45

Granted
1,334,086

 
$
2.82

Vested
(634,514
)
 
$
2.56

Forfeited
(54,039
)
 
$
2.66

Unvested balance at September 27, 2013
1,262,736

 
$
2.77



The total fair value of restricted stock grant shares that vested during the nine months ended September 27, 2013 was $1.6 million.

Performance-Based Stock Awards

The activity related to the Company's performance-based stock awards for the nine months ended September 27, 2013 is as follows:
 
Shares
 
Weighted
Average
Grant Date
Fair Value
Unvested balance at January 1, 2013
421,348

 
$
1.78

Granted
1,984,500

 
$
2.72

Vested
(954,292
)
 
$
2.58

Forfeited
(140,449
)
 
$
1.78

Unvested balance at September 27, 2013
1,311,107

 
$
2.62



On February 14, 2013, the Compensation Committee took certain actions regarding performance-based stock awards that had been awarded in previous years but for which the grant date criteria had not been met as of December 31, 2012. These actions included determining that a certain number of these performance-based shares would vest as of February 15, 2013 (the “Vested Performance Shares”) and subjecting the remaining performance-based shares (the “Future Performance Shares”) to further performance and service conditions. Accordingly, as of February 15, 2013 the grant date criteria were met for both the Vested Performance Shares and the Future Performance Shares and they are reported as "Granted" in the table above. The performance conditions relate to either a portion of or the full fiscal 2013 year and the service conditions were implemented through vesting schedules individually assigned to each Future Performance Share award that provide for service-based vesting through fiscal 2015. On July 26, 2013, the Compensation Committee determined that the performance conditions related to the Future Performance Shares had been satisfied based on the Company's performance for the six months ended June 28, 2013 and accordingly, all of the Future Performance Shares will vest contingent upon continued employment with the Company on the vesting dates. The Company had previously estimated that the conditions related to the Future Performance Shares would be satisfied by June 28, 2013 and had recorded expense in the first and second quarters of 2013 based on that estimate. The Company is recording the unamortized expense related to the Future Performance Shares based on the vesting dates of the respective awards.

21


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

Stock-Based Compensation

The condensed consolidated statements of operations include stock-based compensation for the three and nine months ended September 27, 2013 and September 28, 2012 as follows (in thousands):
 
Three months ended
 
Nine months ended
 
September 27, 2013
 
September 28, 2012
 
September 27, 2013
 
September 28, 2012
Product cost of revenue
$
46

 
$
41

 
$
128

 
$
130

Service cost of revenue
299

 
211

 
761

 
595

Research and development
903

 
524

 
2,402

 
1,773

Sales and marketing
1,313

 
500

 
3,631

 
1,458

General and administrative
1,812

 
1,124

 
6,215

 
2,584

 
$
4,373

 
$
2,400

 
$
13,137

 
$
6,540


There is no income tax benefit for employee stock-based compensation expense for the three and nine months ended September 27, 2013 or September 28, 2012 due to the valuation allowance recorded.

At September 27, 2013, there was $26.7 million, net of expected forfeitures, of unrecognized stock-based compensation expense related to unvested stock options and restricted stock awards. This expense is expected to be recognized over a weighted average period of approximately three years.

(13) MAJOR CUSTOMERS
The following customers each contributed 10% or more of the Company's revenue in at least one of the three or nine month periods ended September 27, 2013 and September 28, 2012:
 
Three months ended
 
Nine months ended
 
 
September 27,
2013
 
September 28,
2012
 
September 27,
2013
 
September 28,
2012
 
AT&T Inc.
18%
 
*
 
17%
 
24%
 
Level 3 Communications
*
 
12%
 
*
 
*
 
__________________________________
* Represents less than 10% of revenue

At September 27, 2013, one customer accounted for 10% or more of the Company's accounts receivable balance, representing approximately 21% of the Company's accounts receivable balance. At December 31, 2012, one customer accounted for 10% or more of the Company's accounts receivable balance, representing approximately 25% of the Company's accounts receivable balance. The Company performs ongoing credit evaluations of its customers and generally does not require collateral on accounts receivable. The Company maintains an allowance for doubtful accounts and such losses have been within management's expectations.



22


SONUS NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements (Continued)
(unaudited)

(14) GEOGRAPHIC INFORMATION

The Company's classification of revenue by geographic area is determined by the location to which the product is shipped or where the services are performed. The following table summarizes revenue by geographic area as a percentage of total revenue:
 
Three months ended
 
Nine months ended
 
 
September 27,
2013
 
September 28,
2012
 
September 27,
2013
 
September 28,
2012
 
United States
66
%
 
76
%
 
70
%
 
75
%
 
Europe, Middle East and Africa
15

 
13

 
12

 
10

 
Japan
8

 
                 *
 
11

 
9

 
Other Asia Pacific
7

 
10

 
5

 
5

 
Other
4

 
1

 
2

 
1

 
 
100
%
 
100
%
 
100
%
 
100
%
 

* Represents less than 1% of revenue

International revenue, both as a percentage of total revenue and absolute dollars, may vary from one period to the next, and accordingly, historical data may not be indicative of future periods.

(15) INCOME TAXES

The Company's income tax provisions for the nine months ended September 27, 2013 and September 28, 2012 reflect the Company's estimates of the effective rates expected to be applicable for the respective full years, adjusted for any discrete events, which are recorded in the period that they occur. These estimates are reevaluated each quarter based on the Company's estimated tax expense for the full year. The estimated effective rates for the nine months ended September 27, 2013 and September 28, 2012 do not include any benefit for the Company's domestic losses, as the Company has concluded that a valuation allowance on any domestic benefit is required.

In September 2013, the U.S. Department of the Treasury and the Internal Revenue Service released final regulations relating to guidance on applying tax rules to amounts paid to acquire, produce or improve tangible personal property as well as rules for materials and supplies. The Company is currently assessing these rules and the impact they will have on its consolidated financial statements, if any.

(16) COMMITMENTS AND CONTINGENCIES

The Company is often a party to disputes and legal proceedings that it considers routine and incidental to its business. In the normal course of business, the Company enters into contractual commitments to purchase services, materials, components, and finished goods from suppliers. Under agreements with certain contract manufacturers, the Company may be liable for purchased raw materials procured for the Company by the applicable contract manufacturer. Management does not expect the results of any of these actions to have a material effect on the Company's business or consolidated financial statements.

(17) SUBSEQUENT EVENTS

On October 24, 2013, Mark T. Greenquist accepted an offer of employment as Chief Financial Officer of the Company, effective November 1, 2013.

On October 29, 2013, Maurice L. Castonguay resigned as Senior Vice President and Chief Financial Officer, effective November 1, 2013.

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


The following discussion of the financial condition and results of operations of Sonus Networks, Inc. should be read in

23


conjunction with the condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and the audited financial statements and notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2012, which was filed with the U.S. Securities and Exchange Commission on March 6, 2013.

Overview

We are a leading provider of networked solutions for communications service providers (e.g., telecommunications, wireless and cable service providers) and enterprises to help them advance, protect and unify their communications and improve collaboration. Our products include session border controllers, Session Initiation Protocol ("SIP") session management servers, Voice over IP ("VoIP") switches, SIP application servers, multiprotocol signaling gateways and network analytics tools. Our solutions address the need for communications service providers and enterprises to seamlessly link and leverage multivendor, multiprotocol communications systems and applications across their networks, around the world and in a rapidly changing ecosystem of IP-enabled devices such as smartphones and tablets.

Currently, we sell our products principally through a direct sales force into the service provider market in the United States, Europe, Asia-Pacific and the Middle East and through indirect channel partners for the enterprise market. We continue to expand our presence into new geographies and markets through our relationships with regional channel partners. In May 2012, we implemented our indirect sales channel program, which is focused primarily on enterprise customers, to capture a larger percentage of the Session Border Controller (“SBC”) and Unified Communications markets into the enterprise market.

Our target customers are comprised of both communications service providers and enterprises. Customers and prospective customers in the service provider space are traditional and emerging communications service providers, including long distance carriers, local exchange carriers, Internet service providers, wireless operators, cable operators, international telephone companies and carriers that provide services to other carriers. Enterprise customers and target enterprise customers include financial institutions, retailers, state and local governments and other multinational corporations. We collaborate with our customers to identify and develop new, advanced services and applications that can help to reduce costs, improve productivity and generate new revenue.

We continue to focus on the key elements of our strategy, which is designed to capitalize on our technology and market lead, and build a premier franchise in multimedia infrastructure solutions. We are currently focusing our major efforts on the following aspects of our business:

expanding our solutions to address emerging Unified Communication and IP-based markets, such as SBC, in the enterprise and service provider markets;
embracing the principles outlined by 3GPP, 4GPP2 and LTE architectures and delivering the industry's most advanced IMS (IP Multimedia Subsystem)-ready SBC product suite;
leveraging our TDM (time division multiplexing)-to-IP gateway technology leadership with service providers to accelerate adoption of SIP-enabled Unified Communication services;
expanding and broadening our customer base by targeting the enterprise for SIP and VoIP access solutions;
expanding our global sales distribution, marketing and support capabilities;
actively contributing to the SIP standards definition and adoption process; and
pursuing strategic go to market partnerships and alliances.

On August 24, 2012, we completed the acquisition of Network Equipment Technologies, Inc. (“NET”), a Delaware corporation. The financial results of NET are included in our financial results for the three and nine months ended September 27, 2013 and in the three and nine months ended September 28, 2012 subsequent to August 24, 2012.

We reported losses from operations of $2.9 million for the three months ended September 27, 2013 and $14.8 million for the three months ended September 28, 2012. We reported losses from operations of $21.0 million for the nine months ended September 27, 2013 and $32.8 million for the nine months ended September 28, 2012.

We reported net losses of $3.8 million for the three months ended September 27, 2013 and $15.6 million for the three months ended September 28, 2012. We reported net losses of $22.4 million for the nine months ended September 27, 2013 and $33.8 million for the nine months ended September 28, 2012.

Our revenue was $68.1 million in the three months ended September 27, 2013 and $57.0 million in the three months ended September 28, 2012. Our revenue was $200.6 million in the nine months ended September 27, 2013 and $179.0 million in the nine months ended September 28, 2012.

24



Our gross profit was $42.3 million in the three months ended September 27, 2013, $32.4 million in the three months ended September 28, 2012, $124.1 million in the nine months ended September 27, 2013 and $107.0 million in the nine months ended September 28, 2012. Our gross profit as a percentage of revenue ("total gross margin") was 62.1% in the three months ended September 27, 2013, 56.9% in the three months ended September 28, 2012, 61.9% in the nine months ended September 27, 2013 and 59.8% in the nine months ended September 28, 2012.

Our operating expenses were $45.2 million in the three months ended September 27, 2013, compared to $47.2 million in the three months ended September 28, 2012. Our operating expenses were $145.1 million in the nine months ended September 27, 2013, compared to $139.8 million in the nine months ended September 28, 2012. Our operating expenses in the current year periods include restructuring expense of $1.2 million in the three months ended September 27, 2013 and $4.8 million in the nine months ended September 27, 2013. Our operating expenses in both the three and nine months ended September 28, 2012 include $2.0 million of restructuring expenses. Our operating expenses include acquisition-related expenses of $4.1 million in the three months ended September 28, 2012 and $5.1 million in the nine months ended September 28, 2012.

We recorded stock-based compensation expense of $4.4 million in the three months ended September 27, 2013 and $2.4 million in the three months ended September 28, 2012. We recorded stock-based compensation expense of $13.1 million in the nine months ended September 27, 2013 and $6.5 million in the nine months ended September 28, 2012. The stock-based compensation actions described below increased stock-based compensation expense while reducing cash salary and bonus expenses in the three and nine months ended September 27, 2013, and we expect a similar effect throughout the remainder of fiscal 2013.

Lower portfolio yield on our investments, coupled with lower amounts invested in cash equivalents and marketable securities, resulted in lower interest income, which was also a factor in our current year three and nine month period losses, as was higher interest expense related to the subordinated notes assumed in connection with the NET acquisition.

See "Results of Operations" in this Management's Discussion and Analysis of Financial Condition and Results of Operations for a discussion of these changes in our revenue and expenses.

On October 24, 2013, Mark T. Greenquist accepted an offer of employment as Chief Financial Officer of the Company, effective November 1, 2013.

On October 9, 2013, we announced the Sonus SBC SWe, the industry's first software-based SBC that delivers unlimited scalability with the same advanced features and functionality found on our Sonus SBC 500 series on a virtualized platform. The Sonus SBC SWe addresses service providers' requirements for network functions virtualization and software-defined networking-enabled SBC technology to scale cloud-based delivery platforms. We believe that the SBC SWe will allow our customers to move seamlessly between hardware and software solutions with assurance that their existing communications and network investments are fully protected.

On September 4, 2013, we announced that Pamela D.A. Reeve had been appointed to our Board of Directors, expanding our Board to nine directors.

In August 2012, we announced that we were implementing a restructuring initiative to streamline operations and reduce our operating costs. In connection with this restructuring plan, we recorded $1.2 million of expense in the three months ended September 27, 2013 for severance and related costs and $4.8 million of expense in the nine months ended September 27, 2013, comprised of $4.5 million for severance and related costs and $0.3 million related to facilities.

On July 29, 2013, we announced that Maurice L. Castonguay, our Senior Vice President and Chief Financial Officer ("Mr. Castonguay"), plans to leave the Company. To facilitate an orderly transition of his duties and responsibilities, Mr. Castonguay and the Company entered into a letter agreement on July 26, 2013 under which Mr. Castonguay agreed to remain with the Company through March 31, 2014. Under the July 26, 2013 letter agreement, Mr. Castonguay agreed to continue to perform the duties and responsibilities of his current roles as Senior Vice President, Chief Financial Officer, Treasurer and Principal Accounting Officer of the Company until the earlier of (i) the time that his successor is hired, at which time Mr. Castonguay agreed to relinquish his current positions and provide transition services at the Company's request in the role of Senior Consultant - Finance through March 31, 2014 and (ii) March 31, 2014. On October 29, 2013, Maurice L. Castonguay resigned as Senior Vice President and Chief Financial Officer, effective November 1, 2013.

On July 29, 2013, we announced that Matthew Dillon would step down as Senior Vice President, Global Services and Systems Management, effective August 15, 2013.

25



In March 2013, 21 of our executives including Raymond P. Dolan, our President and Chief Executive Officer ("Mr. Dolan") elected to receive bonuses with respect to fiscal 2013 (collectively, the "2013 Bonus"), if any are earned, in the form of shares of our common stock (collectively, the "2013 Bonus Shares"). The 2013 Bonus Shares, if any are granted, will be granted on a date concurrent with the timing of normal 2013 bonus payouts and will be fully vested as of the date of grant, with the number of 2013 Bonus Shares calculated by dividing amounts equal to 1.5 times the respective 2013 Bonus amounts earned, as determined by the Compensation Committee of our Board of Directors (the "Compensation Committee") by the closing price of our common stock on the date of grant. We are recording stock-based compensation expense for the 2013 Bonus Shares commensurate with the expected achievement level represented by the accrual for our company-wide cash bonus program, as the performance metrics for each are consistent.

On February 15, 2013, Mr. Dolan elected to accept restricted shares of our common stock in lieu of his base salary for the period from January 1, 2013 through December 31, 2013. Mr. Dolan had previously not received any salary payments from us for this period. On February 15, 2013, we granted Mr. Dolan 183,824 shares of restricted common stock (the "Salary Shares") having a total grant date fair of $500,000, equal to Mr. Dolan's base salary for the year ending December 31, 2013. The number of shares was calculated by dividing Mr. Dolan's base salary for the year by $2.72, the closing price of our common stock on the date of grant. The Salary Shares will vest on December 31, 2013. If Mr. Dolan's employment is terminated by Mr. Dolan with Good Reason (as defined in his employment agreement, as amended) or by us without Cause (as defined in his employment agreement, as amended) before December 31, 2013, a pro rata portion of the Salary Shares will vest on the date of such termination. If Mr. Dolan terminates his employment without Good Reason or we terminate his employment for Cause before December 31, 2013, he will forfeit the Salary Shares. We are recording stock-based compensation expense related to the Salary Shares ratably for the period from January 1, 2013 through December 31, 2013.

On February 14, 2013, the Compensation Committee determined that eight of our executives, excluding Mr. Dolan, would receive their bonuses with respect to fiscal 2012 in the form of restricted shares of our common stock equal to 100% of their respective target bonus amounts for fiscal 2012 (collectively, the "Executive Bonus Shares"). The number of shares granted to each executive was calculated by dividing his/her target bonus amount by the closing price of our common stock on February 15, 2013, the date of grant. The Executive Bonus Shares vested 50% on August 15, 2013 and the remaining 50% will vest on February 15, 2014, contingent upon each such executive's continued employment with us on the final vesting date. We had accrued for the cash payment of bonuses at the expected company-wide cash payout percentage amount at December 31, 2012, which amounts were less than the target bonus amounts for each individual. We are recording the unamortized expense related to the Executive Bonus Shares as stock-based compensation expense through February 15, 2014.

On August 7, 2012, Mr. Dolan elected to receive his fiscal year 2012 bonus, if earned, in the form of restricted shares of our common stock (the “Dolan Bonus Shares”). On August 10, 2012, we granted Mr. Dolan 421,348 Dolan Bonus Shares, which equaled Mr. Dolan's potential 2012 bonus at the maximum level of achievement (150% of Mr. Dolan's annual base salary), divided by $1.78, the closing price of our common stock on the date of grant. During fiscal 2012, we recorded stock-based compensation expense for the Dolan Bonus Shares commensurate with the expected achievement level represented by the accrual for our company-wide cash bonus program, as the performance metrics for each were consistent. On February 14, 2013, the Compensation Committee determined that Mr. Dolan had earned 280,899 Dolan Bonus Shares, of which 50% vested on August 15, 2013 and the remaining 50% will vest on February 15, 2014, subject to Mr. Dolan's continued employment with us on the final vesting date. Mr. Dolan forfeited the remaining 140,449 Dolan Bonus Shares on February 14, 2013. We are recording the unamortized expense related to the Dolan Bonus Shares, including incremental expense arising from the modification of this award, through February 15, 2014.

Certain members of our Board of Directors elected to receive their annual cash retainer in shares of our common stock in lieu of cash payments. Accordingly, we granted approximately 73,000 shares in the aggregate under the 2007 Plan, with a total grant date fair value approximating $220,000, to such members of the Board of Directors, of which approximately 40,000 shares were granted on February 15, 2013 and approximately 33,000 shares were granted on June 17, 2013. All such shares vested immediately.

Critical Accounting Policies and Estimates

Management's discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. We consider the following accounting policies to be both

26


those most important to the portrayal of our financial condition and those that require the most subjective judgment. If actual results differ significantly from management's estimates and projections, there could be a material effect on our condensed consolidated financial statements. The significant accounting policies that we believe are the most critical include the following:

Revenue recognition;
Valuation of inventory;
Loss contingencies and reserves;
Stock-based compensation;
Business combinations;
Goodwill and intangible assets; and
Accounting for income taxes.

For a further discussion of our critical accounting policies and estimates, please refer to our Annual Report on Form 10-K for the fiscal year ended December 31, 2012. There were no significant changes to our critical accounting policies from December 31, 2012 through September 27, 2013.

Results of Operations

Three and nine months ended September 27, 2013 and September 28, 2012

Revenue. Revenue for the three and nine months ended September 27, 2013 and September 28, 2012 was as follows (in thousands, except percentages):

 
Three months ended
 
Increase
from prior year
 
September 27,
2013
 
September 28,
2012
 
$
 
%
Product
$
40,712

 
$
33,520

 
$
7,192

 
21.5
%
Service
27,387

 
23,529

 
3,858

 
16.4
%
Total revenue
$
68,099

 
$
57,049

 
$
11,050

 
19.4
%


 
Nine months ended
 
Increase
from prior year
 
September 27,
2013
 
September 28,
2012
 
$
 
%
Product
$
121,447

 
$
107,517

 
$
13,930

 
13.0
%
Service
79,133

 
71,481

 
7,652

 
10.7
%
Total revenue
$
200,580

 
$
178,998

 
$
21,582

 
12.1
%


Product revenue is comprised of sales of our communication infrastructure products. The products typically incorporated into our trunking and communication application solutions include our GSX9000 and GSX4000 Open Services Switches and our ASX Voice Application Server. The products typically incorporated into our SBC solutions include our SBC 9000 (formerly the NBS 9000), SBC 5200 (formerly the NBS 5200) and our SBC 5100, SBC 5110 and SBC 5210 Session Border Controllers. On October 9, 2013, we announced the Sonus SBC SWe, the industry's first software-based SBC that delivers unlimited scalability with the same advanced features and functionality found on our Sonus SBC 5000 series on a virtualized platform.

Additionally, in connection with our acquisition of NET, we began selling the SBC 1000 (formerly the NET UX 1000), the SBC 2000 (formerly the NET UX 2000) and the SBC VX, a hybrid solution (formerly the NET VX). The SBC 1000 provides SBC SIP communication capability to the enterprise branch and small and medium businesses, while the SBC 2000 provides SBC SIP communication capability to the enterprise branch and medium to large businesses. The SBC VX is a hybrid solution sold to small, medium and large enterprises that require a hybrid solution. Certain of our products may be incorporated into either our trunking and communication applications or SBC solutions; these products include, but are not limited to, our PSX Policy & Routing Server, SGX Signaling Gateway, Sonus Insight Management System, ASX Access Gateway Control Function and our suite of network analytical products.

27



Product revenue for the three and nine months ended September 27, 2013 and September 28, 2012 was comprised of the following (in thousands, except percentages):
 
Three months ended
 
Increase (decrease)
from prior year
 
September 27,
2013
 
September 28,
2012
 
$
 
%
Trunking and communication applications
$
19,401

 
$
13,126

 
$
6,275

 
47.8
%
SBC
21,311

 
20,394

 
917

 
4.5
%
 
$
40,712

 
$
33,520

 
$
7,192

 
21.5
%


 
Nine months ended
 
Increase (decrease)
from prior year
 
September 27,
2013
 
September 28,
2012
 
$
 
%
Trunking and communication applications
$
56,177

 
$
60,449

 
$
(4,272
)
 
(7.1
)%
SBC
65,270

 
47,068

 
18,202

 
38.7
 %
 
$
121,447

 
$
107,517

 
$
13,930

 
13.0
 %


We recognized $6.4 million of product revenue in the aggregate from 171 new customers in the three months ended September 27, 2013 and $1.8 million of product revenue in the aggregate from 40 new customers in the three months ended September 28, 2012. We recognized $12.2 million of product revenue in the aggregate from 524 new customers in the nine months ended September 27, 2013 and $4.8 million of product revenue in the aggregate from 50 new customers in the nine months ended September 28, 2012. The increase in new customers in the three and nine months ended September 27, 2013 compared to the prior year periods is primarily attributable to customers who purchased products from the former NET product portfolio. The NET products generally have a lower purchase price compared to the larger-scale Sonus products and projects. New customers are those from whom we recognize revenue for the first time in a reporting period, although we may have had outstanding orders from such customers for several years, especially for certain multi-year projects. The timing of the completion of customer projects, revenue recognition criteria satisfaction and customer payments included in multiple element arrangements may cause our product revenue to fluctuate from one period to the next.

As we had anticipated as a result of the transition of our customers and our business to SBC, our revenue from sales of our trunking and communication application products decreased in the nine months ended September 27, 2013 compared to the nine months ended September 28, 2012. This decline was offset by the growth in sales of our SBC products in the current year period compared to the same prior year period. However, revenue from sales of our trunking and communication application products increased in the three months ended September 27, 2013 compared to the three months ended September 28, 2012, primarily attributable to multiple capacity and expansion orders from several customers in the current year quarter. We believe that in future quarters the decrease in sales from our trunking and communication application products will resume as previously anticipated. We expect that our product revenue in fiscal 2013 will increase from fiscal 2012 levels, primarily due to increased sales of our SBC products resulting from our continued and increasing focus on expanding our solutions to address emerging Unified Communication and IP-based markets, such as SBC, in the enterprise and service provider markets.

Service revenue is primarily comprised of hardware and software maintenance and support (“maintenance revenue”) and network design, installation and other professional services (“professional services revenue”).

Service revenue for the three and nine months ended September 27, 2013 and September 28, 2012 was comprised of the following (in thousands, except percentages):
 
Three months ended
 
Increase
from prior year
 
September 27,
2013
 
September 28,
2012
 
$
 
%
Maintenance
$
21,500

 
$
18,665

 
$
2,835

 
15.2
%
Professional services
5,887

 
4,864

 
1,023

 
21.0
%
 
$
27,387

 
$
23,529

 
$
3,858

 
16.4
%



28


 
Nine months ended
 
Increase
from prior year
 
September 27,
2013
 
September 28,
2012
 
$
 
%
Maintenance
$
63,191

 
$
55,994

 
$
7,197

 
12.9
%
Professional services
15,942

 
15,487

 
455

 
2.9
%
 
$
79,133

 
$
71,481

 
$
7,652

 
10.7
%


Our increased maintenance revenue in both current year periods compared to the prior year periods is primarily due to our larger installed customer base, which is partially a result of the acquisition of NET. The timing of the completion of projects for revenue recognition, customer payments and maintenance contracts may cause our services revenue to fluctuate from one period to the next. We expect that our service revenue in fiscal 2013 will increase from fiscal 2012 levels as a result of our larger installed customer base.

The following customers each contributed 10% or more of our revenue in at least one of the three or nine month periods ended September 27, 2013 and September 28, 2012:
 
Three months ended
 
Nine months ended
Customer
September 27,
2013
 
September 28,
2012
 
September 27,
2013
 
September 28,
2012
AT&T Inc.
18%
 
*
 
17%
 
24%
Level 3 Communications
*
 
12%
 
*
 
*

* Represents less than 10% of revenue

International revenue was approximately 34% of revenue in the three months ended September 27, 2013 and approximately 24% of revenue in the three months ended September 28, 2012. International revenue was approximately 30% of revenue in the nine months ended September 27, 2013 and approximately 25% of revenue in the nine months ended September 28, 2012. Due to the timing of project completions, we expect that the domestic and international components as a percentage of our revenue will fluctuate from quarter to quarter and year to year.

Our deferred product revenue was $12.0 million at September 27, 2013 and $6.7 million at December 31, 2012. Our deferred service revenue was $34.9 million at September 27, 2013 and $42.0 million at December 31, 2012. Our deferred revenue balance may fluctuate as a result of the timing of revenue recognition, customer payments, maintenance contract renewals, contractual billing rights and maintenance revenue deferrals included in multiple element arrangements.

Cost of Revenue/Gross Profit. Our cost of revenue consists primarily of amounts paid to third-party manufacturers for purchased materials and services, royalties, manufacturing and professional services personnel and related costs, and provision for inventory obsolescence. Our cost of revenue and gross margin for the three and nine months ended September 27, 2013 and September 28, 2012 were as follows (in thousands, except percentages):
 
Three months ended
 
Increase (decrease)
from prior year
 
September 27, 2013
 
September 28, 2012
 
$
 
%
Cost of revenue
 
 
 
 
 
 
 
Product
$
15,415

 
$
11,768

 
$
3,647

 
31.0
 %
Service
10,420

 
12,839

 
(2,419
)
 
(18.8
)%
Total cost of revenue
$
25,835

 
$
24,607

 
$
1,228

 
5.0
 %
Gross margin
 
 
 
 
 
 
 
Product
62.1
%
 
64.9
%
 
 
 
 
Service
62.0
%
 
45.4
%
 
 
 
 
Total gross margin
62.1
%
 
56.9
%
 
 
 
 



29


 
Nine months ended
 
Increase (decrease)
from prior year
 
September 27, 2013
 
September 28, 2012
 
$
 
%
Cost of revenue
 
 
 
 
 
 
 
Product
$
42,844

 
$
31,988

 
$
10,856

 
33.9
 %
Service
33,662

 
40,019

 
(6,357
)
 
(15.9
)%
Total cost of revenue
$
76,506

 
$
72,007

 
$
4,499

 
6.2
 %
Gross margin
 
 
 
 
 
 
 
Product
64.7
%
 
70.2
%
 
 
 
 
Service
57.5
%
 
44.0
%
 
 
 
 
Total gross margin
61.9
%
 
59.8
%
 
 
 
 


The decrease in product gross margin in the three months ended September 27, 2013 compared to the three months ended September 28, 2012 was primarily due to higher manufacturing-related costs, which decreased our product gross margin by approximately two percentage points, and product and customer mix, which decreased our product gross margin by approximately one percentage point. Higher manufacturing-related costs in the current year quarter were primarily comprised of higher employee-related and freight charges; however, the margin impact of these higher costs was partially offset by the impact of higher revenue in the current year quarter.

The decrease in product gross margin in the nine months ended September 27, 2013 compared to the nine months ended September 28, 2012 was primarily due to higher manufacturing-related costs, which reduced our product gross margin by approximately three percentage points, and product and customer mix, which reduced our product gross margin by approximately two percentage points. The decrease in product margin related to higher manufacturing-related costs was primarily attributable to higher third-party manufacturing costs resulting from the inclusion of NET's historically higher contract manufacturing costs in the current year period, which reduced our gross margin by approximately two percentage points, and other manufacturing-related costs, which decreased our product gross margin by approximately one percentage point. The decrease in product gross margin related to product and customer mix was primarily the result of the inclusion in the nine months ended September 28, 2012 of a significant higher margin transaction which contributed to the higher product gross margin in the prior year period, coupled with the inclusion of NET's historically lower product gross margins in the current year period.

The increase in service gross margin in the three months ended September 27, 2013 compared to the three months ended September 28, 2012 was primarily due to lower fixed service costs coupled with higher service revenue, which increased our service gross margin by approximately nine percentage points, and lower third-party service costs, which increased our service gross margin by approximately seven percentage points.

The increase in service gross margin in the nine months ended September 27, 2013 compared to the nine months ended September 28, 2012 was primarily due to higher service revenue coupled with lower fixed service costs, which increased our service gross margin by approximately eight percentage points, lower-third party service costs, which increased our service gross margin by approximately five percentage points, and a decrease in other service costs, primarily travel and related expenses, which increased our service gross margin by approximately one percentage point.

The decrease in our fixed service costs in both the three and nine months ended September 27, 2013 compared to the three and nine months ended September 28, 2012 was primarily attributable to the impact of our recent restructuring initiatives.

We believe that our total gross margin over the next few years will be 60% or greater.

Research and Development Expenses. Research and development expenses consist primarily of salaries and related personnel expenses and prototype costs related to the design, development, testing and enhancement of our products. Research and development expenses for the three and nine months ended September 27, 2013 and September 28, 2012 were as follows (in thousands, except percentages):

30


 
 
 
Increase
from prior year
 
September 27,
2013
 
September 28,
2012
 
$
 
%
Three months ended
$
16,566

 
$
15,612

 
$
954

 
6.1
%
Nine months ended
$
52,086

 
$
51,094

 
$
992

 
1.9
%

The increase in research and development expenses in the three months ended September 27, 2013 compared to the three months ended September 28, 2012 is attributable to $1.1 million of higher employee-related expenses and $0.4 million of higher product development (third-party development, prototype and test equipment) expenses, partially offset by a net decrease of $0.5 million in other research and development expenses. The increase in employee-related expenses in the three months ended September 27, 2013 is the result of $0.7 million of higher bonus expense and $0.4 million of higher stock-based compensation expense.

The increase in research and development expenses in the nine months ended September 27, 2013 compared to the nine months ended September 28, 2012 is attributable to $1.1 million of higher depreciation expense primarily related to equipment and $0.8 million of higher employee-related expense. These increases were partially offset by $0.8 million of lower expense for product development and a net decrease of $0.1 million in other research and development expenses. The increase in employee-related expenses in the nine months ended September 27, 2013 is the result of $0.8 million of higher bonus expense and $0.6 million of higher stock-based compensation expense, partially offset by $0.6 million of net reductions in other employee-related expenses.

Some aspects of our research and development efforts require significant short-term expenditures, the timing of which may cause significant variability in our expenses. We believe that rapid technological innovation is critical to our long-term success, and we are tailoring our investments to meet the requirements of our customers and market. We believe that our research and development expenses for fiscal 2013 will increase modestly from fiscal 2012 levels due to our increased focus on new product development and the inclusion of a full year of expenses for NET.

Sales and Marketing Expenses. Sales and marketing expenses consist primarily of salaries and related personnel costs, commissions, travel and entertainment expenses, promotions, customer trial and evaluations inventory and other marketing and sales support expenses. Sales and marketing expenses for the three and nine months ended September 27, 2013 and September 28, 2012 were as follows (in thousands, except percentages):
 
 
 
Increase
from prior year
 
September 27,
2013
 
September 28,
2012
 
$
 
%
Three months ended
$
18,291

 
$
17,613

 
$
678

 
3.8
%
Nine months ended
$
58,596

 
$
56,339

 
$
2,257

 
4.0
%


The increase in sales and marketing expenses in the three months ended September 27, 2013 compared to the three months ended September 28, 2012 is attributable to $0.5 million of higher marketing and trade show expenses, $0.4 million of higher employee-related expenses, $0.3 million of higher amortization expense related to the intangible assets arising from our acquisition of NET and $0.2 million of higher consulting expenses. These increases were partially offset by $0.7 million of lower expense related to evaluation equipment at customer sites, which was attributable to more conversions of customer evaluation equipment to revenue than new evaluation equipment shipments in the period. The increase in employee-related expenses was attributable to $0.8 million of higher stock-based compensation expense and $0.5 million of higher commissions expense, partially offset by $0.5 million of lower salary expense and $0.4 million of net reductions in other employee-related expenses.

The increase in sales and marketing expenses in the nine months ended September 27, 2013 compared to the nine months ended September 28, 2012 is attributable to $1.4 million of higher marketing and trade show expenses, $1.4 million of higher amortization expense related to the intangible assets arising from our acquisition of NET and $0.3 million of net increases in other sales and marketing expenses. These increases were partially offset by $0.8 million of lower expense related to evaluation equipment at customer sites, which was attributable to more conversions of customer evaluation equipment to revenue than new evaluation equipment shipments in the period.


31


We believe that our sales and marketing expenses will increase in fiscal 2013 from fiscal 2012 levels, primarily attributable to increased personnel and related costs, including such costs attributable to the inclusion of a full year of expenses for NET, as well as our investment in our expanded sales and marketing programs.

General and Administrative Expenses. General and administrative expenses consist primarily of salaries and related personnel costs for executive and administrative personnel, recruiting expenses and audit and professional fees. General and administrative expenses for the three and nine months ended September 27, 2013 and September 28, 2012 were as follows (in thousands, except percentages):
 
 
 
Increase
from prior year
 
September 27,
2013
 
September 28,
2012
 
$
 
%
Three months ended
$
9,178

 
$
7,939