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MERU > SEC Filings for MERU > Form 10-K on 20-Mar-2013All Recent SEC Filings

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Form 10-K for MERU NETWORKS INC


20-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section entitled "Risk Factors" included elsewhere in this Form 10-K.

Overview

We provide a virtualized wireless LAN solution that is designed to cost-effectively optimize the enterprise network to deliver the performance, reliability, predictability and operational simplicity of a wired network, with the advantages of mobility. Our solution represents an innovative approach to wireless networking that utilizes virtualization technology to create an intelligent and self-monitoring wireless network. We sell a virtualized wireless LAN solution built around our System Director Operating System, which runs on our controllers and access points. We also offer additional products designed to deliver centralized network management, predictive and proactive diagnostics and enhanced security.

We were founded in January 2002 with the vision of developing a virtualized wireless LAN solution that enables enterprises to deliver business-critical applications over wireless networks, and become what we refer to as All-Wireless Enterprises. From our inception through 2003, we were principally engaged in the design and development of our virtualized wireless LAN solution. We focused on developing technology that could reliably and predictably deliver business-critical applications using voice, video and data over wireless networks in dense environments. We began commercial shipments of our products in December 2003, and initially targeted markets where the wireless delivery of applications in dense environments is critical, such as healthcare and education. Since that time, we have broadened our focus to include organizations in more markets, and have significantly expanded our geographic reach. To date, our products have been deployed by approximately 7,400 customers worldwide in many markets, including education, healthcare, hospitality, manufacturing, retail, technology, finance, government, telecom, transportation and utilities.

We outsource the manufacturing of our hardware products, including all of our access points and controllers, to original design manufacturers and contract manufacturers. We also outsource the warehousing and delivery of our products to a third-party logistics provider in the United States for worldwide fulfillment.

Our products and support services are sold worldwide, primarily through value-added resellers, or VARs, and distributors, which serve as our channel partners. We employ a sales force that is


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responsible for managing sales within each geographic territory in which we market and sell our products.

Since inception, we have expended significant resources on our research and development operations. Our research and development activities were primarily conducted at our headquarters in Sunnyvale, California until 2005, when we significantly expanded our research and development operations in Bangalore, India. In 2006, we began developing products specifically to leverage the capabilities of a new wireless communication standard promulgated by the Institute of Electrical and Electronics Engineers, or IEEE, the 802.11n standard, and began commercial shipments of our 802.11n products in the second half of 2007.

We believe several emerging trends and developments will be integral to the future growth of our business. The growing number of wireless devices and the increased expectations of the users of these devices are driving demand for better performing wireless networks. Enterprises increasingly view wireless networks as a means to deliver better service to their customers and increase the productivity of their workforce, and as a result, they are shifting from the casual use of wireless networks to the strategic use of wireless networks for business-critical applications. Further, enterprises are increasingly realizing that wireless networks designed to optimize the 802.11n standard and the planned 802.11ac standard can deliver the capacity and performance to support their business-critical applications.

Our ability to capitalize on emerging trends and developments will depend, in part, on our ability to execute our growth strategy of increasing the recognition of our brand and the effectiveness of our solution, expanding the adoption of our solution across markets, and expanding and leveraging our relationships with the channel partners. We continue to evolve our entire organization to further capitalize on growth opportunities.

On March 18, 2012, our board of directors appointed Dr. Bami Bastani, who previously served as the president, chief executive officer, and board member of companies in the mobility, consumer, and broadband markets, as our president and CEO, and a member of our board of directors. Our ability to achieve and maintain profitability as well as our other goals in the future will be affected by, among other things, the continued acceptance of our products, the timing and size of our orders, the average selling prices for our products and services, the costs of our products, and the extent to which we invest in our sales and marketing, research and development, and general and administrative resources.

Our revenues have grown from $1.1 million in 2005 to $97.5 million in 2012. It is difficult to predict our revenues in the near term. Our revenues have in the past fluctuated significantly, and may continue to fluctuate in the future. Further, our revenues during any given quarter depend on multiple factors, including, but not limited to, the amount of orders booked in a prior quarter but not shipped until the given quarter, new orders received and shipped in the given quarter, the amount of deferred revenue recognized in the given quarter and the amount of revenues that meet the accounting standards for revenue recognition. These factors could impact our revenues significantly in any given quarter.

In addition, we believe that there can be significant seasonal factors that may cause the first and third quarters of our fiscal year to have relatively weaker products revenues than the second and fourth fiscal quarters. We believe that this seasonality results from a number of factors, including:


customers with a December 31 fiscal year end may choose to spend remaining budgets before their year end resulting in a positive impact on our products revenues in the fourth quarter of our fiscal year;


the structure of our direct sales compensation program may provide additional financial incentives to our sales personnel for exceeding their annual goals;


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the timing of our annual training for the entire sales force in our first fiscal quarter combined with the above fourth quarter factors can potentially cause our first fiscal quarter to be seasonally weak;


many of our education customers have procurement and deployment cycles that can result in stronger order flow in our second fiscal quarter than other quarters assuming the continued availability of traditional funding sources, such as the E-Rate program in the United States; and


seasonal reductions in business activity during the summer months in the United States, Europe and certain other regions may have a negative impact on our third quarter revenues.

We believe that our historical growth, variations in the number of orders booked in a prior quarter but not shipped until a later quarter and other variations in the amount of deferred revenues may have overshadowed the nature or magnitude of seasonal or cyclical factors that might have influenced our business to date. In addition, the timing of one or more large transactions may overshadow seasonal factors in any particular quarterly period. Seasonal or cyclical variations in our operations may become more pronounced over time and may materially affect our results of operations in the future.

We have incurred losses since inception as we grew our business and invested in research and development, sales and marketing, and administrative functions. As of December 31, 2012, we had an accumulated deficit of $253.0 million.

In April 2012, we entered into a settlement, license and release agreement with Extricom. As part of this agreement, we paid Extricom $2.4 million in 2012. In June 2011, we entered into a license agreement with Motorola and, as part of which, we paid Motorola $7.3 million in 2011.

Vendor Specific Objective Evidence

Our recognition of revenues in a particular period depends on the satisfaction of specific revenue recognition criteria, which we describe in more detail below. We adopted two new accounting standards for certain revenue arrangements at the beginning of fiscal year 2011 that include software elements and multiple deliverable revenue arrangements. The manner in which we recognize our revenues has changed significantly over time, particularly in 2008 and 2009, when we established vendor specific objective evidence of fair value, or VSOE, for our support services. These changes have had a significant impact on the timing of when we recognize revenues from sales of our products and services. Generally, upon establishing VSOE for support services for a customer or class of customers, our total recognized revenues from sales to these customers increased in subsequent periods because we were able to recognize all of the products revenues from these sales in these periods once all revenue recognition criteria were satisfied, and we were no longer required to defer the recognition of products revenues over the support period. We also continued to recognize ratable products and services revenues from sales to customers made prior to establishing VSOE for support services. This impact will decrease over time as our deferred revenue balance declines from the time we established VSOE for support services. We recognize the costs of revenues in the same period in which we recognize the associated revenues. When reviewing our financial performance and making period-to-period comparisons, you should consider the impact that the timing of the adoption of the two new accounting standards and the establishment of VSOE had on our financial results, including the amount of our revenues and costs of revenues.

Key Metrics

We monitor the key financial metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies. We discuss product revenues, support and services revenues and the components of operating income below under "Components of Revenues, Cost of Revenues and Operating Expenses"


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and we discuss our cash and cash equivalents and short-term investments under

"Liquidity and Capital Resources."

                                                            Fiscal Years or as of
                                                              Fiscal Years Ended
                                                         2012        2011        2010
                                                            (dollars in thousands)
Products revenues                                      $  80,770   $  74,279   $ 63,197
Support and services revenues                             16,561      12,957     10,479
Gross margin-products and support and services                64 %        64 %       67 %
Loss from operations(1)                                $ (28,941 ) $ (26,071 ) $ (1,718 )
Cash and cash equivalents and short-term investments      22,855      40,259     67,269
Net cash used in operating activities                    (25,370 )   (22,402 )   (2,119 )



(1) Includes stock-based compensation expense of: $ 7,549 $ 6,174 $ 3,845

Gross margin-products and support and services. We monitor gross margin to measure our cost efficiencies, including primarily whether our manufacturing costs and component costs are in line with our product revenues and our personnel costs associated with our technical support, professional services and training teams are in line with our support and services revenues.

Net cash used in operating activities. We monitor cash flow from operations as a measure of our overall business performance. Our primary uses of cash from operating activities are for personnel-related expenditures, purchases of inventory, costs related to our facilities and litigation reserve expense. Monitoring cash flow from operations enables us to analyze our financial performance without the non-cash effects of certain items such as depreciation and amortization, stock-based compensation expenses, accrued interest on long-term debt, amortization of issuance costs and warrant expense, thereby allowing us to better understand and manage the cash needs of our business.

Components of Revenues, Costs of Revenues and Operating Expenses

Revenues. We derive our revenues from sales of our products, and support and services. Our total revenues are comprised of the following:


Products Revenues-We generate products revenues from sales of our software and hardware products, which primarily consist of our System Director Operating System running our access points and controllers, as well as additional software applications.


Support and Services Revenues-We generate support and services revenues primarily from service contracts for our Meru Assure customer support program, which includes software updates, maintenance releases and patches, telephone and internet access to our technical support personnel and hardware support. We also generate support and services revenues from the professional and training services that we provide to our VARs, distributors and customers.


Ratable Products and Services Revenues-Prior to January 1, 2009, we recognized ratable products and services revenues from sales of our products and services in circumstances where VSOE for support services being provided could not be segregated from the value of the entire sales arrangement, or where we provided technical support or unspecified software upgrades outside of contractual terms. In these cases, revenues were deferred and recognized ratably over either the economic life of the product or the contractual period. As of January 1, 2009, we established VSOE for support services for all our channel partners and customers, and we no longer offer support outside of contractual terms, and therefore, we are able to recognize products revenues and support and services revenues separately.


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Deferred Revenue. Prior to establishing VSOE for our support services provided to VARs, distributors and customers, we recognized the revenues from such sales over either the economic life of the related products or the contractual support period, depending on the party and the time at which the sale occurred. As such, prior to establishing VSOE for support services sold to VARs, distributors and customers, only a small amount of our invoiced products and services within a quarter were recognized as revenues in such quarter, with the majority recorded as deferred revenue. We established VSOE for support services sold to our channel partners, including VARs, distributors and customers, at different times during 2007, 2008 and 2009. The decreases in deferred revenue due to the related recognition of ratable revenue are partially offset by the sale of support services that will be recognized over the term of the support agreements. The total deferred revenue as of December 31, 2012 and 2011 were $18.3 million and $16.2 million, respectively.

Costs of Revenues. Our total costs of revenues is comprised of the following:


Costs of Products Revenues-A substantial majority of the costs of products revenues consists of third-party manufacturing costs and component costs. Our costs of products revenues also include shipping costs, third-party logistics costs, write-offs for excess and obsolete inventory and warranty costs.


Costs of Support and Services Revenues-Costs of support and services revenues is primarily comprised of personnel costs associated with our technical support, professional services and training teams.


Costs of Ratable Products and Services Revenues-Costs of ratable products and services revenues is comprised primarily of deferred costs of products revenues and an allocation of costs of services revenues.

Operating Expenses. Our operating expenses consist of research and development, sales and marketing, general and administrative expenses and litigation reserve expense. The largest component of our operating expenses is personnel costs. Personnel costs consist of salaries, commissions, bonuses and benefits for our employees. We grant our employees and members of our board of directors equity awards and recognize stock-based compensation cost as part of operating expenses. We expect to continue to incur significant stock-based compensation expense as our employee base grows.


Research and Development Expenses. Research and development expenses primarily consist of personnel, engineering, testing and compliance, facilities and professional services costs. We expense research and development costs as incurred. We are devoting a substantial amount of our resources to the continued development of additional functionality for our existing products and the development of new products.


Sales and Marketing Expenses. Sales and marketing expenses represent the largest component of our operating expenses and primarily consist of personnel costs, sales commissions, travel costs, cost for marketing programs and facilities costs.


General and Administrative Expenses. General and administrative expenses primarily consist of personnel, professional services and facilities costs related to our executive, finance, human resource and information technology functions. Professional services consist of outside legal and accounting services and information technology consulting costs. We have incurred additional accounting and legal costs related to compliance with rules and regulations enacted by the SEC, including the additional costs of complying with Section 404 of the Sarbanes-Oxley Act, as well as additional insurance, investor relations and other costs associated with being a public company.


Litigation Reserve Expense. Litigation reserve expense consists of settlements or anticipated settlements of litigation. In 2012, the litigation reserve expense was related to the settlement,


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license and release agreement with Extricom. As part of this agreement, we paid Extricom $2.4 million and expensed the full amount in 2012. In 2011, we entered into a license agreement with Motorola and, as part of which, we agreed to pay Motorola $7.3 million and expensed the full amount in 2011. We record litigation accruals for legal matters which are both probable and estimable. For potential losses for which there is a reasonable possibility (meaning the likelihood is more than remote but less than probable) that a loss exists, we will disclose an estimate of the potential loss or range of such potential loss or include a statement that an estimate of the potential loss cannot be made.

Interest Expense, Net. For 2012, interest expense, net consists primarily of interest expense on debt and customer prompt payment discounts. For 2011 and 2010, interest expense, net consists primarily of interest expense on debt, prompt payment discounts and interest income on cash, cash equivalents and short-term investments balances. As of December 31, 2012, we had $10.1 million of outstanding debt before debt discounts.

Other Income (Expense), Net. In 2012 and 2011, other income (expense), net consists primarily of gains and losses on foreign currency transactions. In 2010, other income (expense), net consists primarily of charges to record fair value adjustments for our warrants to purchase convertible preferred stock and warrants to purchase common stock. Until the closing of our initial public offering on April 6, 2010, our outstanding warrants were classified as a liability on our consolidated balance sheets and any changes in fair value were recognized as a component of other income (expense), net.

Major Channel Partners

    We sell products and services directly to our channel partners, including
VARs and distributors. The following table sets forth our channel partners
representing greater than 10% of revenues in the periods presented (in
percentages):

                                                   Years Ended
                                                  December 31,
                    Major Channel Partners    2012    2011    2010
                    Westcon Group, Inc.          25 %    29 %    34 %
                    Siracom, Inc.                19      11       *
                    Catalyst Telecom, Inc.       13      13      12
                    Ingram Micro Inc.            11       *       *


--------------------------------------------------------------------------------
    *
    Less than 10%

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period-to-period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management's judgments and estimates.


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Revenue Recognition

Our revenues are derived primarily from hardware and software products and related support and services. We often enter into multiple deliverable arrangements and as such the elements of these arrangements are separated and valued based on their relative fair value. The majority of our products are networking communications hardware with embedded software components such that the software functions together with the hardware to provide the essential functionality of the product. Therefore, our hardware deliverables are considered to be non-software elements and are excluded from the scope of industry-specific software revenue recognition guidance. Our products revenues also include revenues from the sale of stand-alone software products. Stand-alone software products may operate on our networking communications hardware, but are not considered essential to the functionality of the hardware. Sales of stand-alone software generally include a perpetual license to our software. Sales of stand-alone software continue to be subject to the industry-specific software revenue recognition guidance. Product support typically includes software updates on a when and if available basis, telephone and internet access to our technical support personnel and hardware support. Software updates provide customers with rights to unspecified software product upgrades and to maintenance releases and patches released during the term of the support period.

Certain arrangements with multiple deliverables continued to have stand-alone software elements that are subject to the existing software revenue recognition guidance along with non-software elements that are subject to the amended revenue accounting guidance. The revenue for these multiple deliverable arrangements is allocated to the stand-alone software elements as a group and the non-software elements based on the relative selling prices of all of the elements in the arrangement using the fair value hierarchy in the amended revenue accounting guidance.

For sales of stand-alone software after December 31, 2010 and for all transactions entered into prior to January 1, 2011, we recognize revenue based on software revenue recognition guidance. Under the software revenue recognition guidance, we use the residual method to recognize revenue when a product agreement includes one or more elements to be delivered at a future date and VSOE of all undelivered elements exists. We establish VSOE for these arrangements based on sales of multi-year support services arrangements on a stand-alone basis. The normal pricing for multi-year support services arrangements was based on the normal price of a one year support services arrangement multiplied by the number of years of support services which was then adjusted for the time value of money and the decreased sales and fulfillment effort for support service periods of longer than one year. In the majority of our contracts, the only element that remains undelivered at the time of delivery of the product is support services. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the contract fee is recognized as products revenues. If evidence of the fair value of one or more undelivered elements does not exist, all revenue is generally deferred and recognized when delivery of those elements occurs or when fair value can be established. When the undelivered element for which we do not have VSOE is support, revenue for the entire arrangement is bundled and recognized ratably over the support period.

VSOE for elements of an arrangement is based upon the normal pricing and discounting practices for those services when sold separately. In determining VSOE, we require that a substantial majority of the selling prices for an element falls within a reasonably narrow pricing range, generally evidenced by a substantial majority of such historical stand-alone transactions falling within a reasonably narrow range of the median rates. In addition, we consider major service groups, geographies, customer classifications, and other variables in determining VSOE.

Third-party evidence of selling price, or TPE, is determined based on competitor prices for similar deliverables when sold separately. We establish estimated selling prices, or ESP, for support services based on our normal pricing and discounting practices for support services. This ESP analysis requires that a substantial majority of the support services selling prices fall within a reasonably narrow pricing . . .

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