10-Q 1 form10q.htm PROCERA NETWORKS INC 10-Q 9-30-2013

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

FORM 10-Q

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

For the quarterly period ended September 30, 2013
OR

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

For the transition period from  _ to _  .

Commission File Number: 000-49862
 

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

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

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

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

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

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

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

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

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

As of November 4, 2013, the registrant had 20,626,006 shares of its common stock, par value $0.001, outstanding.



PROCERA NETWORKS, INC.
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2013
INDEX

 
Page
PART I. FINANCIAL INFORMATION
 
 
 
 
 
 
Item 1.
Consolidated Financial Statements
 
 
 
 
 
 
 
3
 
 
 
 
 
 
4
 
 
 
 
 
 
5
 
 
 
 
 
 
6
 
 
 
 
 
 
7
 
 
 
 
 
Item 2.
20
 
 
 
 
 
Item 3.
28
 
 
 
 
 
Item 4.
28
 
 
 
 
PART II. OTHER INFORMATION
 
 
 
 
 
 
Item 1.
29
 
 
 
 
 
Item 1A.
29
 
 
 
 
 
Item 2.
45
 
 
 
 
 
Item 3.
45
 
 
 
 
 
Item 4.
46
 
 
 
 
 
Item 5.
46
 
 
 
 
 
Item 6.
46
 
 
 
 
47

PART I. FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

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

 
 
September 30,
   
December 31,
 
 
 
2013
   
2012
 
 
 
(unaudited)
   
(note)
 
ASSETS
 
   
 
Current assets:
 
   
 
Cash and cash equivalents
 
$
77,138
   
$
30,933
 
Short-term investments
   
31,723
     
100,762
 
Accounts receivable, net
   
20,295
     
16,603
 
Inventories, net
   
17,048
     
11,240
 
Prepaid expenses and other
   
3,278
     
2,012
 
Total current assets
   
149,482
     
161,550
 
 
               
Property and equipment, net
   
6,197
     
4,474
 
Intangible assets, net
   
6,881
     
 
Goodwill
   
13,089
     
960
 
Deferred tax asset
   
891
     
 
Other non-current assets
   
95
     
54
 
Total assets
 
$
176,635
   
$
167,038
 
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
 
$
4,858
   
$
5,453
 
Deferred revenue
   
10,358
     
6,953
 
Accrued liabilities
   
5,706
     
4,949
 
Total current liabilities
   
20,922
     
17,355
 
 
               
Non-current liabilities:
               
Deferred revenue
   
2,572
     
2,878
 
Deferred tax liability
   
1,771
     
 
Total liabilities
   
25,265
     
20,233
 
 
               
Commitments and contingencies
   
     
 
 
               
Stockholders’ equity:
               
Preferred stock, $0.001 par value; 15,000 shares authorized; none issued and outstanding
   
     
 
Common stock, $0.001 par value; 32,500 shares authorized; 20,621 and 19,696 shares issued and outstanding at September 30, 2013 and December 31, 2012, respectively
   
21
     
20
 
Additional paid-in capital
   
218,347
     
199,793
 
Accumulated other comprehensive loss
   
(1,084
)
   
(76
)
Accumulated deficit
   
(65,914
)
   
(52,932
)
Total stockholders’ equity
   
151,370
     
146,805
 
Total liabilities and stockholders’ equity
 
$
176,635
   
$
167,038
 

Note: Amounts have been derived from the December 31, 2012 audited consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

3

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

 
 
Three Months Ended
   
Nine Months Ended
 
 
 
September 30,
2013
   
September 30,
2012
   
September 30,
2013
   
September 30,
2012
 
Sales:
 
   
   
   
 
Product sales
 
$
16,301
   
$
12,948
   
$
40,328
   
$
34,640
 
Support sales
   
5,032
     
3,113
     
13,015
     
8,418
 
Total net sales
   
21,333
     
16,061
     
53,343
     
43,058
 
Cost of sales:
                               
Product cost of sales
   
10,080
     
4,053
     
22,451
     
12,671
 
Support cost of sales
   
896
     
487
     
2,442
     
956
 
Total cost of sales
   
10,976
     
4,540
     
24,893
     
13,627
 
 
                               
Gross profit
   
10,357
     
11,521
     
28,450
     
29,431
 
 
                               
Operating expenses:
                               
Research and development
   
3,945
     
1,931
     
12,532
     
5,414
 
Sales and marketing
   
7,322
     
4,573
     
21,293
     
13,053
 
General and administrative
   
2,510
     
2,386
     
9,498
     
6,823
 
Total operating expenses
   
13,777
     
8,890
     
43,323
     
25,290
 
 
                               
Income (loss) from operations
   
(3,420
)
   
2,631
     
(14,873
)
   
4,141
 
Interest and other income, net
   
232
     
161
     
203
     
108
 
 
                               
Income (loss) before income taxes
   
(3,188
)
   
2,792
     
(14,670
)
   
4,249
 
Income tax provision (benefit)
   
(205
)
   
29
     
(1,688
)
   
141
 
Net income (loss)
 
$
(2,983
)
 
$
2,763
   
$
(12,982
)
 
$
4,108
 
 
                               
Net income (loss) per share – basic
 
$
(0.15
)
 
$
0.14
   
$
(0.65
)
 
$
0.24
 
Net income (loss) per share – diluted
 
$
(0.15
)
 
$
0.14
   
$
(0.65
)
 
$
0.23
 
 
                               
Shares used in computing net income (loss) per share:
                               
Basic
   
20,031
     
19,305
     
20,007
     
17,304
 
Diluted
   
20,031
     
19,801
     
20,007
     
17,824
 

See accompanying notes to condensed consolidated financial statements.
4

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

 
 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Net income (loss)
 
$
(2,983
)
 
$
2,763
   
$
(12,982
)
 
$
4,108
 
 
                               
Unrealized gain (loss) on short-term investments
   
29
     
46
     
(21
)
   
27
 
Foreign currency translation adjustments
   
566
     
265
     
(987
)
   
190
 
Other comprehensive income (loss)
   
595
     
311
     
(1,008
)
   
217
 
 
                               
Comprehensive income (loss)
 
$
(2,388
)
 
$
3,074
   
$
(13,990
)
 
$
4,325
 

See accompanying notes to condensed consolidated financial statements.
5

Procera Networks, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
 
 
Nine Months Ended
September 30,
 
 
 
2013
   
2012
 
Cash flows from operating activities:
 
   
 
Net income (loss)
 
$
(12,982
)
 
$
4,108
 
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
               
Depreciation
   
1,342
     
587
 
Amortization of intangible assets
   
1,179
     
 
Stock-based compensation expense:
               
Stock options
   
2,852
     
1,755
 
Restricted stock awards
   
962
     
438
 
Amortization of premium on investments
   
773
     
539
 
Amortization of deferred compensation
   
4,301
     
 
Provision for bad debts
   
49
     
6
 
Provision for excess and obsolete inventory
   
588
     
555
 
Changes in deferred taxes
   
(1,550
)
   
 
Changes in assets and liabilities:
               
Accounts receivable
   
(3,171
)
   
(4,865
)
Inventories
   
(6,393
)
   
(501
)
Prepaid expenses and other current assets
   
2,205
     
(572
)
Deferred compensation advanced to escrow
   
(2,701
)
   
 
Accounts payable
   
(1,220
)
   
1,640
 
Accrued liabilities
   
458
     
503
 
Deferred revenue
   
2,557
     
3,394
 
Net cash provided by (used in) operating activities
   
(10,751
)
   
7,587
 
 
               
Cash flows from investing activities:
               
Purchase of Vineyard Networks, net of cash received
   
(8,962
)
   
 
Purchase of property and equipment
   
(2,209
)
   
(2,588
)
Purchase of short-term investments
   
(36,019
)
   
(92,189
)
Sales of short-term investments
   
11,212
     
2,002
 
Maturities of short-term investments
   
93,120
     
12,330
 
Net cash provided by (used in) investing activities
   
57,142
     
(80,445
)
 
               
Cash flows from financing activities:
               
Proceeds from issuance of common stock
   
     
88,025
 
Proceeds from issuance of common stock – exercise of options
   
428
     
2,998
 
Proceeds from issuance of common stock – exercise of warrants
   
     
27
 
Payments on notes payable
   
(497
)
   
 
Net cash provided by (used in) financing activities
   
(69
)
   
91,050
 
 
               
Effect of exchange rates on cash and cash equivalents
   
(117
)
   
55
 
 
               
Net increase in cash and cash equivalents
   
46,205
     
18,247
 
 
               
Cash and cash equivalents, beginning of period
   
30,933
     
23,900
 
 
               
Cash and cash equivalents, end of period
 
$
77,138
   
$
42,147
 
 
               
Non-cash investing and financing activities:
               
Issuance of common stock in connection with Vineyard acquisition
 
$
11,140
   
$
 

See accompanying notes to condensed consolidated financial statements.
6

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

1. DESCRIPTION OF BUSINESS

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

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

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

Procera has prepared the condensed consolidated financial statements included herein pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) applicable to interim financial information.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations.  However, in the opinion of management, the financial statements include all the normal and recurring adjustments that are necessary to fairly present the results of the interim periods presented. The interim results presented are not necessarily indicative of results for any subsequent interim period, the year ending December 31, 2013, or any other future period. The consolidated balance sheet at December 31, 2012 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by United States generally accepted accounting principles (“U.S. GAAP”) for complete financial statements.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in Procera’s Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 15, 2013.

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

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

As a result of the immaterial errors discussed above, the unaudited condensed consolidated financial statements for the nine months ended September 30, 2013 reflect the following immaterial adjustments related to prior periods, which were recorded in the quarter ended March 31, 2013: the reversal of a revenue deal resulting in a reduction of $0.6 million of revenue and a reduction of $0.2 million of cost of sales; inventory charges resulting in an increase of $0.4 million in cost of sales, and additional general and administrative costs of $43,000.

Significant Accounting Policies

The accounting and reporting policies of the Company conform to U.S. GAAP and to the practices within the telecommunications industry.  There have been no significant changes in the Company’s significant accounting policies during the three and nine months ended September 30, 2013 compared to what was previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 15, 2013.
7

Recent Accounting Pronouncements

In July 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2013-7, “Income Taxes (Topic 740): Income Taxes: Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” (“ASU 2013-7”).  ASU 2013-7 provides guidance on the financial statement presentation of an unrecognized tax benefit, as either a reduction of a deferred tax asset or as a liability, when a net operating loss carryforward, similar tax loss or a tax credit carryforward exists.  The amendments will be effective for interim and annual periods beginning after December 15, 2013 and may be applied on a retrospective basis.  Early adoption is permitted.  The Company does not expect the adoption of these amendments to have a significant impact on the Company’s consolidated financial position or results of operations.

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

3. CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

The following is a summary of cash equivalents and short-term investments by type of instrument at September 30, 2013 and December 31, 2012 (in thousands):

 
 
September 30, 2013
 
 
 
Amortized
   
Gross Unrealized
   
Fair
 
 
 
Cost
   
Gains
   
Losses
   
Value
 
Money market funds
 
$
65,817
   
$
   
$
   
$
65,817
 
Commercial paper
   
4,998
     
     
     
4,998
 
U.S. agency securities
   
8,439
     
1
     
     
8,440
 
Corporate bonds
   
18,287
     
1
     
(3
)
   
18,285
 
Total investments
 
$
97,541
   
$
2
   
$
(3
)
 
$
97,540
 
 
                               
Reported as:
                               
Cash equivalents
 
$
65,817
   
$
   
$
   
$
65,817
 
Short-term investments
   
31,724
     
2
     
(3
)
   
31,723
 
Total investments
 
$
97,541
   
$
2
   
$
(3
)
 
$
97,540
 

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

As of September 30, 2013, all investments were classified as available-for-sale with unrealized gains and losses recorded as a separate component of accumulated other comprehensive income (loss).  Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase.  Short-term investments generally have a remaining maturity of greater than three months at the date of purchase and an effective maturity of less than one year.  As of September 30, 2013, the Company had certain investments with a maturity greater than one year. However, management has the ability, if necessary, to liquidate any of its investments in order to meet the Company’s liquidity needs in the next 12 months.  Accordingly, investments with contractual maturities greater than one year from the date of purchase are classified as short-term on the accompanying condensed consolidated balance sheets.  None of the Company’s short-term investments have been at a continuous unrealized loss position for greater than 12 months.
8

The Company reviews its investments for impairment quarterly.  For investments with an unrealized loss, the factors considered in the review include the credit quality of the issuer, the duration that the fair value has been less than the adjusted cost basis, severity of impairment, reason for the decline in value and potential recovery period, the financial condition and near-term prospects of the investees, and whether the Company would be required to sell an investment due to liquidity or contractual reasons before its anticipated recovery.  Based on its review, the Company did not identify any investments that were other-than-temporarily impaired during the three and nine months ended September 30, 2013.

The Company did not incur any material realized gains or losses in the three and nine months ended September 30, 2013 and 2012.  The cost of securities sold was determined based on the specific identification method.

4. FAIR VALUE MEASUREMENTS

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

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

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

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

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

The following is a summary of cash equivalents and short-term investments by type of instrument as of September 30, 2013 and December 31, 2012, measured at fair value on a recurring basis (in thousands):

 
 
September 30, 2013
 
 
 
Level 1
   
Level 2
   
Level 3
   
Total
 
Money market funds
 
$
65,817
   
$
   
$
   
$
65,817
 
Commercial paper
   
     
4,998
     
     
4,998
 
U.S. agency securities
   
     
8,440
     
     
8,440
 
Corporate bonds
   
     
18,285
     
     
18,285
 
Total assets measured at fair value
 
$
65,817
   
$
31,723
   
$
   
$
97,540
 

 
 
December 31, 2012
 
 
 
Level 1
   
Level 2
   
Level 3
   
Total
 
Money market funds
 
$
13,505
   
$
   
$
   
$
13,505
 
Commercial paper
   
     
9,696
     
     
9,696
 
U.S. agency securities
   
     
51,294
     
     
51,294
 
Corporate bonds
   
     
34,751
     
     
34,751
 
U.S. Government bonds
   
     
5,021
     
     
5,021
 
Total assets measured at fair value
 
$
13,505
   
$
100,762
   
$
   
$
114,267
 

In general, and where applicable, the Company uses quoted market prices in active markets for identical assets to determine fair value.  This pricing methodology applies to Level 1 investments which are comprised of money market funds.  If quoted prices in active markets for identical assets are not available, then the Company uses quoted prices for similar assets or inputs other than quoted prices that are observable, either directly or indirectly.  These investments are included in Level 2 and consist of commercial paper, U.S. agency securities, and U.S. Government and corporate bonds. U.S. agency securities and U.S. Government and corporate bonds are valued at a consensus price, which is a weighted average price based on market prices from a variety of industry standard data providers used as inputs to a distribution-curve based algorithm. Commercial paper is valued using market prices where available, adjusting for accretion of the purchase price to face value at maturity.
9

During the three and nine months ended September 30, 2013 and 2012, the Company did not have any transfers between Level 1 and Level 2 fair value instruments.

5. ACQUISITIONS

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

For the three months ended September 30, 2013, Vineyard contributed approximately $0.8 million in revenue and $0.6 million in net loss. For the nine months ended September 30, 2013, Vineyard contributed approximately $1.7 million in revenue and $1.7 million in net loss.

The total purchase price was $20.9 million, consisting of $9.8 million cash consideration and $11.1 million in the Company’s common stock in exchange for 100% of the outstanding securities of Vineyard.  Of the consideration paid, $2.0 million and $1.9 million in cash and stock, respectively, will be held in escrow for a period of 12, 18 or 36 months from the closing of the acquisition and will be released subject to resolution of certain contingencies.  In addition to the purchase consideration, the Company has recorded deferred compensation of $5.9 million, consisting of approximately $2.7 million in cash consideration and $3.2 million in the Company’s common stock, related to retention agreements with Vineyard’s three founders, which will be disbursed from the escrow account after one year of continuous employment with the Company.  The Company recognized $1.5 million and $4.3 million in compensation costs related to these retention agreements for the three and nine months ended September 30, 2013, respectively.

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

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

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

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

Intangible Assets Acquired

The following table presents details of the intangible assets acquired in connection with the acquisition of Vineyard, which was completed during the first quarter of 2013 (in thousands, except years):
10

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

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

Pro Forma Financial Information

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

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
2013
 
2012
 
 
 
 
 
 
Pro forma revenues
 
$
21,440
   
$
16,695
   
$
54,474
   
$
44,232
 
Pro forma net income (loss)
   
(1,408
)
   
277
     
(6,393
)
   
(2,574
)
Basic and diluted earnings (loss) per share
 
$
(0.07
)
 
$
0.01
   
$
(0.31
)
 
$
(0.14
)

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

These adjustments are as follows (in thousands):

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
2013
 
2012
 
 
 
 
 
 
Acquisition-related expenses for Vineyard
 
$
   
$
   
$
(1,026
)
 
$
 
Intangible amortization
   
     
417
     
36
     
1,242
 
Net change in stock compensation expense
   
     
267
     
(636
)
   
1,461
 
Increase (decrease) in deferred compensation expense
   
(1,468
)
   
1,468
     
(4,279
)
   
4,405
 
Increase in weighted average common shares outstanding for shares issued and not already included in the weighted average common shares outstanding
   
302
     
518
     
309
     
518
 

6. GOODWILL AND INTANGIBLE ASSETS

Changes in the carrying value of goodwill for the nine months ended September 30, 2013 were as follows (in thousands):
11

 
Nine Months Ended
 
 
September 30,
 
 
2013
 
Balance, December 31, 2012
 
$
960
 
Additions from Vineyard acquisition
   
12,751
 
Translation adjustments
   
(622
)
Balance, September 30, 2013
 
$
13,089
 

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

The following table is a summary of acquired intangible assets with remaining net book values at September 30, 2013 (in thousands, except weighted average remaining life):

 
 
Gross
Carrying
Value
   
Accumulated
Amortization
   
Net
Carrying
Value
   
Weighted Average Remaining Life
 
Developed technology
 
$
5,626
   
$
(820
)
 
$
4,806
     
4.27
 
Customer relationships
   
2,428
     
(353
)
   
2,075
     
4.27
 
Balance at September 30, 2013
 
$
8,054
   
$
(1,173
)
 
$
6,881
         

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

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

The changes in the carrying value of acquired intangible assets during the nine months ended September 30, 2013 were as follows (in thousands):

 
 
Gross
Carrying
Value
   
Accumulated
Amortization
   
Net
Carrying
Value
 
Balance at December 31, 2012
 
$
   
$
   
$
 
Additions
   
8,460
     
(1,173
)
   
7,287
 
Translation adjustments
   
(406
)
   
     
(406
)
Balance at September 30, 2013
 
$
8,054
   
$
(1,173
)
 
$
6,881
 

The following table presents the estimated future amortization of intangible assets as of September 30, 2013 (in thousands):

Fiscal Year
 
Amortization
 
2013 (remaining three months)
 
$
403
 
2014
   
1,611
 
2015
   
1,611
 
2016
   
1,611
 
2017
   
1,611
 
Thereafter
   
34
 
Total
 
$
6,881
 

7. CERTAIN FINANCIAL STATEMENT INFORMATION

Accounts receivable:

Accounts receivable at September 30, 2013 and December 31, 2012 consisted of the following (in thousands):
12

 
 
September 30,
2013
   
December 31,
2012
 
Accounts receivable
 
$
20,473
   
$
16,699
 
Less: allowance for doubtful accounts
   
(178
)
   
(96
)
Total
 
$
20,295
   
$
16,603
 

Inventories:

Inventories are stated at the lower of cost, which approximates actual costs on a first in, first out basis, or market. Inventories at September 30, 2013 and December 31, 2012 consisted of the following (in thousands):

 
 
September 30,
2013
   
December 31,
2012
 
Finished goods
 
$
16,864
   
$
10,886
 
Raw materials
   
184
     
354
 
Inventories, net
 
$
17,048
   
$
11,240
 

Accrued Liabilities:

Accrued liabilities at September 30, 2013 and December 31, 2012 consisted of the following (in thousands):

 
 
September 30,
2013
   
December 31,
2012
 
Payroll and related
 
$
2,630
   
$
2,166
 
Sales commissions
   
1,300
     
1,112
 
Warranty
   
234
     
406
 
Audit and legal services
   
200
     
368
 
Other
   
1,342
     
897
 
Total accrued liabilities
 
$
5,706
   
$
4,949
 

Warranty Reserve

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

The following table summarizes warranty reserve activity during the nine months ended September 30, 2013 and 2012 (in thousands):

 
 
Nine Months Ended
September 30,
 
 
 
2013
   
2012
 
Warranty accrual, beginning of period
 
$
406
   
$
565
 
Changes in liability for pre-existing warranties
   
(56
)
   
40
 
Deductions for warranty claims processed during the period
   
(116
)
   
(136
)
Warranty accrual, end of period
 
$
234
   
$
469
 

Accumulated Other Comprehensive Income (Loss):

The components of accumulated other comprehensive income (loss) at September 30, 2013 and December 31, 2012, net of taxes, were as follows (in thousands):
13

 
 
Foreign Currency Translation Adjustments
   
Net Unrealized Gain (Loss) on Short-Term Investments
   
Total
 
Accumulated other comprehensive income (loss) as of December 31, 2012
 
$
(96
)
 
$
20
   
$
(76
)
Other comprehensive income (loss), net of tax
   
(987
)
   
(21
)
   
(1,008
)
Accumulated other comprehensive income (loss) as of September 30, 2013
 
$
(1,083
)
 
$
(1
)
 
$
(1,084
)

The Company did not have any reclassifications out of accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2013.  The Company did not have any other-than-temporary loss on its available-for-sale securities for all periods presented.

8. STOCKHOLDERS’ EQUITY

Common Stock Transactions

On January 9, 2013, the Company issued 825,060 unregistered shares with a value of approximately $14.7 million (gross value), pursuant to the Company’s acquisition of Vineyard as part of the purchase consideration in exchange for 100% of the outstanding securities of Vineyard, and deferred compensation to the founders of Vineyard.  On February 13, 2013, the Company filed with the SEC a Registration Statement on Form S-3 covering the resale of these shares.  The Registration Statement on Form S-3 was declared effective by the SEC on March 7, 2013.  Pursuant to the agreement, approximately 518,000 shares were transferred to the former Vineyard shareholders at closing, with the remainder being held in escrow for a period of 12, 18 or 36 months from the closing of the acquisition.

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

Equity Incentive Plan and Stock Option Activity

The Company’s 2007 Equity Incentive Plan, as amended (the “Plan”), provides for the grant of stock options and restricted stock awards (“RSAs”) to eligible employees, consultants, and non-employee directors of the Company.  As of September 30, 2013, 860,651 shares of the Company’s common stock were available for future grant under the Plan.  On January 9, 2013, the Company granted to certain former Vineyard employees who became employees of the Company upon closing of the Vineyard acquisition options to purchase an aggregate of 412,000 shares of the Company’s common stock.  These options were granted outside of the Plan as inducements material to such employees joining the Company.

The following table summarizes the Company’s stock option activity for the nine months ended September 30, 2013 and 2012 (in thousands, except per share data):

 
 
Nine Months Ended September 30,
 
 
 
2013
   
2012
 
 
 
Options
   
Weighted
Average
Exercise
Price
   
Options
   
Weighted
Average
Exercise
Price
 
Outstanding at the beginning of the period
   
1,332
   
$
14.65
     
1,198
   
$
10.35
 
Granted
   
622
     
16.25
     
254
     
20.97
 
Exercised
   
(54
)
   
7.78
     
(302
)
   
9.92
 
Cancelled
   
(240
)
   
18.67
     
(37
)
   
11.84
 
Outstanding at the end of the period
   
1,660
   
$
15.23
     
1,113
   
$
12.86
 
Vested and expected to vest at the end of the period
   
1,555
   
$
15.08
     
1,067
   
$
12.71
 
Exercisable at the end of the period
   
609
   
$
11.40
     
611
   
$
11.44
 

As of September 30, 2013, the aggregate intrinsic value of options outstanding, options vested and expected to vest and options exercisable was $3.9 million, $3.9 million and $3.1 million, respectively.  As of September 30, 2013, the weighted average remaining contractual life of options outstanding, options vested and expected to vest and options exercisable was 8.28 years, 8.22 years and 6.80 years, respectively. The total intrinsic value of options exercised during the three and nine months ended September 30, 2013 was $0.2 million and $0.4 million, respectively.  The total intrinsic value of options exercised during the three and nine months ended September 30, 2012 was $1.4 million and $3.1 million, respectively.
14




The weighted average remaining contractual life and weighted average per share exercise price of options outstanding and of options exercisable as of September 30, 2013 were as follows (in thousands, except exercise prices and years):

   
Options Outstanding
   
Options Exercisable
 
Range of Exercise Prices
   
Number of
Shares
   
Weighted
Average
Remaining
Contractual
Life (years)
   
Weighted
Average
Exercise Price
   
Number of
Shares
   
Weighted
Average
Exercise Price
 
$
4.30 – $ 5.70
     
201
     
6.19
   
$
5.06
     
176
   
$
5.04
 
 
6.00 – 9.72
     
133
     
5.16
     
7.42
     
125
     
7.30
 
 
9.93 – 14.49
     
358
     
9.75
     
13.35
     
163
     
13.89
 
 
14.50 – 33.50
     
968
     
8.69
     
19.11
     
145
     
19.84
 
$
4.30 – $ 33.50
     
1,660
     
8.28
   
$
15.23
     
609
   
$
11.40
 

The following table summarizes the Company’s RSA activity for the nine months ended September 30, 2013 and 2012 (in thousands, except per share data):

 
Nine Months Ended September 30,
 
 
2013
 
2012
 
 
Awards
 
Weighted
Average
Grant Date
Fair Value
 
Awards
 
Weighted
Average
Grant Date
Fair Value
 
Unvested outstanding at the beginning of the period
   
253
   
$
15.79
     
136
   
$
9.24
 
Granted
   
40
     
14.45
     
17
     
20.86
 
Vested
   
(18
)
   
19.05
     
(25
)
   
8.75
 
Cancelled
   
(1
)
   
20.25
     
     
 
Unvested outstanding at the end of the period
   
274
   
$
15.36
     
128
   
$
10.90
 

The weighted average remaining contractual term for the RSAs outstanding as of September 30, 2013 was 2.56 years. As of September 30, 2013, the aggregate pre-tax intrinsic value of the RSAs outstanding was $2.7 million.

9. NET INCOME (LOSS) PER SHARE

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

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

 
 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Numerator:
 
   
   
   
 
Net income (loss)
 
$
(2,983
)
 
$
2,763
   
$
(12,982
)
 
$
4,108
 
 
                               
Denominator:
                               
Weighted average common shares - basic
   
20,031
     
19,305
     
20,007
     
17,304
 
Dilutive effect of employee equity incentive plans
   
     
496
     
     
506
 
Dilutive effect of warrants
   
     
     
     
14
 
Weighted average common shares - diluted
   
20,031
     
19,801
     
20,007
     
17,824
 
 
                               
Net income (loss) per share:
                               
Basic
 
$
(0.15
)
 
$
0.14
   
$
(0.65
)
 
$
0.24
 
Diluted
 
$
(0.15
)
 
$
0.14
   
$
(0.65
)
 
$
0.23
 
 
                               
Antidilutive securities:
                               
Options and restricted stock
   
1,192
     
285
     
1,185
     
262
 

15

10. STOCK-BASED COMPENSATION

The following table summarizes employee stock-based compensation expense, net of income tax, as it relates to the Company’s statement of operations for the three and nine months ended September 30, 2013 and 2012 (in thousands):

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
2013
 
2012
 
 
 
 
 
 
Cost of goods sold
 
$
101
   
$
34
   
$
281
   
$
98
 
Research and development
   
218
     
76
     
933
     
296
 
Sales and marketing
   
385
     
296
     
1,348
     
942
 
General and administrative
   
365
     
415
     
1,252
     
857
 
Total stock-based compensation expense
 
$
1,069
   
$
821
   
$
3,814
   
$
2,193
 

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

No income tax benefits were recognized in the three and nine months ended September 30, 2013 and 2012 due to current period operating losses and carry-forwards available to offset income in the prior year periods.  No stock-based compensation has been capitalized in inventory due to the immateriality of such amounts.

As of September 30, 2013, total unrecognized compensation cost related to unvested stock options was $8.9 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 3.13 years, and total unrecognized compensation cost related to non-vested RSAs was $2.7 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 2.56 years.

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

The following assumptions were used in determining the fair value of stock options granted during the three and nine months ended September 30, 2013 and 2012:

 
 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Expected term (years)
   
4.77
     
4.04
     
4.84
     
4.10
 
Expected volatility
   
78.2
%
   
79.3
%
   
78.2
%
   
75.5
%
Risk-free interest rate
   
1.43
%
   
0.58
%
   
0.92
%
   
0.67
%
Expected dividend yield
   
0
%
   
0
%
   
0
%
   
0
%

The weighted average grant date fair value of options granted during the three and nine months ended September 30, 2013 was $8.71 and $9.75, respectively.  The weighted average grant date fair value of options granted during the three and nine months ended September 30, 2012 was $13.14 and $10.98, respectively.
16

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

11. RELATED PARTY TRANSACTIONS

On July 19, 2010, the Company entered into a Master OEM Purchase and Sales Agreement (the “OEM Agreement”) with GENBAND US LLC and GENBAND Ireland Ltd. (collectively, “GENBAND”), pursuant to which GENBAND may purchase any of the Company’s existing software and hardware products, as well as procure licenses and services related to such products from the Company.  Pursuant to the OEM Agreement, the Company’s Board of Directors supported the election of Mark Pugerude, Chief Strategy Officer of GENBAND, as a director of the Company beginning in fiscal 2012 through the Company’s 2012 Annual Meeting of Stockholders on August 27, 2012, and B.G. Kumar, Executive Vice President and President of the Networking and Applications Product Unit of GENBAND, as a director of the Company beginning on August 27, 2012, the date of the Company’s 2012 Annual Meeting of Stockholders.  Mr. Kumar’s service on the Company’s Board of Directors ended on May 30, 2013, the date of the Company’s 2013 Annual Meeting of Stockholders.

During the three and nine months ended September 30, 2013, the Company recognized revenue of approximately $0.1 million on sales to GENBAND.  During the three and nine months ended September 30, 2012, the Company recognized revenue of approximately $0.1 million and $1.7 million, respectively, on sales to GENBAND.  At December 31, 2012, the Company had accounts receivable of approximately $38,000 from GENBAND.

Effective April 15, 2013, Procera and GENBAND terminated the OEM Agreement and the letter agreement, dated July 19, 2010 (the “Letter Agreement”), between the Company and GENBAND US LLC. The termination of the OEM Agreement and the Letter Agreement was effected pursuant to the execution of a transition agreement between Procera and GENBAND.  The transition agreement permits GENBAND to continue to perform its functions for existing customers, as provided under the OEM Agreement, for the remainder of the current service term, and further provides that Procera will continue to provide support or maintenance to GENBAND’s existing customers under or in connection with the OEM Agreement and for which GENBAND previously submitted a purchase order.

12. COMMITMENTS AND CONTINGENCIES

Legal

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

Operating Leases

The Company leases its operating and office facilities for various terms under long-term, non-cancelable operating lease agreements.  The leases expire at various dates through 2018 and provide for renewal options ranging from month-to-month to three year terms.  In the normal course of business, it is expected that these leases will be renewed or replaced by leases on other properties.  The leases provide for increases in future minimum annual rental payments based on defined increases which are generally meant to correlate with the Consumer Price Index, subject to certain minimum increases.  Also, the agreements generally require the Company to pay executory costs (real estate taxes, insurance and repairs).

As of September 30, 2013, future minimum lease payments due under operating leases are as follows (in thousands):

Fiscal years ending December 31,
 
Amount
 
2013 (remaining)
 
$
255
 
2014
   
873
 
2015
   
683
 
2016
   
561
 
2017
   
447
 
Thereafter
   
169
 
Total future minimum lease payments
 
$
2,988
 

17

The Company entered into a new lease arrangement for its corporate headquarters in Fremont, California effective November 2013, and the minimum lease payment amounts associated with this new lease are reflected in the table above.

Secured Line of Credit

On December 10, 2009, the Company entered into a two-year loan and security agreement for a secured line of credit facility (“Secured Credit Facility”) for short-term working capital purposes with Silicon Valley Bank.  On February 3, 2012, the Secured Credit Facility was amended and restated (the “Amended Secured Credit Facility”) to increase the secured line of credit facility from $2.0 million to $10.0 million and to provide for borrowings through February 2, 2014. Pursuant to the Amended Secured Credit Facility, borrowings bear interest at the prime rate plus 1%, but not less than 4.25% on an annual basis.  The Company will pay Silicon Valley Bank a $35,000 commitment fee in each of the two years under the Amended Secured Credit Facility. The Amended Secured Credit Facility is secured by substantially all of the Company’s assets.  The terms of the Amended Secured Credit Facility include a financial covenant requiring a minimum company liquidity ratio and restrictions on the Company’s ability to incur certain additional indebtedness, pay dividends, create or permit liens on assets or engage in mergers, consolidations or dispositions.  The Amended Secured Credit Facility may be terminated at any time by the Company during the term of the agreement, to take effect three business days after the Company provides written notice to Silicon Valley Bank.  In connection with such termination, the Company would be obligated to pay Silicon Valley Bank a $50,000 termination fee.  The Company was in compliance with the financial covenants as of September 30, 2013.  At September 30, 2013 and December 31, 2012, the Company had no outstanding balance under the Amended Secured Credit Facility.

Concentrations

For the three months ended September 30, 2013, revenue from two customers represented 33% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2013, revenue from Shaw Communications, Inc. represented 13% of net revenue, and two other customers represented 13% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the three months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 16% and 24% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 17% and 10% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.

At September 30, 2013, accounts receivable from three customers represented 37%, 15% and 11%, respectively, of total accounts receivable, with no other single customer accounting for more than 10% of the accounts receivable balance.  At December 31, 2012, accounts receivable from three customers represented 14%, 12% and 12%, respectively, of total accounts receivable with no other single customer accounting for more than 10% of the accounts receivable balance.

Indemnification

The Company generally agrees to indemnify customers against legal claims that the Company's products infringe certain third party property rights. As of September 30, 2013 and 2012, the Company has not been required to make any payments resulting from infringement claims asserted against customers and has not recorded any related reserves.

13. INCOME TAXES

The Company’s effective tax rate was 12% for the nine months ended September 30, 2013 and 3% for the nine months ended September 30, 2012.  For the three and nine months ended September 30, 2013, the Company recorded an income tax benefit of $0.2 million and $1.7 million, respectively, on a loss before provision for income taxes of $3.2 million and $14.7 million, respectively.  For the three and nine months ended September 30, 2012, the Company recorded an income tax provision of $29,000 and $0.1 million, respectively, on an income before provision for income taxes of $2.8 million and $4.2 million, respectively. The effective tax rate for the nine months ended September 30, 2013 differs from the federal statutory tax rate as a result of the income tax benefit related to the release of Vineyard’s pre-existing income tax valuation allowance, the amortization of the acquired intangibles, state taxes and earnings taxed in foreign jurisdictions.

In 2002, the Company established a valuation allowance for substantially all of its deferred tax assets.   Since that time, the Company has continued to record a valuation allowance.  A valuation allowance is required to be established or maintained when it is more likely than not that all or a portion of deferred tax assets will not be realized.  The Company will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal.
18

The Company recognizes interest and penalties related to uncertain tax positions in income tax expense.  As of September 30, 2013, the Company had no accrued interest or penalties related to uncertain tax positions.   The federal returns for the years ended 2009 through the current period and most state returns for the years ended 2008 through the current period remain open to examination.  In addition, all of the net operating losses and research and development credit carryforwards that may be used in future years are still subject to adjustment.  The Company is also subject to examinations in other foreign jurisdictions, including Australia and Sweden beginning in 2006 through the current period.

At September 30, 2013, the Company had $193,000 of unrecognized tax benefits, a total of $158,000 which would affect the Company’s effective tax rate if recognized. The Company does not anticipate that the total unrecognized tax benefits will change significantly over the next 12 months.

14. SEGMENT INFORMATION

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

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

 
 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Sales:
 
   
   
   
 
United States
 
$
4,572
   
$
4,949
   
$
13,916
   
$
16,042
 
Canada and Latin America
   
1,708
     
2,633
     
8,401
     
7,487
 
Europe, Middle East and Africa
   
9,737
     
3,031
     
19,108
     
10,749
 
Asia Pacific
   
5,316
     
5,448
     
11,918
     
8,780
 
 
                               
Total
 
$
21,333
   
$
16,061
   
$
53,343
   
$
43,058
 

The following are summaries of long-lived assets by geographical region (in thousands):

 
 
September 30,
2013
   
December 31,
2012
 
Long-lived assets:
 
   
 
United States
 
$
1,495
   
$
1,750
 
Canada
   
293
     
 
Europe
   
4,406
     
2,719
 
Asia Pacific
   
3
     
5
 
Total
 
$
6,197
   
$
4,474
 

19

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

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

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

Cautionary Note Regarding Forward-Looking Statements

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

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

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

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

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

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

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

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

Overview

We are a leading provider of Internet Intelligence solutions designed for carriers, service providers and enterprises worldwide.  Procera’s PacketLogic solutions provide actionable intelligence and policy enforcement to ensure a high quality experience for any Internet connected devices.  Network operators deploy our technology to enable real-time visibility, superior performance and scalability, and deliver personalized services for millions of enterprises and consumers.  Enterprises utilize our embedded Network Application Visibility Library (“NAVL”) solutions to ensure that they can deliver “bring your own device” and Cloud services to their employees.  We believe that the intelligence our products provide about users and their usage enables our network operator customers to make informed business decisions.  Our network operator customers include mobile service providers, broadband service providers, cable multiple system operators (“MSOs”), Internet Service Providers (“ISPs”), educational institutions, enterprises and government agencies.  We sell our products directly to network operators; through partners, value added resellers and system integrators; and to other network solution suppliers for incorporation into their network solutions.
20

Our Intellegent Policy Enforecement (“IPE”) products are part of the high-growth market for mobile packet and broadband core products.  The market for IPE products was $596 million in 2012 and is expected to grow to $1.9 billion in 2017, a 2012–2017 compounded annual growth rate of 26%.  Our bundled products deliver a solution that is a key element of the mobile packet and broadband core ecosystems.  Our solutions are often integrated with additional elements in the mobile packet and broadband core, including Policy Management and Charging functions, and are compliant with the widely adopted 3rd Generation Partnership Program (“3GPP”) standard.  In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, network operators are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers.  We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products.

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

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

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

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

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

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

Critical Accounting Estimates

The discussion and analysis of our financial condition and results of operations are based upon financial statements which have been prepared in accordance with Generally Accepted Accounting Principles in the United States (“U.S. GAAP”).  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities.  On an ongoing basis, we evaluate these estimates.  We base our estimates on historical experience and on assumptions that are believed to be reasonable.  These estimates and assumptions provide a basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions, and these differences may be material.
21

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

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

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

Results of Operations

Comparison of Three and Nine Months Ended September 30, 2013 and 2012

Revenue

Revenue for the three and nine months ended September 30, 2013 and 2012 was as follows (in thousands, except percentages):

 
Three Months Ended
September 30,
 
     
   
Nine Months Ended
September 30,
   
     
 
 
2013
   
2012
 
Increase
 
2013
   
2012
 
Increase
 
 
 
 
 
 
Net product revenue
 
$
16,301
   
$
12,948
     
26
%
 
$
40,328
   
$
34,640
     
16
%
Net support revenue
   
5,032
     
3,113
     
62
%
   
13,015
     
8,418
     
55
%
Total revenue
 
$
21,333
   
$
16,061
     
33
%
 
$
53,343
   
$
43,058
     
24
%

Our revenue is derived from two sources: 1) product revenue, which includes sales of our hardware appliances bundled with software licenses, separate software licenses and software upgrades; and 2) service revenue, which consists primarily of software maintenance and customer support revenue and secondarily of professional services.  Maintenance and customer support revenue is recognized over the support period, which is typically 12 months.

Total product revenue in the three and nine months ended September 30, 2013 was $16.3 million and $40.3 million, an increase of 26% and 16%, respectively, compared with $12.9 million and $34.6 million in the three and nine months ended September 30, 2012. The increase in product revenue in the three and nine months ended September 30, 2013 compared to the comparable prior year periods reflected the recognition of a significant orderfrom one of our Tier 1 service provider customers, in addition to follow-on orders from existing customers and continued sales to our network operator customers, including mobile service providers, fixed line service providers, and cable multiple system operators.  We also continued to add new enterprise and higher education customers.   The increase in revenue also reflected our continued expansion in international markets, including the Middle East, Japan and Latin America.  The increase in support revenue in the three and nine months ended September 30, 2013 compared to the comparable prior year periods reflected the continued expansion of the installed base of our product to which we have sold ongoing support services, as well as growth in professional services revenue. For the three and nine months ended September 30, 2013, Vineyard contributed $0.6 million and $1.0 million in product revenue, respectively, and $0.2 million and $0.7 million in support revenue, respectively.  There was no revenue in our results for Vineyard in 2012 as the acquisition was completed in early 2013.  For the three months ended September 30, 2013, revenue from two customers represented 33% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2013, revenue from Shaw Communications, Inc. represented 13% of net revenue, and two other customers represented 13% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the three months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 16% and 24% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 17% and 10% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.
22

Sales to customers located in the United States as a percentage of total revenue were 21% and 26% for the three and nine months ended September 30, 2013, respectively, compared to 31% and 37% for the three and nine months ended September 30, 2012, respectively.

We believe that our revenue will increase in the remaining quarter of the fiscal year ending December 31, 2013, both sequentially and as compared with the fourth quarter of the fiscal year ended December 31, 2012.

Cost of Sales

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

The following table presents the breakdown of cost of sales by category for the three and nine months ended September 30, 2013 and 2012 (in thousands, except percentages):

 
 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
 
 
2013
   
2012
   
Increase
   
2013
   
2012
   
Increase
 
Product costs
 
$
10,080
   
$
4,053
     
149
%
 
$
22,451
   
$
12,671
     
77
%
Percent of net product revenue
   
62
%
   
31
%
           
56
%
   
37
%
       
 
                                               
Support costs
 
$
896
   
$
487
     
84
%
 
$
2,442
   
$
956
     
155
%
Percent of net support revenue
   
18
%
   
16
%
           
19
%
   
11
%
       
 
                                               
Total cost of sales
 
$
10,976
   
$
4,540
     
142
%
 
$
24,893
   
$
13,627
     
83
%
Percent of total net revenue
   
51
%
   
28
%
           
47
%
   
32
%
       

Total cost of sales in the three and nine months ended September 30, 2013 increased by $6.4 million and $11.3 million, respectively, compared to the three and nine months ended September 30, 2012.  Cost of sales as a percentage of revenue increased by 23 and 15 percentage points for the three and nine months ended September 30, 2013, respectively, compared to the same periods in the prior year.  The increase in cost of sales in 2013 primarily reflected higher material costs associated with increased product sales and higher support costs for increased customer support and professional services personnel. The increase also reflected amortization of developed technology intangible assets acquired as part of the Vineyard acquisition in January 2013 of $0.3 million and $0.8 million in the three and nine months ended September 30, 2013, respectively.  The increase in cost of sales as a percentage of revenue primarily reflected a higher proportion of hardware sales, including greater chasis-based hardware sales in the three and nine months ended September 30, 2013 as compared to the corresponding periods of 2012. Stock-based compensation recorded to cost of sales in the three and nine months ended September 30, 2013 was $0.1 million and $0.3 million, respectively, compared to $34,000 and $0.1 million, respectively, in the corresponding periods of 2012.

Gross Profit

Gross profit for the three and nine months ended September 30, 2013 and 2012 was as follows (in thousands, except percentages):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
Decrease
 
2013
 
2012
 
Decrease
 
 
 
   
   
   
   
   
 
Gross profit
 
$
10,357
   
$
11,521
     
10
   
$
28,450
   
$
29,431
     
3
 
Percent of total net revenue
   
49
%
   
72
%
           
53
%
   
68
%
       

23

Our total gross profit margin for the three and nine months ended September 30, 2013 decreased by 23 and 15 percentage points to 49% and 53%, respectively, compared to 72% and 68% for the three and nine months ended September 30, 2012, respectively.  The decrease resulted from a higher proportion of hardware sales, particularly chasis-based hardware sales in the three and nine months ended September 30, 2013, higher support and service costs and amortization of acquired intangible assets.  We expect our gross profit margin to increase in the remaining quarter of the fiscal year ending December 31, 2013, as compared with the third quarter of 2013.

Operating Expenses

Operating expenses for the three and nine months ended September 30, 2013 and 2012 were as follows (in thousands, except percentages):

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
Increase
 
2013
 
2012
 
Increase
 
 
 
 
 
 
 
 
Research and development
 
$
3,945
   
$
1,931
     
104
%
 
$
12,532
   
$
5,414
     
131
%
Sales and marketing
   
7,322
     
4,573
     
60
%
   
21,293
     
13,053
     
63
%
General and administrative
   
2,510
     
2,386
     
5
%
   
9,498
     
6,823
     
39
%
Total
 
$
13,777
   
$
8,890
     
55
%
 
$
43,323
   
$
25,290
     
71
%

In the three and nine months ended September 30, 2013, our total operating expenses increased to support the scale of our operations as we hired additional employees in each function of our Company, invested in testing equipment for the development of our products, invested in infrastructure, and increased the use of outside services, including legal, audit and accounting services. Additionally, our costs have increased due to the integration of Vineyard personnel and related operating costs.

We anticipate that our operating expenses will continue to increase in subsequent periods and that total operating expenses for the remaining quarter of the year ending December 31, 2013 will exceed those incurred during the third quarter of 2013.

Research and Development

Research and development expenses include costs associated with personnel focused on the development or improvement of our products, prototype materials, initial product certifications, testing equipment and software costs.  Research and development costs include sustaining and enhancement efforts for products already released and development costs associated with planned new products.  Research and development expenses for the three and nine months ended September 30, 2013 and 2012 were as follows (in thousands, except percentages):

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
Increase
 
2013
 
2012
 
Increase
 
 
 
 
 
 
 
 
Research and development
 
$
3,945
   
$
1,931
     
104
%
 
$
12,532
   
$
5,414
     
131
%
As a percentage of net revenue
   
18
%
   
12
%
           
23
%
   
13
%
       

Research and development expenses for the three and nine months ended September 30, 2013 increased by $2.0 million and $7.1 million, respectively, compared to the three and nine months ended September 30, 2012 as a result of increased research and development personnel and the corresponding additional employee compensation costs, including the addition of Vineyard personnel, and amortization of deferred compensation of $0.8 million and $2.2 million, respectively, in the three and nine months ended September 30, 2013 associated with the Vineyard acquisition, as well as an increase in testing equipment costs.  The additional personnel are expected to allow us to enhance our core product features and functionality in order to support new sales and to achieve follow-on sales to our current customers.  Stock-based compensation recorded to research and development expenses in the three and nine months ended September 30, 2013 was $0.2 million and $0.9 million, respectively, compared with $0.1 million and $0.3 million, respectively, for the corresponding periods in 2012.  Research and development expenses as a percentage of revenue increased 6 and 10 percentage points for the three and nine months ended September 30, 2013, respectively, compared to the corresponding periods in 2012 primarily due to the addition of Vineyard employees.
24

Sales and Marketing

Sales and marketing expenses primarily include personnel costs, sales commissions and marketing expenses, such as trade shows, channel development and literature. Sales and marketing expenses for the three and nine months ended September 30, 2013 and 2012 were as follows (in thousands, except percentages):

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
Increase
 
2013
 
2012
 
Increase
 
 
 
 
 
 
 
 
Sales and marketing
 
$
7,322
   
$
4,573
     
60
%
 
$
21,293
   
$
13,053
     
63
%
As a percentage of net revenue
   
34
%
   
28
%
           
40
%
   
30
%
       

Sales and marketing expenses for the three and nine months ended September 30, 2013 increased by $2.7 million and $8.2 million, respectively, compared to the three and nine months ended September 30, 2012.  The increase reflected the addition of sales and marketing personnel as a result of the Vineyard acquisition, hiring of additional sales and marketing employees, and the corresponding higher compensation costs and higher commission costs as a result of the increase in revenue.  The increase also reflected the amortization of deferred compensation of $0.7 million and $2.1 million, respectively, and the amortization of acquired intangible assets of $0.2 million and $0.4 million, respectively, in the three and nine months ended September 30, 2013 associated with the Vineyard acquisition.  Stock-based compensation recorded to sales and marketing expenses in the three and nine months ended September 30, 2013 was $0.4 million and $1.3 million, respectively, compared with $0.3 million and $0.9 million, respectively, in the corresponding periods of 2012.  Sales and marketing expenses as a percentage of revenue increased 6 and 10 percentage points for the three and nine months ended September 30, 2013, respectively, compared to the corresponding periods in 2012 primarily due to the addition of Vineyard related costs.

General and Administrative

General and administrative expenses consist primarily of personnel and facilities costs related to our executive, finance functions and fees for professional services.  Professional services include costs for legal advice and services, accounting and tax professionals, independent auditors and investor relations. General and administrative expenses for the three and nine months ended September 30, 2013 and 2012 were as follows (in thousands, except percentages):

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
Increase
 
2013
 
2012
 
Increase
 
 
 
 
 
 
 
 
General and administrative
 
$
2,510
   
$
2,386
     
5
%
 
$
9,498
   
$
6,823
     
39
%
As a percentage of net revenue
   
12
%
   
15
%
           
18
%
   
16
%
       

General and administrative expenses for the three and nine months ended September 30, 2013 increased by $0.1 million and $2.7 million, respectively, compared to the three and nine months ended September 30, 2012, reflecting increased accounting and human resource personnel related costs, legal and audit fees and increased use of contractors and outside services. The increase also reflects $1.6 million in business development costs for legal, accounting and investment banking fees in the nine months ended September 30, 2013 compared to $0.6 million in business development costs in the nine months ended September 30, 2012 associated with completed and potential mergers, acquisitions and partnership agreements. Stock-based compensation recorded to general and administrative expense in the three and nine months ended September 30, 2013 was $0.4 million and $1.3 million, respectively, compared to $0.4 million and $0.9 million, respectively, in the corresponding periods in 2012.  General and administrative expenses as a percentage of revenue decreased 3 percentage points and increased 2 percentage points for the three and nine months ended September 30, 2013, respectively, compared to the corresponding periods in 2012.  The decrease as a percentage of revenue in the three months ended September 30, 2013 resulted from a smaller 5% increase in general and administrative expenses, as compared with a 33% increase in revenue.  The increase as a percentage of revenue for the nine months ended September 30, 2013 reflected additional personnel, professional services and business development costs, which resulted in general and administrative expenses increasing at a faster rate than revenue in the nine month period.
25

Interest and Other Income (Expense), Net

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
Increase
 
2013
 
2012
 
Increase
 
 
($ in thousands)
 
 
($ in thousands)
 
 
 
 
 
 
 
 
 
Interest and other income (expense), net
 
$
232
   
$
161
     
44
%
 
$
203
   
$
108
     
88
%

Interest and other income (expense), net increased in the three and nine months ended September 30, 2013 compared to the three and nine months ended September 30, 2012.  The increase in the three months ended September 30, 2013 reflected higher foreign currency gains partially offset by lower interest income.  The increase in the nine months ended September 30, 2013 reflected relatively flat interest income offset by lower forign currency losses.

Provision for Income Taxes

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
Change
 
2013
 
2012
 
Change
 
 
($ in thousands)
 
 
($ in thousands)
 
 
 
 
 
 
 
 
 
Provision for income taxes
 
$
(205
)
 
$
29
     
(807
)%
 
$
(1,688
)
 
$
141
     
(1297
)%

We are subject to taxation primarily in the U.S., Australia, Canada, Japan, Singapore and Sweden as well as in a number of U.S. states, including California.  The tax benefit for the three and nine months ended September 30, 2013 primarily reflects the following Vineyard acquisition related items: amortization of intangible assets acquired and the tax impact of book/tax differences on deferred revenue.  The tax benefit for the nine months ended September 30, 2013 also included the reversal of Vineyard’s pre-existing income tax valuation allowance upon acquisition.

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

Liquidity and Capital Resources

Cash, Cash Equivalents and Investments

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

 
Nine Months Ended
 
 
September 30,
 
 
2013
   
2012
 
 
($ in thousands)
 
Net cash provided by (used in) operating activities
 
$
(10,751
)
 
$
7,587
 
Net cash provided by (used in) investing activities
   
57,142
     
(80,445
)
Net cash provided by (used in) financing activities
   
(69
)
   
91,050
 
Effect of exchange rate changes on cash and cash equivalents
   
(117
)
   
55
 
Net increase in cash and cash equivalents
 
$
46,205
   
$
18,247
 

During the nine months ended September 30, 2013, we used $10.8 million in cash from operating activities as compared to $7.6 million generated from operating activities for the nine months ended September 30, 2012.  Cash used by operating activities during the nine months ended September 30, 2013 primarily consisted of our net loss of $13.0 million and net working capital uses of cash of $8.3 million, offset by non-cash charges of $10.5 million. Non-cash charges consisted primarily of stock-based compensation of $3.8 million, amortization of intangible assets of $1.2 million, amortization of premium on investments of $0.8 million, depreciation expense of $1.3 million and amortization of deferred compensation of $4.3 million, partially offset by changes in deferred taxes of $1.6 million. Working capital uses of cash consisted primarily of an increase in inventory of $6.4 million resulting from material purchases in anticipation of future sales, an increase in accounts receivable of $3.2 million resulting from higher sales, an advance payment to escrow of $2.7 million recorded as deferred compensation related to retention agreements with Vineyard’s three founders which are payable after one year of continuous employment with the Company and a decrease in accounts payable of $1.2 million associated with payments on inventory purchases.  Working capital sources of cash included a decrease in prepaid expenses and other current assets of $2.2 million primarily resulting from the receipt of a tax credit, an increase in accrued liabilities of $0.5 million as a result of higher accrued commissions and bonuses on the higher level of sales, and a $2.6 million increase in deferred revenues as a result of our expanding customer base.
26

Net cash provided by investing activities of $57.2 million during the nine months ended September 30, 2013 consisted of proceeds from net purchases, sales and maturities of short-term investments of $68.3 million, partially offset by net cash consideration associated with the acquisition of Vineyard of $9.0 million, and purchases of lab and testing equipment for use in research and development of $2.2 million.

Net cash used in financing activities of $0.1 million during the nine months ended September 30, 2013 consisted of the repayment of debt acquired from Vineyard of $0.5 million, offset by proceeds from the exercise of stock options of $0.4 million.

Our cash, cash equivalents and short-term investments at September 30, 2013 consisted of bank deposits with third party financial institutions, money market funds, U.S. agency securities, commercial paper and corporate bonds.  Our investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relationship to our investment guidelines and market conditions.  Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase.  Short-term investments generally have a remaining maturity of greater than three months at the date of purchase and the portfolio of short-term investments have a weighted-average maturity of less than one year.  All investments are classified as available for sale.
  
In January 2013, we acquired Vineyard in Kelowna, Canada.  The aggregate total consideration of approximately $20.9 million consisted of $9.8 million in cash and 825,060 shares of our common stock.  In addition to the purchase consideration, we have recorded deferred compensation of $5.9 million, consisting of approximately $2.7 million in cash consideration and $3.2 million in our common stock, related to retention agreements with Vineyard’s three founders, which will be disbursed from the escrow account after one year of continuous employment with the Company.

On December 10, 2009, we entered into a two-year loan and security agreement for a secured credit facility of $2.0 million for short-term working capital purposes with Silicon Valley Bank.  Borrowings under the facility bore interest at the prime rate plus 1%, but not less than 5% per annum.  On February 3, 2012, the agreement was amended and restated to increase the credit facility from $2.0 million to $10.0 million for an additional two-year period beginning on that date.  Borrowings under the amended and restated credit facility bear interest at the prime rate plus 1%, but not less than 4.25% on an annual basis.  At September 30, 2013, we had no borrowings outstanding under this credit facility.

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

Off-Balance Sheet Arrangements

As of September 30, 2013, we had no off-balance sheet items as described by Item 303(a)(4) of Regulation S-K.  We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligations under a variable interest in an unconsolidated entity that provide us with financing, liquidity, market risk or credit risk support.

Contractual Obligations

We lease facility space under non-cancelable operating leases in California and Sweden that extend through 2018. The details of these contractual obligations are further explained in Note 12 of the Notes to Condensed Consolidated Financial Statements.

We use third-party contract manufacturers to assemble and test our hardware products.  In order to reduce manufacturing lead-times and ensure an adequate supply of inventories, our agreements with some of these manufacturers allow them to procure long lead-time component inventory based on rolling production forecasts provided by us.  We may be contractually obligated to purchase long lead-time component inventory procured by certain manufacturers in accordance with our forecasts.  In addition, we issue purchase orders to our third-party manufacturers that may not be cancelable at any time.  As of September 30, 2013, we had open non-cancelable purchase orders amounting to approximately $10.3 million, primarily with our third-party contract manufacturers.
27

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Foreign Currency Risk

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

Interest Rate Sensitivity

We had unrestricted cash, cash equivalents and short term investments totaling approximately $108.9 million at September 30, 2013.  Cash equivalents and short-term investments are composed of money market funds, U.S. agency securities, commercial paper and corporate bonds.  Our investment policy requires investments to be of high credit quality, primarily rated A/A2, with the objective of minimizing the potential risk of principal loss.  Short-term investments generally have an effective maturity of less than one year and are classified as available-for sale and, consequently, are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income (loss).  Because of the short weighted-average maturity of our investment portfolio at September 30, 2013, we believe that the fair value of our investment portfolio would not be significantly impacted by either a hypothetical 100 basis point increase or decrease in market interest rates.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

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

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

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the period ended September 30, 2013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
28

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

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

Item 1A. Risk Factors

We have marked with an asterisk (*) those risk factors below that reflect material changes from the risk factors included in our Annual Report on Form 10-K for the year ended December 31, 2012, filed with the Securities and Exchange Commission (the “SEC”) on March 15, 2013.

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

Risks Related to Our Business

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

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

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

successfully introducing new products and entering new markets;

successfully servicing and upgrading new products once introduced;

increasing brand recognition;

developing strategic relationships and alliances;

managing expanding operations and sales channels;

successfully responding to competition; and

attracting, retaining and motivating qualified personnel.

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

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

From time to time, we may release guidance in our earnings releases, earnings conference calls or otherwise, regarding our future performance that represents our management’s estimates as of the time of release of the guidance.  Any such guidance, which will include forward-looking statements, will be based on projections prepared by our management.
29

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

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

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

A substantial majority of our current revenues and much of our anticipated future growth depend on the development, introduction and market acceptance of new and enhanced products in our PacketLogic product line that address additional market requirements in a timely and cost-effective manner.  In the past, we have experienced delays in product development and such delays may occur in the future.  We do not currently have plans or resources to develop additional product lines and, as a result, our future growth will largely be determined by market acceptance and continued development of our PacketLogic product line.

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

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

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

Due to our lengthy sales cycle, particularly to larger customers, and our revenue recognition practices, we expect our revenue may fluctuate significantly from period to period. In pursuing sales opportunities with larger enterprises, we expect that we will make fewer sales to larger entities, but that the magnitude of individual sales will be greater.  We may report substantial revenue growth in the period that we recognize the revenue from a large sale, which may not be repeated in an immediately subsequent period.  Because our revenues may fluctuate materially from period to period, the price of our common stock may decline. In addition, even after we have received commitments from a customer to purchase our products, in accordance with our revenue recognition practices, we may not be able to recognize and report the revenue from that purchase for months or years after the time of purchase. As a result, there could be significant delays in our receipt and recognition of revenue following sales orders for our products.
30

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

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

*A failure to manage inventories thus incurring excess inventory or shortages could result in decreased revenue and gross margins and harm our business.

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

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

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

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

For the three months ended September 30, 2013, revenue from two customers represented 33% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2013, revenue from Shaw Communications, Inc. represented 13% of net revenue, and two other customers represented 13% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the three months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 16% and 24% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 17% and 10% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  The proportion of our revenue derived from a limited number of customers may be even higher in any future year or quarter.  If we cannot maintain or replace the customers that purchase large amounts of our products, if our customers do not place follow-on orders, or if they do not purchase products at the levels or at the times that we anticipate, or successfully negotiate higher discounts, our ability to maintain or grow our revenue will be adversely affected.
31

*Changes in customer or product mix, downward pressure on sales prices, changes in volume of orders and other factors could cause our gross margin percentage to fluctuate or decline in the future.
 
Our gross profit margins have fluctuated from period to period, and these fluctuations are expected to continue in the future. Within the last two years, our gross profit margin has fluctuated from 49% in the quarter ended September 30, 2013 to 72% in the quarter ended September 30, 2012. Factors that may cause our gross margins to fluctuate include customer and product mix, market acceptance of our new products, competitive pricing dynamics, geographic and/or market segment pricing strategies, decreases in average selling prices of our products, our ability to successfully develop new products, and our ability to manage manufacturing, labor and materials cost. A higher proportion of hardware sales versus software and service revenue in any period generally results in a lower gross profit margin for that period. In addition, our industry has been characterized by declining product prices over time, and we are under continuous pressure to reduce our prices to increase or even maintain our market share. Forecasting our gross margins is difficult due to our lengthy sales cycle, particularly to larger customers, and our revenue recognition practices. Because our gross profit margins may fluctuate materially from period to period, or decline over time, the price of our common stock may decline.

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

We seek to manage our growth so as not to exceed our available capital resources.  If our customer base and market grow rapidly, we would need to expand to meet this demand.  This expansion could place a significant strain on our management, products and support operations, sales and marketing personnel and other resources, which could harm our business.

If demand for our products and services grows rapidly, we may experience difficulties meeting the demand. For example, the installation and use of our products require customer training.  If we are unable to provide adequate training and support for our products, the implementation process will be longer and customer satisfaction may be lower.  In addition, we may not be able to exploit fully the growing market for our products and services, and our competitors may be better able to satisfy this demand.  We cannot assure you that our systems, procedures or controls will be adequate to support the anticipated growth in our operations.  The failure to meet the challenges presented by rapid customer and market expansion could cause us to miss sales opportunities and otherwise have a negative impact on our sales and profitability.

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

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

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

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

integrating the operations and technologies of the two companies;

retaining and assimilating the key personnel of each company;

retaining existing customers of both companies and attracting additional customers;

leveraging our existing sales channels to sell new products into new markets;

developing an appropriate sales and marketing organization and sales channels to sell new products into new markets;
32

retaining strategic partners of each company and attracting new strategic partners; and

implementing and maintaining uniform standards, internal controls, processes, procedures, policies and information systems.

The process of integrating operations and technology could cause an interruption of, or loss of momentum in, our business and the loss of key personnel.  The diversion of management’s attention and any delays or difficulties encountered in connection with an acquisition and the integration of our operations and technology could have an adverse effect on our business, results of operations or financial condition.  Furthermore, the execution of these post-transaction integration activities will involve considerable risks and may not come to pass as we envision.  The inability to integrate the operations, technology and personnel of an acquired business with ours, or any significant delay in achieving integration, could have a material adverse effect on results of operations and financial condition and, as a result, on the market price of our common stock.

We may not achieve the desired benefits from our acquisitions, including the revenue and other synergies and growth that we anticipate from the acquisition in the timeframe that we originally expect, and the costs of achieving these benefits may be higher than what we originally had anticipated because of a number of risks, including but not limited to the possibility that the acquisition may not further our business strategy as we expected and the possibility that we may not be able to expand the reach and customer base for current and future products as expected.  As a result of these risks, our acquisitions may not immediately contribute to our earnings as expected, or at all, we may not achieve expected revenue synergies or realization of efficiencies related to the integration of the businesses when expected, or at all, and we may not achieve the other anticipated strategic and financial benefits of the acquisitions.

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

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