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AFOP > SEC Filings for AFOP > Form 10-K on 14-Mar-2014All Recent SEC Filings

Show all filings for ALLIANCE FIBER OPTIC PRODUCTS INC

Form 10-K for ALLIANCE FIBER OPTIC PRODUCTS INC


14-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our Consolidated Financial Statements and Notes thereto included elsewhere in this report.

Recent Accounting Pronouncements

See Note 1 to the Consolidated Financial Statements for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on our results of operations and financial condition, which is incorporated herein by reference.


Critical Accounting Policies and Estimates

General

Management's discussion and analysis of our financial condition and results of operations is based on our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, bad debts, inventories, asset impairments, income taxes, contingencies, and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values for assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect management's more significant judgments and estimates used in the preparation of our Consolidated Financial Statements:

Revenue Recognition

We recognize revenue upon shipment of our products to customers, provided that we have received a purchase order, the price is fixed, collection of the resulting receivable is reasonably assured and transfer of title and risk of loss has occurred. Subsequent to the sale of our products, we have no obligation to provide any modification or customization upgrades, enhancements or post contract customer support.

Stock-based Compensation Expense

We measure and recognize compensation expense for stock options, RSUs and shares purchased pursuant to our ESPP based on their estimated fair value and recognize the costs in the financial statements under Accounting Standards Codification ("ASC") 718. The fair value of RSUs is equal to the market value of our common stock on the date the award is granted. We estimate the fair value of stock options and ESPP shares using the Black-Scholes valuation model. We expense the estimated fair value to earnings on a straight-line basis.

Allowance for Doubtful Accounts

Allowances are provided for estimated returns and potential uncollectable trade receivables. Provisions for return allowances are recorded at the time revenue is recognized based on our historical product returns, current economic trends and changes in customer demand. Such allowances are adjusted periodically to reflect actual and anticipated experience. We also identify specific accounts considered to have a high risk of uncollectibility and reserve the full amount. Material differences may result in the amount and timing of our revenue for any period if management made different judgments or utilized different estimates.

Inventories

Inventories are stated at the lower of cost or market, with cost being determined using standard cost, which approximates actual cost on a first-in, first-out basis. Market value is determined as the lower of replacement cost or net realizable value. Provisions are made for excess and obsolete inventory based on historical usage and management's estimates of future demand. Inventory reserves, once established, are only reversed upon sale or disposition of related inventory.

Short-Term and Long-Term Investments

We generally invest our cash in certificates of deposit and corporate bonds. Such investments are made in accordance our investment policy, which establishes guidelines relative to diversification and maturities designed to maintain safety and liquidity. These guidelines are periodically reviewed and modified in light of trends in yields and interest rates.

Valuation of Long-Lived Assets

We review the valuation of long-lived assets and assess the impairment of the assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable due to: significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of our use of the assets or the strategy for the overall business; and significant negative industry or economic trends. When we determine that the carrying value of long-lived assets may not be recoverable based on the existence of one or more of the above indicators of impairment, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. We did not record any asset impairment charge for the year ended December 31, 2013 or 2012.


Income Taxes

We account for income taxes in accordance with ASC 740-10. ASC 740-10 requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.

We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. In making such determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial operations. In the event we were to determine that we would be able to realize our deferred income tax assets in the future in excess of their net recorded amount, we would make an adjustment to the valuation allowance, which would reduce the provision for income taxes.

Management assesses the available positive and negative evidence to estimate if sufficient future taxable income will be generated to utilize the existing deferred tax assets. Based on this assessment, as of December 31, 2013, a reduction in valuation allowance in the amount of $8.2 million has been recorded. The amount of the deferred tax asset considered realizable, however, could be adjusted if estimates of future taxable income are reduced.

ASC 740-10 also prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. Differences between tax positions taken or expected to be taken in a tax return and the benefit recognized and measured pursuant to the interpretation are referred to as "unrecognized benefits." A liability is recognized for an unrecognized tax benefit because it represents an enterprise's potential future obligation to the taxing authority for a tax position that was not recognized as a result of applying the provisions of ASC 740-10. As of December 31, 2013 and 2012, the total amount of unrecognized tax benefits were $0.7 million and $0 million respectively.

Deferred tax assets pertaining to windfall tax benefits on exercise of share awards and the corresponding credit to additional paid-in capital are recorded if the related tax deduction reduces tax payable. We have elected the "with-and-without approach" regarding ordering of windfall tax benefits to determine whether the windfall tax benefit did reduce taxes payable in the current year. Under this approach, the windfall tax benefits would be recognized in additional paid-in capital only if an incremental tax benefit is realized after considering all other tax benefits presently available to us.

We consider the earnings of certain non-U.S. subsidiaries to be indefinitely invested outside the United States on the basis of estimates that future domestic cash generation will be sufficient to meet future domestic cash needs. We have not recorded a deferred tax liability of approximately $1.3 million related to U.S. federal and state income taxes and foreign withholding taxes on approximately $3.4 million of undistributed earnings of foreign subsidiaries indefinitely invested outside the United States. Should we decide to repatriate the foreign earnings, we would have to adjust the income tax provision in the period we determined that the earnings will no longer be indefinitely invested outside the United States.

Overview

We were founded in December 1995 and commenced operations to design, manufacture and market fiber optic interconnect products, which we call our connectivity products. We have broadened our connectivity product line to include attenuators, planar lightwave circuit splitters, and fused fiber products. We started selling our optical passive products and other wavelength management products in July 2000. Since introduction, sales of optical passive products have fluctuated with the overall market for these products.


We market and sell our products predominantly through our direct sales force. From our inception through December 31, 2013, we derived the majority of our revenues from our connectivity product line. Our optical passive products contributed as a percentage of revenues 24.2% and 30.0% for the years ended December 31, 2013 and 2012, respectively. Our cost of revenues consists of raw materials, components, direct labor, manufacturing overhead and production start-up costs. We expect that our cost of revenues as a percentage of revenues will fluctuate from period to period based on a number of factors including:

changes in manufacturing volume;

costs incurred in establishing additional manufacturing lines and facilities;

inventory write-downs and impairment charges related to manufacturing assets;

mix of products sold;

changes in our pricing and pricing by our competitors;

mix of sales channels through which our products are sold; and

mix of domestic and international sales.

Research and development expenses consist primarily of salaries and related personnel expenses, fees paid to outside service providers, materials costs, test units, facilities, overhead and other expenses related to the design, development, testing and enhancement of our products. We expense our research and development costs as they are incurred. We believe that a significant level of investment for product research and development is required to remain competitive. We expect research and development expenses may increase as we intend to continue to invest in our research and product development efforts during 2014.

Sales, marketing, and administrative expenses consist of salaries, commissions and related expenses for personnel engaged in marketing, sales and technical support functions, as well as the costs associated with trade shows, promotional activities and travel expenses. It also consists of salaries and related expenses for executive, finance, administrative, accounting and human resources personnel, insurance and professional fees for legal and accounting support. We intend to continue to invest amounts similar to our spending levels in 2013 in our sales and marketing efforts, both domestically and internationally, in order to increase market awareness and to generate sales of our products. We expect administrative expenses will increase in absolute dollars to support our revenue growth, higher insurance premiums, and costs associated with compliance with Section 404 of the Sarbanes-Oxley Act of 2002.

We cannot be certain that our expenditures will result in higher revenues. In addition, we believe our future success depends upon establishing and maintaining successful relationships with a variety of key customers.

We own one hundred percent interest in the outstanding common stock of Alliance Fiber Optic Products, Ltd (formally named Transian Technology Ltd. Co.), a Taiwan corporation. This wholly owned subsidiary is engaged in design and manufacturing of our products.

In December 2000, we established a wholly owned subsidiary, Alliance Fiber Optic Products, in the People's Republic of China, which we have developed as a manufacturing facility. We commenced production at this facility in the third quarter of 2003.

Results of Operations

The following table sets forth the relationship between various components of operations, stated as a percentage of revenues, for the periods indicated.


                                                     Years Ended December 31,
                                                       2013            2012
      Revenues                                          100.0 %         100.0 %

      Cost of revenues:                                  61.7            65.7
         Gross profit                                    38.3            34.3

      Operating expenses:
         Research and development                         4.9             7.1
         Selling, marketing and administrative           10.9            14.9
            Total operating expenses                     15.8            22.0

      Income from operations                             22.5            12.3
      Interest and other income, net                      0.9             1.6
      Income before benefit for income taxes             23.4            13.9
      Benefit for income taxes                            1.3             6.8
      Net income                                         24.7 %          20.7 %

Comparison of Fiscal Year 2013 and Fiscal Year 2012

Revenues. Revenues were $76.1 million and $46.6 million for the years ended December 31, 2013 and 2012, respectively. Connectivity products revenue increased to $57.7 million in 2013 from $32.6 million in 2012. Optical passive products revenue increased to $18.4 million in 2013 from $14.0 million in 2012. Revenues increased mainly due to increased orders for our products by our customers which resulted in higher volume shipments.

Cost of Revenues. Cost of revenues for the year ended December 31, 2013 increased to $47.0 million from $30.6 million in fiscal year 2012. Cost of revenues as a percentage of net revenues decreased to 61.7% in the year ended December 31, 2013 from 65.7% in fiscal year 2012. The lower cost of revenues percentage in 2013 resulted from increased factory utilization due to higher production levels.

Gross Profit. Gross profit for the year ended December 31, 2013 was $29.1 million, or 38.3% of revenues, compared with gross profit of $16.0 million, or 34.3% of revenues, in fiscal year 2012. Gross profit on connectivity products increased to $25.2 million in 2013 from $13.0 million in 2012. Gross profit on optical passive products increased to $3.9 million in 2013 from $3.0 million in 2012. For the year ended December 31, 2013, the utilization of our factories was higher due to the increased volume shipments of our products, which contributed to higher gross margins. However, our average selling prices are declining, which we believe may negatively impact our gross profit and may offset any benefits from improved absorption.

Research and Development Expenses. Research and development expenses increased to $3.7 million in the year ended December 31, 2013 from $3.3 million in fiscal year 2012. As a percentage of revenues, research and development expenses decreased to 4.9% in 2013 from 7.1% in 2012 as a result of increased revenues. We expect research and development expenses may increase as we intend to continue to invest in our research and product development efforts.

Sales, Marketing and Administrative Expenses. Sales, marketing and administrative expenses increased to $8.3 million in the year ended December 31, 2013 from $7.0 million in fiscal year 2012. The higher sales, marketing and administrative expenses were due to higher stock based compensation charges and higher bonuses and commissions as a result of higher revenues. As a percentage of revenues, sales, marketing and administrative expenses decreased to 10.9% in 2013 from 14.9% in 2012 as a result of increased revenues. We intend to continue to invest amounts similar to our spending levels in 2013 in our sales, marketing, and administrative efforts, both domestically and internationally, as we work to increase market awareness and to generate additional sales of our products.

Stock-Based Compensation. Total stock-based compensation was $1.9 million and $1.1 million for the years ended December 31, 2013 and 2012, respectively. The increase was due to restricted stock units granted in 2011 and 2013 and stock options granted in 2012 and 2013, and resulted in higher stock-based compensation expense.


Interest and Other Income, Net. Interest and other income, net, was $0.7 million for each of the years ended December 31, 2013 and 2012. These amounts consisted primarily of interest income, which fluctuated based on cash balances and changes in interest rates.

Income Taxes. An income tax benefit of $1.0 million and $3.2 million were recorded for the years ended December 31, 2013 and 2012, respectively. The benefit for the years ended December 31, 2013 and 2012 were as a result of reduction of valuation allowances for deferred tax assets which offset current taxes due.

In prior periods, California tax law suspended the use of net operating losses (NOLs). Beginning in 2012, the moratorium on the utilization of the NOLs was lifted.

As of December 31, 2013, we had approximately $7.5 million and $6.5 million of NOL carryforwards for federal and state tax purposes, respectively, which will expire after 2022 for federal and after 2016 for state purposes, if not utilized.

As of December 31, 2013, we had approximately $1.2 million and $0.9 million of research credit carryforwards for federal and state tax purposes, respectively, which will expire after 2018 for federal tax purposes. The state tax credit can be carried forward indefinitely.

Liquidity and Capital Resources

Comparison of Fiscal Year 2013 and Fiscal Year 2012

Net cash provided by operating activities was $19.7 million in 2013. The increase in our cash provided by operating activities in 2013 was primarily due to net income of $18.8 million, an increase in accounts payable of $5.1 million, an increase in accrued expenses of $3.0 million, and contribution from adjustments for non-cash charges, including depreciation and stock based compensation of $2.8 million. These were offset by an increase in inventory of $3.7 million, an increase in accounts receivable of $3.5 million, an increase in deferred tax assets of $2.3 million, and an increase in prepaid expenses of $0.5 million.

Net cash provided by operating activities was $9.3 million in 2012. The increase in our cash provided by operating activities in 2012 was primarily due to net income of $9.6 million, an increase in accounts payable of $ 2.9 million, and contribution from adjustments for non-cash charges, including depreciation of $1.6 million and stock based compensation of $1.1 million. These were offset by an increase in deferred tax assets of $3.7 million and an increase in accounts receivable of $1.4 million.

Net cash used in investing activities was $7.6 million and $4.3 million in 2013 and 2012, respectively. In 2013, we spent $7.8 million to acquire property and equipment and $0.2 million in purchases of long-term investments, which was offset in part by net proceeds from the sale of short-term securities of $0.4 million. In 2012, we spent $1.5 million to acquire property and equipment and the net purchase of short-term and long-term investments were $2.8 million.

Net cash generated by financing activities was $2.1 million in 2013. Cash generated by financing activities in 2013 comprised $5.2 million proceeds from the exercise of options to purchase shares of our common stock and $0.5 million from common stock issued through our ESPP, which was offset by $2.8 million used to pay cash dividends and $0.9 million used to repurchase common stock pursuant to our stock repurchase program.

Net cash used in financing activities was $14.7 million in 2012. Net cash used in financing activities was primarily due to $11.0 million used to pay cash dividends and $4.8 million used to repurchase common stock pursuant to our stock repurchase program, which was offset by proceeds from the exercise of options to purchase shares of our common stock and common stock issued through our ESPP.

Our principal source of liquidity as of December 31, 2013 consisted of $18.6 million in cash and cash equivalents, $28.1 million interest bearing marketable securities, and $10.4 in long-term investments. We believe that our current cash, cash equivalents, short-term and long-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, our future growth, including potential acquisitions, may require additional funding. If cash generated from operations is insufficient to satisfy our long-term liquidity requirements, we may need to raise capital through additional equity or debt financings, additional credit facilities, strategic relationships or other arrangements. If additional funds are raised through the issuance of securities, these securities could have rights, preferences and privileges senior to those of the holders of our common stock, and the terms of any debt facility could impose restrictions on our operations. The sale of additional equity or debt securities could result in additional dilution to our stockholders, and additional financing may not be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain additional funding, we may be required to reduce our research and development and marketing expenses. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products. Our failure to raise capital when needed could harm our business, financial condition and operating results.


Contractual Obligations

The lease on our corporate headquarters in Sunnyvale, California, has a six-year term commencing on July 22, 2004. In June 2010, we renewed the lease for an 18,088 square foot facility in the same building, which lease will expire in January 2016.

In Taiwan, we lease a total of approximately 33,052 square feet in one facility located in Tu-Cheng City, Taiwan. This lease expires at various times from May 2013 to January 2015. In December 2000, we purchased approximately 8,200 square feet of space immediately adjacent to the leased facility for $0.8 million. In November 2013, we purchased approximately 5,748 square feet of space which we previous leased for $1.6 million, bringing the total square footage to approximately 47,000 square feet.

We lease a 132,993 square foot facility in Shenzhen, China, which lease will expire in October 2014.

The following summarizes our contractual obligations at December 31, 2013 (in thousands):

                                                 Payments Due By Period
                                         Less than                              More than
 Contractual obligations       Total      1 year      1-3 Years    4-5 Years     5 Years
 Operating Lease Obligations      984          684          298            2            -

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements, as such term is defined in rules promulgated by the Securities and Exchange Commission, that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

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