Stock-Based Compensation

Overview

We issue stock-based awards to certain of our employees and our Board of Directors pursuant to our 2000 Stock Incentive Plan, as amended, (the “Plan”) and our 2001 Employee Stock Purchase Plan (the “ESPP”) and recognize related stock-based compensation for both equity and liability-classified stock-based awards in our consolidated financial statements. The Plan provides for the granting to employees and consultants of Comtech (including prospective employees and consultants): (i) incentive and non-qualified stock options, (ii) restricted stock units (“RSUs”), (iii) RSUs with performance measures (which we refer to as “performance shares”), (iv) restricted stock, (v) stock units (reserved for issuance to non-employee directors) and share units (reserved for issuance to employees) (collectively, “share units”) and (vi) stock appreciation rights (“SARs”), among other types of awards. Our non-employee directors are eligible to receive non-discretionary grants of stock-based awards, subject to certain limitations. The aggregate number of shares of common stock which may be issued, pursuant to the Plan, may not exceed 8,962,500. Stock options granted may not have a term exceeding ten years or, in the case of an incentive stock award granted to a stockholder who owns stock representing more than 10.0% of the voting power, no more than five years. We expect to settle all outstanding awards under the Plan and ESPP with new shares.

As of July 31, 2014, we had granted stock-based awards pursuant to the Plan representing the right to purchase and/or acquire an aggregate of 7,024,007 shares (net of 2,783,766 expired and canceled awards), of which an aggregate of 4,711,014 have been exercised or converted into common stock, substantially all of which related to stock options.

As of July 31, 2014, the following stock-based awards, by award type, were outstanding:



	July 31, 2014
Stock options	2,132,896
Performance shares	121,163
RSUs and restricted stock	51,171
Share units	7,763
Total	2,312,993

Our ESPP, approved by our shareholders on December 12, 2000, provides for the issuance of 675,000 shares of our common stock. Our ESPP is intended to provide our eligible employees the opportunity to acquire our common stock at 85% of fair market value at the date of issuance. Through July 31, 2014, we have cumulatively issued 554,743 shares of our common stock to participating employees in connection with our ESPP.

Stock-based compensation for awards issued is reflected in the following line items in our Consolidated Statements of Operations:



	Fiscal Years Ended July 31,
	2014			2013		2012
Cost of sales	$	252,000		174,000		284,000
Selling, general and administrative expenses	3,403,000			2,470,000		2,716,000
Research and development expenses	608,000			486,000		572,000
Stock-based compensation expense before income tax benefit	4,263,000			3,130,000		3,572,000
Estimated income tax benefit	(1,550,000		)	(1,198,000	)	(1,308,000	)
Net stock-based compensation expense	$	2,713,000		1,932,000		2,264,000

Stock-based compensation for equity-classified awards is measured at the date of grant, based on an estimate of the fair value of the award and is generally expensed over the vesting period of the award. At July 31, 2014, unrecognized stock-based compensation of $8,829,000, net of estimated forfeitures of $544,000, is expected to be recognized over a weighted average period of 3.0 years. Total stock-based compensation capitalized and included in ending inventory at July 31, 2014 and 2013 was $68,000 and $72,000, respectively. There are no liability-classified stock-based awards outstanding as of July 31, 2014. Included in accrued expenses at July 31, 2013 was $1,000 relating to the potential cash settlement of liability-classified SARs.

Stock-based compensation expense, by award type, is summarized as follows:



	Fiscal Years Ended July 31,
	2014			2013		2012
Stock options	$	2,752,000		2,400,000		3,279,000
Performance shares	976,000			382,000		52,000
ESPP	184,000			189,000		232,000
RSUs and restricted stock	293,000			140,000		13,000
Share units	41,000			24,000		12,000
Equity-classified stock-based compensation expense	4,246,000			3,135,000		3,588,000
Liability-classified stock-based compensation expense (benefit) (SARs)	17,000			(5,000	)	(16,000	)
Stock-based compensation expense before income tax benefit	4,263,000			3,130,000		3,572,000
Estimated income tax benefit	(1,550,000		)	(1,198,000	)	(1,308,000	)
Net stock-based compensation expense	$	2,713,000		1,932,000		2,264,000

ESPP stock-based compensation expense primarily relates to the 15% discount offered to employees participating in the ESPP.

The estimated income tax benefit, as shown in the above table, was computed using income tax rates expected to apply when the awards are settled and results in a deferred tax asset which is netted in our long-term deferred tax liability in our Consolidated Balance Sheet. The actual income tax benefit recognized for tax reporting is based on the fair market value of our common stock at the time of settlement and can significantly differ from the estimated income tax benefit recorded for financial reporting.

The following table reconciles the actual tax benefit recognized for tax deductions relating to the settlement of stock-based awards to the excess income tax benefit reported as a cash flow from financing activities in our Consolidated Statements of Cash Flows:



	Fiscal Years Ended July 31,
	2014		2013		2012
Actual income tax benefit recorded for the tax deductions relating to the settlement of stock-based awards	$	2,339,000	$	420,000	$	438,000
Less: Tax benefit initially recognized on settled stock-based awards vesting subsequent to the adoption of accounting standards that require us to expense stock-based awards	1,540,000		155,000		197,000
Excess income tax benefit recorded as an increase to additional paid-in capital	799,000		265,000		241,000
Less: Tax benefit initially disclosed but not previously recognized on settled equity-classified stock-based awards vesting prior to the adoption of accounting standards that require us to expense stock-based awards	61,000		—		10,000
Excess income tax benefit from settled equity-classified stock-based awards reported as a cash flow from financing activities in our Consolidated Statements of Cash Flows	$	738,000	265,000		231,000

As of July 31, 2014 and 2013, the amount of hypothetical tax benefits related to stock-based awards, recorded as a component of additional paid-in-capital, was $17,574,000 and $19,981,000, respectively. These amounts represent the initial hypothetical tax benefit of $8,593,000 determined upon adoption of ASC 718 (which reflects our estimate of cumulative actual tax deductions for awards issued and settled prior to the August 1, 2005), adjusted for actual excess income tax benefits or shortfalls since that date. During fiscal 2014, 2013 and 2012, we recorded $2,407,000, $2,805,000 and $1,332,000, respectively, as a net reduction to additional paid-in capital and accumulated hypothetical tax benefits, which primarily represents the reversal of unrealized deferred tax assets associated with certain vested equity-classified stock-based awards that expired during the respective periods.

Stock Options

The following table summarizes the Plan's activity (including SARs):



	Awards (in Shares)		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (Years)	Aggregate Intrinsic Value
Outstanding at July 31, 2011	3,580,168		$	31.86
Granted	423,528		29.24
Expired/canceled	(390,148	)	35.71
Exercised	(155,145	)	20.64
Outstanding at July 31, 2012	3,458,403		31.61
Granted	296,525		26.07
Expired/canceled	(616,135	)	39.96
Exercised	(90,883	)	13.01
Outstanding at July 31, 2013	3,047,910		29.94
Granted	458,110		29.14
Expired/canceled	(492,060	)	42.90
Exercised	(881,064	)	26.55
Outstanding at July 31, 2014	2,132,896		$	28.17	6.72	$	12,003,000

Exercisable at July 31, 2014	949,254		$	27.99	4.91	$	5,519,000

Vested and expected to vest at July 31, 2014	2,070,258		$	28.17	6.69	$	11,664,000

Stock options outstanding as of July 31, 2014 have exercise prices ranging between $13.19 - $34.15. The total intrinsic value relating to stock options exercised during the fiscal years ended July 31, 2014, 2013 and 2012 was $6,464,000, $1,272,000 and $1,654,000, respectively. Stock options granted during the fiscal years ended July 31, 2014, 2013 and 2012 had exercise prices equal to the fair market value of our common stock on the date of grant, a contractual term of five or ten years and a vesting period of three or five years. There were no SARs granted during the prior three fiscal years. The total intrinsic value relating to 7,000 SARs exercised during fiscal 2014 was $18,000 and there were no SARs exercised during fiscal 2013 and 2012.

During fiscal 2014, at the election of certain holders of vested stock options, 618,970 stock options were net settled upon exercise. As a result, 79,890 net shares of our common stock were issued after reduction of shares retained to satisfy the exercise price and minimum statutory tax withholding requirements. There were no net settlements in fiscal 2013 or 2012.

The estimated per-share weighted average grant-date fair value of stock options granted during fiscal 2014, 2013 and 2012 was $5.35, $4.45 and $6.53, respectively, and was determined using the Black-Scholes option pricing model, and included the following weighted average assumptions:



	Fiscal Years Ended July 31,
	2014		2013		2012
Expected dividend yield	3.94	%	4.22	%	3.76	%
Expected volatility	30.36	%	30.09	%	36.63	%
Risk-free interest rate	1.47	%	1.02	%	0.64	%
Expected life (years)	5.32		5.39		5.29

Expected dividend yield is the expected annual dividend as a percentage of the fair market value of our common stock on the date of grant, based on our Board's annual dividend target at the time of grant, which was increased from $1.10 per share to $1.20 per share during fiscal 2014. The expected dividend yield was $1.10 per share for grants in 2013 and 2012. We estimate expected volatility by considering the historical volatility of our stock, the implied volatility of publicly-traded call options on our stock, the implied volatility of call options embedded in our 3.0% convertible senior notes (prior to their settlement) and our expectations of volatility for the expected life of stock options. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for an instrument which closely approximates the expected term. The expected term is the number of years we estimate that awards will be outstanding prior to exercise and is determined by employee groups with sufficiently distinct behavior patterns. Assumptions used in computing the fair value of stock-based awards reflect our best estimates, but involve uncertainties relating to market and other conditions, many of which are outside of our control. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by recipients of stock-based awards.

Performance Shares, RSUs, Restricted Stock and Share Unit Awards

The following table summarizes the Plan's activity relating to performance shares, RSUs, restricted stock and share units:



	Awards (in Shares)		Weighted Average Grant Date Fair Value		Aggregate Intrinsic Value
Outstanding at July 31, 2012	48,081		$	26.28
Granted	54,253		25.37
Outstanding at July 31, 2013	102,334		25.80
Granted	95,326		26.48
Converted to common stock	(7,857	)	26.18
Forfeited	(9,706	)	24.83
Outstanding at July 31, 2014	180,097		$	26.20	$	6,087,000

Vested at July 31, 2014	18,662		$	26.97	$	631,000

Vested and expected to vest at July 31, 2014	174,574		$	26.21	$	5,901,000

The total intrinsic value relating to fully-vested awards converted into our common stock during the fiscal year ended July 31, 2014 was $220,000. Performance shares granted to employees prior to fiscal 2014 vest over a 5.3 year period, beginning on the date of grant if pre-established performance goals are attained, and are convertible into shares of our common stock generally at the time of vesting, on a one-for-one basis for no cash consideration. The performance shares granted to employees during fiscal 2014 principally vest over a three year performance period that ends on July 31, 2016, if pre-established performance goals are attained or as specified pursuant to the Plan and related agreement. As of July 31, 2014, the number of outstanding performance shares included in the above table, and the related compensation expense, primarily assume achievement of the pre-established goals at a target level. On September 23, 2014, our Board of Directors determined that the pre-established performance goals for performance shares granted in fiscal 2013 had been attained, and as a result, the first tranche of 5,568 performance shares vested and converted into 4,149 shares of our common stock, after reduction of shares retained to satisfy deferral requirements.

RSUs and restricted stock granted to non-employee directors have a vesting period of three years and are convertible into shares of our common stock generally at the time of termination, on a one-for-one basis for no cash consideration, or earlier under certain circumstances. RSUs granted to employees have a vesting period of five years and are convertible into shares of our common stock generally at the time of vesting, on a one-for-one basis for no cash consideration.

Share units are vested when issued and are convertible into shares of our common stock generally at the time of termination, on a one-for-one basis for no cash consideration, or earlier under certain circumstances. No share units granted to date have been converted into common stock.

The fair value of performance shares, RSUs, restricted stock and share units is determined using the closing market price of our common stock on the date of grant, less the present value of any estimated future dividend equivalents such awards are not entitled to receive. RSUs and performance shares granted in fiscal 2012 are not entitled to dividend equivalents. RSUs, performance shares and restricted stock granted in fiscal 2013 and 2014 are entitled to dividend equivalents unless forfeited before vesting occurs; however, performance shares granted in fiscal 2013 were not entitled to such dividend equivalents until our Board of Directors determined that the pre-established performance goals were met. Share units granted in fiscal 2014 are entitled to dividend equivalents while the underlying shares are unissued.

Dividend equivalents are subject to forfeiture, similar to the terms of the underlying stock-based awards, and are payable in cash generally at the time of conversion of the underlying shares into our common stock. During fiscal 2014, we accrued $113,000 of dividend equivalents, which was recorded as a reduction to retained earnings, and paid out $4,000. There were no dividend equivalents paid prior to fiscal 2014. As of July 31, 2014 and July 31, 2013, accrued dividend equivalents were $116,000 and $7,000, respectively.

Stock-Based Awards Granted Subsequent to July 31, 2014

In August 2014, our Board of Directors authorized the issuance of 250,000 non-qualified stock options and 60,000 performance shares, respectively, to certain officers and key employees. The stock options vest over a five year period and have a ten year contractual term. The performance shares were granted at a target level and vest if the pre-established performance goals are met at the end of the performance periods, at a minimum of a "threshold" level, and the employee remains employed through the date that the Board of Directors determines achievement of the performance goals, or as specified pursuant to the Plan and related agreements. Total unrecognized compensation expense related to such awards, net of estimated forfeitures and assuming achievement of the pre-established performance goals at a target level, approximated $3,346,000.