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PKT > SEC Filings for PKT > Form 10-Q on 9-Aug-2013All Recent SEC Filings

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Form 10-Q for PROCERA NETWORKS, INC.


9-Aug-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; 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.


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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 NAVL solutions to ensure that they can deliver BYOD 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 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.

Our IPE products are part of the high-growth market for mobile packet and broadband core products. The market for IPE products is expected to grow from $596 million in 2012 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 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 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.

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.


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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.

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 Six Months Ended June 30, 2013 and 2012

Revenue

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

                               Three Months Ended                        Six Months Ended
                                   June 30,                                 June 30,
                        2013         2012        Increase        2013         2012        Increase
Net product revenue   $ 13,617     $ 11,863             15 %   $ 24,028     $ 21,692             11 %
Net support revenue      4,222        2,802             51 %      7,982        5,305             50 %
Total revenue         $ 17,839     $ 14,665             22 %   $ 32,010     $ 26,997             19 %

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 and six months ended June 30, 2013 was $17.8 million and $32.0 million, an increase of 22% and 19%, respectively, compared with $14.7 million and $27.0 million in the three and six months ended June 30, 2012. The increase in product revenue in the three and six months ended June 30, 2013 compared to the comparable prior year periods reflected 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; and we continued to add new higher education customers. For the three and six months ended June 30, 2013, Vineyard contributed $0.3 million and $0.5 million in product revenue and $0.3 million and $0.5 million in support revenue, respectively. The increase in support revenue in the three and six months ended June 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. For the three months ended June 30, 2013, revenue from Shaw Communications, Inc. represented 18% of net revenue and two other customers represented 17% and 13% of net revenue, with no other single customer accounting for more than 10% of net revenue. For the six months ended June 30, 2013, revenue from Shaw Communications, Inc. represented 17% of net revenue and revenue from Cox Communications, Inc. represented 14% of net revenue, with no other single customer accounting for more than 10% of net revenue. For the three months ended June 30, 2012, revenue from Shaw Communications, Inc. and two additional customers represented 16%, 22%, and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue. For the six months ended June 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 18% and 12% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.


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Sales to customers located in the United States as a percentage of total revenues were 21% and 29% for the three and six months ended June 30, 2013, respectively, compared to 41% and 42% for the three and six months ended June 30, 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 and six months ended June 30, 2013 and 2012 (in thousands, except percentages):

                                  Three Months Ended                          Six Months Ended
                                       June 30,                                   June 30,
                          2013          2012         Increase        2013          2012         Increase
Product costs           $   6,283     $   5,171             22 %   $  12,370     $   8,619             44 %
Percent of net
product revenue                46 %          44 %                         51 %          39 %

Support costs                 831           247            236 %       1,546           469            230 %
Percent of net
support revenue                20 %           9 %                         19 %           9 %

Total cost of sales     $   7,114     $   5,418             31 %   $  13,916     $   9,088             53 %
Percent of total net
revenue                        40 %          37 %                         43 %          34 %

Total cost of sales in the three and six months ended June 30, 2013 increased by $1.7 million and $4.8 million, respectively, compared to the three and six months ended June 30, 2012. Cost of sales as a percentage of revenue increased by 3 and 9 percentage points for the three and six months ended June 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 $0.2 million and $0.5 million in the three and six months ended June 30, 2013, respectively. The increase in cost of sales as a percentage of revenue primarily reflected a higher proportion of hardware sales in the three and six months ended June 30, 2013. Stock-based compensation recorded to cost of sales in the three and six months ended June 30, 2013 was $0.1 million and $0.2 million, respectively, compared to $30,000 and $0.1 million, respectively, in the corresponding periods of 2012.

Gross Profit

Gross profit for the three and six months ended June 30, 2013 and 2012 was as
follows (in thousands, except percentages):

                                  Three Months Ended                            Six Months Ended
                                       June 30,                                     June 30,
                          2013         2012          Increase         2013          2012          Increase

Gross profit            $  10,725     $   9,247              16 %   $  18,094     $  17,909                1 %
Percent of total net

revenue 60 % 63 % 57 % 66 %

Our total gross profit margin for the three and six months ended June 30, 2013 decreased by 3 and 9 percentage points to 60% and 57%, respectively, compared to 63% and 66% for the three and six months ended June 30, 2012, respectively. The decrease resulted from a higher proportion of hardware sales in the three and six months ended June 30, 2013, higher support and service costs and amortization of acquired intangible assets. We expect our gross profit amounts to increase in the second half of the fiscal year ending December 31, 2013, as compared with the first half of 2013, while we expect continued pressure on our profit margin percent due to product mix in the second half of 2013.


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Operating Expense

Operating expenses for the three and six months ended June 30, 2013 and 2012 was
as follows (in thousands, except percentages):

                                    Three Months Ended                      Six Months Ended
                                        June 30,                               June 30,
                               2013        2012        Change        2013         2012        Change
Research and development     $  4,186     $ 1,791          134 %   $  8,587     $  3,482          147 %
Sales and marketing             7,349       4,474           64 %     13,970        8,480           65 %
General and administrative      3,352       2,078           61 %      6,989        4,437           58 %
Total                        $ 14,887     $ 8,343           78 %   $ 29,546     $ 16,399           80 %

In the three and six months ended June 30, 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 during the same period 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                          Six Months Ended
                                      June 30,                                   June 30,
                          2013          2012         Increase        2013          2012         Increase
Research and
development             $   4,186     $   1,791            134 %   $   8,587     $   3,482            147 %
As a percentage of

net revenue 23 % 12 % 27 % 13 %

Research and development expenses for the three and six months ended June 30, 2013 increased by $2.4 million and $5.1 million, respectively, compared to the three and six months ended June 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 $1.4 million, respectively, in the three and six months ended June 30, 2013 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 and six months ended June 30, 2013 was $0.2 million and $0.7 million, respectively, compared with $0.1 million and $0.2 million, respectively, for the corresponding periods in 2012. Research and develop expenses as a percentage of revenue increased 11% and 14% for the three and six months ended June 30, 2013, respectively, compared to the corresponding periods in 2012 primarily due to the addition of Vineyard employees.

Sales and Marketing

Sales and marketing expenses primarily include personnel costs, sales
commissions and marketing expenses, such as trade shows, channel development and
literature.
                                       24
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                                       Three Months Ended                    Six Months Ended
                                           June 30,                             June 30,
                                  2013        2012       Change        2013        2012       Change
                                       ($ in thousands)                     ($ in thousands)

Sales and marketing $ 7,349 $ 4,474 64 % $ 13,970 $ 8,480 65 % As a percentage of net revenue 41 % 31 % 44 % 31 %

Sales and marketing expenses for the three and six months ended June 30, 2013 increased by $2.9 million and $5.5 million compared to the three and six months ended June 30, 2012, respectively. The increase reflected the addition of sales and marketing personnel during 2012 and in the three and six months ended June 30, 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 $1.4 million, respectively, and the amortization of acquired intangible assets of $0.1 million and $0.2 million, respectively, in the three and six months ended June 30, 2013 associated with the Vineyard acquisition. Stock-based compensation recorded to sales and marketing expenses in the three and six months ended June 30, 2013 was $0.4 million and $1.0 million, respectively, compared with $0.3 million and $0.6 million, respectively, in the corresponding periods of 2012. Sales and marketing expenses as a percentage of revenue increased 10% and 13% for the three and six months ended June 30, 2013, respectively, compared to the corresponding periods in 2012 primarily due to the addition of Vineyard employees.

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                   Six Months Ended
                                           June 30,                            June 30,
                                  2013        2012       Change       2013        2012       Change
                                       ($ in thousands)                    ($ in thousands)

General and administrative $ 3,352 $ 2,078 61 % $ 6,989 $ 4,437 58 % As a percentage of net revenue 19 % 14 % 22 % 16 %

General and administrative expenses for the three and six months ended June 30, 2013 increased by $1.3 million and $2.6 million, respectively, compared to the three and six months ended June 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 reflected $0.6 million and $1.6 million in business development costs for legal, accounting and investment banking fees in the three and six months ended June 30, 2013, respectively, compared to $0.6 million in business development costs in the three and six months ended June 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 six months ended June 30, 2013 was $0.5 million and $0.9 million, respectively, compared to $0.2 million and $0.4 million, respectively, in the corresponding periods in 2012. General and administrative expenses as a percentage of revenue increased 5% and 6% for the three and six months ended June 30, 2013, respectively, compared to the corresponding periods in 2012 primarily due to the addition of new general and administrative employees and business development expenses mentioned above.

Interest and Other Income (Expense), Net
. . .
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