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PKT > SEC Filings for PKT > Form 10-Q on 10-May-2013All Recent SEC Filings

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Form 10-Q for PROCERA NETWORKS INC


10-May-2013

Quarterly Report


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

The following is a discussion of our results of operations and current financial position. This discussion 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;

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

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

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 Intelligent Policy Enforcement ("IPE") solutions 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. Our solutions provide granular network intelligence intended to enable network operators to improve the quality and longevity of their networks, better monetize their network infrastructure investments, control security hazards and create and deploy new services for their users. We believe that the intelligence our products provide about users and their usage enables our network operator customers to make qualified 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.


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Our IPE products are part of the high-growth market for mobile packet and broadband core products. The market for IPE products was expected to reach $601.7 million in 2012 and is expected to grow to $1.8 billion in 2016, a 2011-2016 compounded annual growth rate of 30.4%. 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 products are marketed under the PacketLogic and Network Application Visibility Library ("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 customer.

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 (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 our hardware and application based software based IPE and DPI solutions, as well as expanding the way we sell solutions to customers, and therefore expanding our customer base, previously comprised primarily of network operators, allowing us to provide complementary technology and solutions to a greater number of customers.

We were incorporated in 2002 and became a public company in October 2003. 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

Our 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.

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.


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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 Months Ended March 31, 2013 and 2012

Revenue

Revenue for the three months ended March 31, 2013 and 2012 was as follows (in
thousands, except percentages):

                                       Three Months Ended
                                            March 31,
                                        2013          2012        Increase
               Net product revenue   $   10,411     $  9,829              6 %
               Net support revenue        3,760        2,503             50 %
               Total revenue         $   14,171     $ 12,332             15 %

Our revenue is derived from two sources: 1) product revenue, which includes sales of our hardware appliances bundled with software licenses, separate software licenses or 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 twelve months.

Total revenue in the three months ended March 31, 2013 was $14.2 million, an increase of 15% compared with $12.3 million in the three months ended March 31, 2012, and reflected a 6% increase in product revenue and a 50% increase in support revenue. The increase in product revenue in 2013 compared to the first quarter of 2012 reflected follow-on orders from existing customers and included increased sales to our newer network operator customers, including mobile service providers, fixed line service providers, and cable multiple system operators; and we continued to add new higher education customers. The increase in product revenue also continued to reflect increased sales of our mid-range PL8000 series products. Vineyard contributed $0.2 million in product and $0.2 million in support revenue for the three months ended March 31, 2013. The increase in support revenue in 2013 compared to the first quarter of 2012 reflected the continued expansion of the installed base of our product to which we have sold ongoing support services. In the three months ended March 31, 2013, sales to two customers, Cox Communications, Inc. and Shaw Communications, Inc., represented 22% and 17% of total net revenues, respectively. In the three months ended March 31, 2012, sales to three customers, Shaw Communications, Inc., Cox Communications, Inc. and a third customer, represented 21%, 20% and 12% of total net revenues, respectively.

Sales to customers located in the Americas as a percentage of total revenues were 59% and 62% for the three months ended March 31, 2013 and 2012, respectively.

We believe that our revenue will continue to grow in each of the remaining quarters of the fiscal year ending December 31, 2013, as compared with 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 months ended March 31, 2013 and 2012 (in thousands, except percentages):

                                             Three Months Ended
                                                  March 31,
                                              2013          2012       Increase
          Product costs                    $    6,087      $ 3,447            77 %
          Percent of net product revenue           58 %         35 %

          Support costs                           715          222           222 %
          Percent of net support revenue           19 %          9 %

          Total costs of sales             $    6,802      $ 3,669            85 %
          Percent of total net revenue             48 %         30 %


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Total cost of sales in the three months ended March 31, 2013 increased by $3.1 million compared to the three months ended March 31, 2012, and increased as a percentage of revenue by 18 percentage points. 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 $0.3 million of amortization of developed technology intangible assets acquired as part of the Vineyard acquisition in January 2013. The increase in cost of sales as a percentage of revenue primarily reflected a higher proportion of hardware sales in the first quarter of 2013. Stock-based compensation recorded to cost of sales in the three months ended March 31, 2013 and 2012 was $0.1 million and $34,000, respectively.

Gross Profit

Gross profit for the three months ended March 31, 2013 and 2012 was as follows
(in thousands, except percentages):

                                      Three Months Ended
                                           March 31,
                                                                 Increase/
                                       2013          2012       (Decrease)
               Total gross profit   $    7,369      $ 8,663            (15) %
               Total gross margin           52 %         70 %

Our total gross profit margin for the three months ended March 31, 2013 decreased by 18 percentage points to 52% compared to 70% for the three months ended March 31, 2012. The decrease resulted from a higher proportion of hardware sales in the first quarter of 2013, higher support and service costs and amortization of acquired intangible assets. We expect our gross profit margin to increase in each of the remaining quarters of the fiscal year ending December 31, 2013, as compared with the first quarter of 2013.

Operating Expense

Operating expenses for the three months ended March 31, 2013 and 2012 was as
follows (in thousands, except percentages):

                                          Three Months Ended
                                               March 31,
                                           2013          2012       Increase
           Research and development     $     4,401     $ 1,691           160  %
           Sales and marketing                6,621       4,006            65  %
           General and administrative         3,637       2,360            54  %
           Total                        $    14,659     $ 8,057            82  %

In the first three months of 2013, our total operating expenses increased to support the scale of our operations as we have 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 this trend will continue in subsequent periods and that total operating expenses for the remainder of the year ending December 31, 2013 will exceed those incurred in the year ended December 31, 2012.

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.

                                                Three Months Ended
                                                     March 31,
                                                 2013          2012       Increase
                                                 ($ in thousands)
       Research and development               $    4,401      $ 1,691           160 %
       As a percentage of total net revenue           31 %         14 %

Research and development expenses for the three months ended March 31, 2013 increased by $2.7 million compared to the three months ended March 31, 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 $0.7 million associated with the Vineyard acquisition. 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 months ended March 31, 2013 and 2012 was $0.5 million and $0.1 million, respectively.


Index

Sales and Marketing

Sales and marketing expenses primarily include personnel costs, sales
commissions and marketing expenses, such as trade shows, channel development and
literature.

                                               Three Months Ended
                                                    March 31,
                                                2013          2012        Increase
                                                ($ in thousands)
      Sales and marketing                    $    6,621      $ 4,006             65 %
      As a percentage of total net revenue           47 %         32 %

Sales and marketing expenses for the three months ended March 31, 2013 increased by $2.6 million compared to the three months ended March 31, 2012. The increase reflected the addition of sales and marketing personnel during 2012 and in the three months ended March 31, 2013, 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 the amortization of acquired intangible assets of $0.1 million associated with the Vineyard acquisition. Stock-based compensation recorded to sales and marketing expenses in the three months ended March 31, 2013 and 2012 was $0.6 million and $0.3 million, respectively.

General and Administrative

General and administrative expenses consist primarily of personnel and
facilities costs related to our executive, finance functions and service fees
for professional services. Professional services include costs for legal advice
and services, accounting and tax professionals, independent auditors and
investor relations.

                                                Three Months Ended
                                                     March 31,
                                                 2013          2012       Increase
                                                 ($ in thousands)
       General and administrative             $    3,637      $ 2,360           54  %
       As a percentage of total net revenue           26 %         19 %

General and administrative expenses for the three months ended March 31, 2013 increased by $1.3 million compared to the three months ended March 31, 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 reflected $1.0 million in business development costs for legal, accounting and investment banking fees associated with the Vineyard acquisition, compared to $0.6 million in business development costs in the three months ended March 31, 2012 associated with potential mergers, acquisitions and partnership agreements. Stock-based compensation recorded to general and administrative expense in the three months ended March 31, 2013 and 2012 was $0.4 million and $0.3 million, respectively.

Interest and Other Income (Expense), Net

                                              Three Months Ended
                                                   March 31,
                                              2013             2012
                                               ($ in thousands)
Interest and other income (expense), net   $       (50 )       $   1

Interest and other income (expense) decreased in the three months ended March 31, 2013 compared to the three months ended March 31, 2012 mainly due to higher foreign currency transaction losses from our foreign subsidiaries in the first three months of 2013 versus 2012.

Provision for Income Taxes

                                         Three Months Ended
                                              March 31,
                                          2013           2012
                                          ($ in thousands)
Provision (benefit) for income taxes   $      (623 )     $  28


Index

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 months ended March 31, 2013 primarily reflects the following Vineyard acquisition related items: reversal of Vineyard's pre-existing income tax valuation allowance upon acquisition, amortization of intangible assets acquired, and the tax impact of book/tax differences on deferred revenue.

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 ASC 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.

Adjustment to Previously Announced Preliminary Quarterly Results

On May 2, 2013, we filed a Current Report on Form 8-K, which contained a press release announcing our financial results for the quarter ended March 31, 2013. In the press release, we reported stock-based compensation expense of approximately $938,000 for the quarter ended March 31, 2013. Subsequent to the issuance of our press release, we determined we needed to record a one-time stock compensation charge of approximately $660,000 related to the acceleration of unvested stock options to purchase common shares of Vineyard Networks Inc. in connection with our acquisition of Vineyard on January 9, 2013. The additional expense was allocated as follows: $52,000 for cost of sales, $297,000 for research and development, $267,000 for sales and marketing and $44,000 for general and administrative. As a result, the Condensed Consolidated Statements of Operations for the three months ended March 31, 2013 contained in our press release has been adjusted to increase stock-based compensation expense to $1.598 million for the three months ended March 31, 2013.

Liquidity and Capital Resources

Cash, Cash Equivalents and Investments

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

                                                             Three Months Ended
                                                                  March 31,
                                                             2013           2012
                                                              ($ in thousands)
   Net cash (used in) provided by operating activities    $   (4,580 )    $   3,647
. . .
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