ShoreTel, Inc.
ShoreTel Inc (Form: 10-Q, Received: 05/09/2011 14:15:58)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

 
(Mark one)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended March 31, 2011
 
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from              to
 
Commission File Number 001-33506  
 

SHORETEL, INC.
(Exact name of Registrant as specified in its charter)

     
Delaware
 
77-0443568
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
     
960 Stewart Drive, Sunnyvale, California
 
94085-3913
(Address of principal executive offices)
 
(Zip Code)
 
(408) 331-3300
(Registrant’s telephone number, including area code)

 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   x     No    o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   o     No   o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
     
Large accelerated filer o
 
Accelerated filer x
     
Non-accelerated filer o  (Do not check if a smaller reporting company)
 
Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes   ¨     No   x
 
As of April 29, 2011, 47,166,545 shares of the registrant’s common stock were outstanding .



 
 

 
 
SHORETEL, INC. AND SUBSIDIARIES
 
FORM 10-Q for the Quarter Ended March 31, 2011
 
INDEX
 
Page
PART I: Financial Information
3
       
Item 1
 
3
 
 
3
 
 
4
 
 
5
 
 
6
Item 2
 
16
Item 3
 
27
Item 4
 
     27
   
PART II: Other information
28
       
Item 1
 
         28
Item 1A
 
         28
Item 2
 
         29
Item 6
 
         29
 
 
         30
 
 
         31

 
2

 
PART I. FINANCIAL INFORMATION
 
ITEM 1:
 
SHORETEL, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
(Unaudited)
 
   
March 31,   2011
   
June 30   2010
 
ASSETS
 
 
   
 
 
CURRENT ASSETS:
 
 
   
 
 
Cash and cash equivalents
  $ 73,923     $ 68,426  
Short-term investments
    28,708       47,375  
Accounts receivable, net of allowance of $756 and $876 as of March 31, 2011 and June 30, 2010, respectively
    27,076       24,596  
Inventories
    16,459       9,954  
Prepaid expenses and other current assets
    4,107       8,125  
Total current assets
    150,273       158,476  
PROPERTY AND EQUIPMENT, net
    8,576       6,019  
GOODWILL
    7,415        
INTANGIBLE ASSETS, net
    9,122       5,025  
OTHER ASSETS
    658       1,201  
TOTAL ASSETS
  $ 176,044     $ 170,721  
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
CURRENT LIABILITIES:
               
Accounts payable
  $ 8,634     $ 7,868  
Accrued expenses and other
    7,500       10,061  
Accrued employee compensation
    9,768       8,261  
Deferred revenue
    22,548       19,450  
Total current liabilities
    48,450       45,640  
LONG-TERM LIABILITIES:
               
Long-term deferred revenue
    10,557       9,269  
Other long-term liabilities
    1,395       1,346  
Total liabilities
    60,402       56,255  
COMMITMENTS AND CONTINGENCIES (Note 12)
               
STOCKHOLDERS’ EQUITY:
               
Preferred stock, $0.001 par value: authorized 5,000; none issued and outstanding
           
Common stock and additional paid-in capital, par value $0.001 per share, authorized 500,000; issued and outstanding, 46,451 and 45,370 shares as of March 31, 2011 and June 30, 2010, respectively
    233,495       222,491  
Accumulated other comprehensive income
    81       191  
Accumulated deficit
    (117,934 )     (108,216 )
Total stockholders’ equity
    115,642       114,466  
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  $ 176,044     $ 170,721  
 
See Notes to Condensed Consolidated Financial Statements

 
3

 
SHORETEL, INC. AND SUBSIDIARIES
 
(In thousands, except per share amounts)
(Unaudited)
 
   
Three Months Ended
March 31,
   
Nine Months Ended
March 31,
 
   
2011
   
2010
   
2011
   
2010
 
REVENUE:
 
 
   
 
   
 
   
 
 
Product
  $ 41,248     $ 28,945     $ 114,387     $ 83,685  
Support and services
    10,329       8,089       29,198       22,556  
Total revenue
    51,577       37,034       143,585       106,241  
COST OF REVENUE:
                               
Product (1)
    12,979       10,049       37,593       29,369  
Support and services (1)
    3,515       2,933       9,616       8,323  
Total cost of revenue
    16,494       12,982       47,209       37,692  
GROSS PROFIT
    35,083       24,052       96,376       68,549  
OPERATING EXPENSES:
                               
Research and development (1)
    12,562       8,634       33,396       23,666  
Sales and marketing (1)
    18,920       14,726       54,437       39,653  
General and administrative (1)
    6,377       5,214       19,118       14,596  
Total operating expenses
    37,859       28,574       106,951       77,915  
LOSS FROM OPERATIONS
    (2,776 )     (4,522 )     (10,575 )     (9,366 )
OTHER INCOME (EXPENSE):
                               
Interest income
    105       100       447       296  
Other
    61       (220 )     333       (128 )
Total other income (expense)
    166       (120 )     780       168  
LOSS BEFORE BENEFIT FROM INCOME TAXES
    (2,610 )     (4,642 )     (9,795 )     (9,198 )
BENEFIT FROM INCOME TAXES
    228       153       77       87  
NET LOSS
  $ (2,382 )   $ (4,489 )   $ (9,718 )   $ (9,111 )
Net loss per share — basic and diluted
  $ (0.05 )   $ (0.10 )   $ (0.21 )   $ (0.20 )
Shares used in computing net loss per share — basic and diluted
    46,249       44,941       45,862       44,731  
____________                                
(1) Includes stock-based compensation expense as follows:
                               
Cost of product revenue
  $ 32     $ 34     $ 94     $ 99  
Cost of support and services revenue
    111       207       472       553  
Research and development
    1,086       805       2,688       2,248  
Sales and marketing
    459       911       2,212       2,528  
General and administrative
    1,112       861       2,786       2,320  
Total stock-based compensation expense
  $ 2,800     $ 2,818     $ 8,252     $ 7,748  
 
See Notes to Condensed Consolidated Financial Statements

 
4

 
SHORETEL, INC. AND SUBSIDIARIES
 
(In thousands)
(Unaudited)
 
   
Nine Months Ended
March 31,
 
   
2011
   
2010
 
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
   
 
 
Net loss
  $ (9,718 )   $ (9,111 )
Adjustments to reconcile net loss to net cash provided by operating activities:
               
Depreciation and amortization
    3,219       2,045  
Amortization of premium (discount) on investments
    500       72  
Stock-based compensation expense
    8,252       7,748  
Loss on disposal of property and equipment
    97       155  
Benefit from doubtful accounts receivable recovered
    (120 )     (83 )
Changes in assets and liabilities, net of effect of acquisition:
               
Accounts receivable
    (2,300 )     1,920  
Inventories
    (6,444 )     (513 )
Prepaid expenses and other current assets
    4,078       (3,746 )
Other assets
    578       988  
Accounts payable
    749       (273 )
Accrued expenses and other
    (2,612 )     5,611  
Accrued employee compensation
    1,400       1,338  
Deferred revenue
    4,291       4,082  
Net cash provided by operating activities
    1,970       10,233  
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Purchases of property and equipment
    (5,137 )     (3,518 )
Purchases of short-term investments
    (3,136 )     (19,652 )
Proceeds from maturities of short-term investments
    21,194       6,635  
Cost of acquisition of a business
    (11,375 )      
Purchases of software license and other
    (770 )     (1,200 )
Net cash provided by (used in) investing activities
    776       (17,735 )
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Proceeds from issuance of common stock to employees
    3,177       1,504  
Taxes paid on vested and released stock awards
    (426 )     (118 )
Net cash provided by financing activities
    2,751       1,386  
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    5,497       (6,116 )
CASH AND CASH EQUIVALENTS - Beginning of period
    68,426       73,819  
CASH AND CASH EQUIVALENTS - End of period
  $ 73,923     $ 67,703  
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
               
Cash paid (refunded) during the period for income taxes, net
  $ (1,572 )   $  
NONCASH INVESTING AND FINANCING ACTIVITIES:
               
Vesting of accrued early exercised stock options
  $     $ 18  
Purchase of property and equipment included in period-end accounts payable
  $ 443     $ 465  
 
See Notes to Condensed Consolidated Financial Statements

 
5

 
SHORETEL, INC. AND SUBSIDIARIES
 
(Unaudited)
 
1. Description of Business
 
ShoreTel, Inc. and its subsidiaries (referred herein as “the Company”) is a leading provider of Pure Internet Protocol, or “IP”, unified communications systems for enterprises. The Company’s systems are based on its distributed software architecture and switch-based hardware platform which enable multi-site enterprises to be served by a single telecommunications system. The Company’s systems enable a single point of management, easy installation and a high degree of scalability and reliability, and provide end users with a consistent, full suite of features across the enterprise, regardless of location. As a result, management believes that the Company’s systems enable enhanced end user productivity and provide lower total cost of ownership and higher customer satisfaction than alternative systems.
 
2. Basis of Presentation and Significant Accounting Policies
 
The accompanying condensed consolidated financial statements as of March 31, 2011 and for the three months and nine months ended March 31, 2011 and 2010 have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and the notes thereto, included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2010.
 
In the opinion of the management, all adjustments (which include normal recurring adjustments) necessary to present a fair statement of financial position as of March 31, 2011, and June 30, 2010,  results of operations for the three months and nine months ended March 31, 2011 and 2010, and cash flows for the nine months ended March 31, 2011 and 2010, as applicable, have been made. The results of operations for the three months and nine months ended March 31, 2011 are not necessarily indicative of the operating results to be expected for the full fiscal year or any future periods.
 
Computation of Net Loss Per Share
 
Basic net loss per common share is determined by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per common share is determined by dividing net loss by the weighted average number of common shares used in the basic loss per common share calculation plus the number of common shares that would be issued assuming conversion of all potentially dilutive securities outstanding under the treasury stock method. Potentially dilutive securities of 9.5 million and 8.3 million for the three and nine months ended March 31, 2011 and 2010, respectively, were not included in the computation of dilutive net loss per share because to do so would have been anti-dilutive.
 
Comprehensive Income (Loss)
 
Other comprehensive income (loss) consists of net income (loss) for the period plus unrealized gains (losses) on short-term investments. Accordingly, comprehensive loss was $2.5 million and $4.5 million for the three months ended March 31, 2011 and 2010, and $9.8 million and $9.0 million for the nine months ended March 31, 2011 and 2010, respectively.
 
Goodwill and Other Intangible Assets
           
The Company allocates the purchase price of acquired companies to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. Such allocations require management to make significant estimates and assumptions, especially with respect to intangible assets.
 
Goodwill is measured and tested for impairment on an annual basis in the fourth quarter of our fiscal year in accordance with Accounting Standards Codification No. 350 (“ASC 350”), Intangibles – Goodwill and Other, or more frequently if we believe indicators of impairment exist. Triggering events for impairment reviews may include indicators such as adverse industry or economic trends, restructuring actions, lower projections of profitability, or a sustained decline in our market capitalization. The Company has one reporting unit. The performance of the test involves a two-step process. The first step requires comparing the fair value of our reporting unit to its net book value, including goodwill. A potential impairment exists if the fair value of the reporting unit is lower than its net book value. The second step of the process is only performed if a potential impairment exists, and it involves determining the difference between the fair value of the reporting unit’s net assets other than goodwill to the fair value of the reporting unit and if the difference is less than the net book value of goodwill, an impairment exists and is recorded.
 
 
6

 
The Company reviews the carrying values of long-lived assets whenever events and circumstances, such as reductions in demand, lower projections of profitability, significant changes in the manner of our use of acquired assets, or significant negative industry or economic trends, indicate that the net book value of an asset may not be recovered through expected undiscounted future cash flows from its use and eventual disposition. If this review indicates that there is an impairment, the impaired asset is written down to its fair value, which is typically calculated using: (i) quoted market prices and/or (ii) discounted expected future cash flows. The estimates regarding future anticipated revenue and cash flows, the remaining economic life of the products and technologies, or both, may differ from those used to assess the recoverability of assets. In that event, impairment charges or shortened useful lives of certain long-lived assets may be required, resulting in a reduction in net income or an increase to net loss in the period when such determinations are made.
 
Critical estimates in valuing certain intangible assets include, but are not limited to: future expected cash flows from customer contracts, customer lists, distribution agreements, acquired developed technologies and patents; expected costs to develop the in-process research and development into commercially viable products and estimating cash flows from the projects when completed. Management's estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable.
 
Recently Adopted Accounting Pronouncements
 
In October 2009, the Financial Accounting Standards Board (“FASB”) amended the accounting standards for revenue recognition to remove tangible products containing software components and non-software components that function together to deliver the product’s essential functionality from the scope of industry specific software revenue recognition guidance. In October 2009, the FASB also amended the standards for multiple deliverable revenue arrangements to:
 
 
(i)
provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and how the arrangement consideration should be allocated among its elements;
 
(ii)
require an entity to allocate the revenue using estimated selling prices (ESP) of the deliverables if there is no vendor specific objective evidence (VSOE) or third party evidence of selling price (TPE); and
 
(iii)
eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method.
 
This new accounting guidance became applicable to the Company beginning the first quarter of its 2011 fiscal year. The Company adopted this guidance for transactions that were entered into or materially modified on or after July 1, 2010 using the prospective basis of adoption.
 
The Company derives its revenue from sales of IP telecommunications systems and related support and services. The typical system includes a combination of IP phones, switches and software applications. Product revenue is recognized when persuasive evidence of an arrangement exists, product has shipped or delivery has occurred (depending on when title passes), the sales price is fixed or determinable and free of contingencies and significant uncertainties, and collection is probable. The fee is considered fixed or determinable at the execution of an agreement, based on specific products and quantities to be delivered at specified prices. The agreements with customers generally do not include rights of return or acceptance provisions. To the extent that the Company’s agreements contain acceptance terms, the Company recognizes revenue upon product acceptance, unless the acceptance provision is deemed to be perfunctory. Even though substantially all of the contractual agreements do not provide return privileges, there are circumstances for which the Company will accept a return. The Company maintains a reserve for such returns based on historical experience. Payment terms to customers generally range from net 30 to net 60 days. In the event payment terms are extended materially from the Company’s standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payment becomes due. The Company assesses the ability to collect from its customers based on a number of factors, including credit worthiness and past transaction history of the customer. If the customer is not deemed credit worthy, the Company defers all revenue from the arrangement until payment is received and all other revenue recognition criteria have been met. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue. Provisions for return allowances and product warranties are recorded at the time revenue is recognized based on the Company’s historical experience. The provision for return allowances is recorded as a reduction to revenues on the statement of operations and is included as a reduction to account receivables on the balance sheet.
 
The Company’s core software (herein after referred to as “essential software”) is integrated with hardware and is essential to the functionality of the integrated system product. The Company also sells additional software which provides increased features and functions, but is not essential to the overall functionality of the integrated system products (herein after referred to as ‘non-essential software’). At the initial purchase, the customer generally bundles together the hardware, essential software, non-essential software, as needed and up to five years of post-contractual support. Thereafter, if the enterprise customer increases end users and functionality, it may add more hardware, software components, and related post-contractual support by purchasing them separately.
 
The new guidance does not generally change the units of accounting for the Company’s revenue transactions. Most of the products and services continue to qualify as separate units of accounting. Many of the Company’s products have both software and non-software components that function together to deliver the essential functionality of the integrated system product. The Company analyzes all of its software and non-software products and services and considers the features and functionalities of the individual elements and the stand alone sales of those individual components among other factors, to determine which elements are essential or non-essential to the overall functionality of the integrated system product.
 
 
7

 
For transactions entered into prior to the first quarter of fiscal year 2011, the Company recognized revenue based on industry specific software revenue recognition guidance. In accordance with industry specific software revenue recognition guidance, the Company utilized the residual method to determine the amount of product revenue to be recognized. Under the residual method, the fair value of the undelivered elements, such as post-contractual support, is deferred and the remaining portion of the arrangement consideration is recognized as product revenue. VSOE of fair value is limited to the price charged when the same element is sold separately. VSOE of fair value is established for post-contractual support based on the volume and pricing of the stand alone sales within a narrow range. The fair value of the post-contractual support is recognized on a straight-line basis over the term of the related support period, which is typically one to five years.
 
For transactions entered into or materially modified on or after the beginning of the first quarter of fiscal year 2011, the total arrangement fees were allocated to all the deliverables based on their respective relative selling prices. The relative selling price is determined using VSOE when available. When VSOE cannot be established, the Company attempts to determine the TPE for the deliverables. TPE is determined based on competitor prices for similar deliverables when sold separately by the competitors. Generally the Company’s product offerings differ from those of its competitors and comparable pricing of its competitors is often not available. Therefore, the Company is typically not able to determine TPE. When the Company is unable to establish selling price using VSOE or TPE, the Company uses ESP in its allocation of arrangement fees. The ESP for a deliverable is determined as the price at which the Company would transact if the products or services were sold on a stand alone basis.
 
The Company has been able to establish VSOE for its professional and post contractual support services mainly based on the volume and the pricing of the stand alone sales for these services within a narrow range. The Company establishes its ESP for products by considering factors including, but not limited to, geographies, customer segments and pricing practices. The determination of ESP is made through consultation with and formal approval by the Company’s management. The Company regularly reviews VSOE, TPE and ESP and maintains internal controls over the establishment and updates of these estimates.
 
The Company’s multiple element arrangements may include non-essential software deliverables that are subject to the industry specific software revenue recognition guidance. The revenue for these multiple element arrangements is allocated to the non-essential software deliverables and the non-software deliverables based on the relative selling prices of all of the deliverables in the arrangement using the hierarchy in the new revenue accounting guidance. As the Company has not been able to obtain VSOE for all of the non-essential software deliverables in the arrangement, revenue allocated to such non-essential software elements is recognized using the residual method in accordance with industry specific software revenue recognition guidance as the Company was able to obtain VSOE for the undelivered elements bundled with such non-essential software elements. Under the residual method, the amount of revenue recognized for the delivered non-essential software elements equaled the total allocated consideration less the VSOE of any undelivered elements bundled with such non-essential software elements.
 
Total revenue as reported and pro forma total revenue that would have been reported during the three and nine months ended March 31, 2011, if the transactions entered into or materially modified on or after July 1, 2010 were subject to previous accounting guidance, are shown in the following table:
 
   
Three Months Ended March 31, 2011
(Unaudited)
   
Nine Months Ended March 31, 2011
(Unaudited)
 
(In thousands)
 
As Reported
   
Pro Forma Basis  As If The Previous Accounting Guidance Were in Effect
   
As Reported
   
Pro Forma Basis As If The Previous Accounting Guidance Were in Effect
 
Total revenue
  $ 51,577     $ 51,619     $ 143,585     $ 143,480  
 
The impact to total revenue during the three and nine months ended March 31, 2011 of the new revenue accounting guidance was primarily to decrease product revenues by $42,000 and increase product revenues by $105,000, respectively.
 
In terms of the timing and pattern of revenue recognition, the new accounting guidance for revenue recognition is not expected to have a significant effect on total revenues in periods after the initial adoption when applied to multiple element arrangements due to the existence of VSOE for most of the Company’s service offerings which remain undelivered after the software and non-software tangible products are delivered at the inception of the arrangement. The Company’s future revenue recognition for multiple element arrangements is not expected to differ materially from the results in the current period. However, as the Company’s marketing and product strategies evolve, the Company may modify its pricing practices in the future, which could result in changes in selling prices, including both VSOE and ESP which could impact future revenues.
 
 
8

 
3. Business Combination
 
On October 19, 2010, the Company acquired Agito Networks, Inc. (“Agito”), a privately-held company based in Santa Clara, California that provided mobility solutions to enterprises to reduce mobile phone costs, provide high-quality, low cost coverage, increase productivity with greater responsiveness, accessibility and simplify unified communications for mobile workers and their peers. The acquisition of Agito expands and enhances the Company’s product offering by adding Agito’s mobility solution to the Company’s existing range of products, software and services. The purchase price of approximately $11.4 million was paid in cash. The resulting goodwill recognized during the acquisition is deductible for tax purposes. The purchase price was allocated to tangible and intangible assets and liabilities assumed, based on their estimated fair values as follows (amounts in thousands):

Tangible assets
  $ 261  
Goodwill
    7,415  
Intangible assets
    4,220  
Liabilities assumed
    (521 )
 
  $ 11,375  
 
The Company recorded revenues of $0.3 million for the three and nine months ended March 31, 2011 from the mobility solutions products acquired from Agito. The Company has integrated the mobility solutions business within its own business operations and therefore unable to report expenses or earnings related to the acquired business. The unaudited pro forma financial information in the table below summarizes the combined results of operations for the Company and Agito as though the companies were combined as of the beginning of fiscal year 2010. The pro forma financial information for all periods presented also includes the business combination accounting effects resulting from the acquisition, including amortization charges from acquired intangible assets, adjustments to interest expenses for certain borrowings and exclusion of acquisition-related expenses and their related tax effects as though the companies were combined as of the beginning of fiscal year 2010. The pro forma financial information as presented below is for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisition had taken place at the beginning of fiscal year 2010.
 
   
(Unaudited)
Three Months   Ended March 31,
   
( Unaudited)
Nine Months Ended March 31,
 
(In thousands, except per share ammounts )  
2010
   
2011
    2010  
Total revenue
  $ 37,284     $ 144,028     $ 106,784  
Net loss
    (6,086 )     (11,224 )     (13,827 )
Basic and diluted earnings per share
    (0.14 )     (0.24 )     (0.31 )
 
4. Balance Sheet Details
 
Balance sheet components consist of the following:
 
(In thousands)
 
March 31,
2011
   
June 30,
2010
 
Inventories:
 
 
   
 
 
Raw materials
  $ 263     $ 335  
Work in process
    295       526  
Finished goods
    15,901       9,093  
Total inventories
  $ 16,459     $ 9,954  
Property and equipment, net:
               
Computer equipment and tooling
  $ 10,541     $ 9,559  
Software
    2,273       1,354  
Furniture and fixtures
    1,768       1,196  
Leasehold improvements and other
    2,537       583  
Total property and equipment
  $ 17,119     $ 12,692  
Less accumulated depreciation and amortization
    (8,543 )     (6,673 )
Total property and equipment, net
  $ 8,576     $ 6,019  
Deferred revenue - current and long-term:
               
Product
  $ 1,466     $ 966  
Support and services
    31,639       27,753  
Total deferred revenue
  $ 33,105     $ 28,719  
 
 
9

 
Intangible assets:
 
The following is a summary of the Company’s intangible assets (in thousands):
 
   
March 31, 2011
   
June 30, 2010
 
   
Gross Carrying
  Amount
   
Accumulated
Amortiza tion
   
Net Carrying
Amou nt
   
Gross Carrying
Amount
   
Accumulated
Amortiza tion
   
Net Carrying
Amount
 
Patents
  $ 2,935     $ (878 )   $ 2,057     $ 2,310     $ (532 )   $ 1,778  
Technology
    4,130       (464 )     3,666                    
Customer relationships
    300       (19 )     281                    
Intangible assets in process
    3,118             3,118       3,247             3,247  
Other intangible assets
  $ 10,483     $ (1,361 )   $ 9,122     $ 5,557     $ (532 )   $ 5,025  
 
The Company acquired $2.8 million of identifiable technology, $0.3 million of customer relationships and $1.1 million of other intangible assets in-process from Agito Networks, Inc. as a part of the business combination discussed in Note 3. The Company transferred approximately $1.3 million from intangible assets in-process to technology as one of the projects reached its completion during the quarter ended December 31, 2010. The intangible assets are amortized over useful lives ranging from 3 years to 7 years.
 
Amortization of intangible assets for three months ended March 31, 2011 and 2010 was $0.4 million and $0.1 million, respectively, and for nine months ended March 31, 2011 and 2010 was $0.9 million and $0.3 million, respectively.
 
The estimated future amortization expenses for intangible assets for the next five years and thereafter are as follows (in thousands):
 
       
Years Ending June 30,
 
 
 
2011 (remaining three months)
  $ 441  
2012
    1,764  
2013
    1,764  
2014
    1,459  
2015
    458  
2016
    62  
Thereafter
    56  
Total
  $ 6,004  

 
10

 
Short-Term Investments:
 
The following tables summarize the Company’s short-term investments (in thousands):
 
   
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Fair Value
 
As of March 31, 2011
 
 
   
 
   
 
   
 
 
Corporate notes and commercial paper
  $ 11,680     $ 46     $     $ 11,726  
U.S. Government agency securities
    16,947       35             16,982  
Total short-term investments
  $ 28,627     $ 81     $     $ 28,708  
As of June 30, 2010
                               
Corporate notes and commercial paper
  $ 33,280     $ 142     $ (50 )   $ 33,372  
U.S. Government agency securities
    13,904       99             14,003  
Total short-term investments
  $ 47,184     $ 241     $ (50 )   $ 47,375  
 
The following table summarizes the contractual maturities of the Company’s short-term investments (in thousands):
 
   
Amortized Cost
   
Fair Value
 
As of March 31, 2011
 
 
   
 
 
Less than 1 year
  $ 28,627     $ 28,708  
Due in 1 to 3 years
           
Total
  $ 28,627     $ 28,708  
                 
   
Amortized Cost
   
Fair Value
 
As of June 30, 2010
               
Less than 1 year
  $ 33,956     $ 34,133  
Due in 1 to 3 years
    13,228       13,242  
Total
  $ 47,184     $ 47,375  
 
Actual maturities may differ from the contractual maturities because issuers may have the right to call or prepay certain obligations.
 
5.  Fair Value Disclosure
 
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal market (or most advantageous market, in the absence of a principal market) for the asset or liability in an orderly transaction between market participants at the measurement date. Further, entities are required to maximize the use of observable inputs and minimize the use of unobservable inputs in measuring fair value, and to utilize a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. The three levels of inputs used to measure fair value are as follows:
 
 
·
Level 1 — Quoted prices in active markets for identical assets or liabilities.
 
 
·
Level 2 — Observable inputs other than quoted prices included within Level 1, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; and inputs other than quoted prices that are observable or are derived principally from, or corroborated by, observable market data by correlation or other means.
 
 
·
Level 3 — Unobservable inputs that are supported by little or no market activity, are significant to the fair value of the assets or liabilities, and reflect our own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.
 
The tables below set forth the Company’s cash equivalents and short-term investments measured at fair value on a recurring basis (in thousands):
 
 
11

 
   
As of March 31, 2011
 
   
Fair Value
   
Level 1
   
Level 2
   
Level 3
 
Cash and cash equivalents:
                       
Money market funds
  $ 59,739     $ 59,739     $     $  
Short-term investments:
                               
Corporate notes and commercial paper
    11,726             11,726        
U.S. Government agency securities
    16,982             16,982        
Total financial instruments measured and recorded at fair value as of March 31, 2011
  $ 88,447     $ 59,739     $ 28,708     $  
 
The above table excludes $14.2 million of cash balances on deposit at banks.
 
   
As at June 30, 2010
 
   
Fair Value
   
Level 1
   
Level 2
   
Level 3
 
Cash and cash equivalents:
                       
Money market funds
  $ 51,660     $ 51,660     $     $  
Short-term investments:
                               
Corporate notes and commercial paper
    33,372             33,372        
U.S. Government agency securities
    14,003             14,003        
Total financial instruments measured and recorded at fair value as of June 30, 2010
  $ 99,035     $ 51,660     $ 47,375     $  
 
The above table excludes $16.8 million of cash balances on deposit at banks.

Money market funds are classified within Level 1 of the fair value hierarchy because they are valued using quoted market price in active markets. Short-term investments are classified within Level 2 of the fair value hierarchy because they are valued based on other observable inputs, including broker or dealer quotations, or alternative pricing sources. When quoted prices in active markets for identical assets or liabilities are not available, the Company relies on non-binding quotes from independent pricing services. Non-binding quotes are based on proprietary valuation models prepared by independent pricing services. These models use algorithms based on inputs such as observable market data, quoted market prices for similar instruments, historical pricing trends of a security as relative to its peers, internal assumptions of the independent pricing service and statistically supported models. The Company corroborates the reasonableness of non-binding quotes received from the independent pricing service by comparing them to the a) actual experience gained from the purchases and redemption of investment securities, b) quotes received on similar securities obtained when purchasing securities and c) monitoring changes in ratings of similar securities and the related impact on the fair value. The types of instruments valued based on other observable inputs include corporate notes and commercial paper and U.S. Government agency securities. We reviewed our financial and non-financial assets and liabilities for the three and nine months ended March 31, 2011 and 2010 and concluded that there were no material impairment charges during each of these periods.
 
6.  Income Taxes
 
The Company recorded a benefit for income taxes of $228,000 and $77,000 for the three months and nine months ended March 31, 2011, compared to a benefit for income taxes of $153,000 and $87,000 for the three and nine months ended March 31, 2010.  The tax benefit determined for the three and nine months ended March 31, 2011 is primarily the result of a federal income tax refund claim filed during the three months ended March 31, 2011 for the carryback of tax year 2010 alternative minimum tax (AMT) losses to prior years.
 
The Company maintains liabilities for uncertain tax positions. As of March 31, 2011 and June 30, 2010, the Company’s total amounts of unrecognized tax benefits were $2.2 million and $2.1 million, respectively. Of the total of $2.2 million and $2.1 million of unrecognized tax benefits, respectively, only $0.1 million and $0.3 million, respectively, if recognized, would impact the effective tax rate.
 
While management believes that the Company has adequately provided for all tax positions, amounts asserted by tax authorities could be greater or less than the Company’s current position. Accordingly, the Company’s provisions on federal, state and foreign tax related matters to be recorded in the future may change as revised estimates are made or the underlying matters are settled or otherwise resolved. The Company does not expect its unrecognized tax benefits to change materially over the next 12 months.
 
The Company’s only major tax jurisdiction is the United States. The Company is currently undergoing an income tax examination by the Internal Revenue Service (IRS) for its fiscal years 2008 and 2009.   For the various foreign and state taxing jurisdictions in which the Company operates, tax years from 2000 through 2010 remain open and subject to tax examination.
 
 
12

 
7.  Common Stock
 
Common Shares Reserved for Issuance
 
At March 31, 2011, the Company has reserved shares of common stock for issuance as follows (in thousands):
 
Reserved under stock option plans
    14,281  
Reserved under employee stock purchase plan
    860  
Total
    15,141  
 
8.   Stock-Based Compensation
 
The Company estimated the grant date fair value of stock option awards and Employee Stock Purchase Plan (ESPP) rights using the Black-Scholes option valuation model with the following assumptions:
 
   
Nine Months Ended
March 31,
 
Employee Incentive Plans
 
2011
   
2010
 
Expected life of option (in years)
    5.75-6.26       6.08-6.50  
Expected life of ESPP right (in years)
    0.50       0.50  
Risk-free interest rate for option
    1.43-2.12 %     2.3-2.47 %
Risk-free interest rate for ESPP right
    0.18-0.20 %     0.16-0.27 %
Volatility for option
    57 %     57-58 %
Volatility for ESPP right
    46-51 %     59-138 %
Dividend yield
    0 %     0 %
 
During both the three months ended March 31, 2011 and 2010, the Company recorded stock-based compensation expense of $2.8 million, net of forfeitures. During the nine months ended March 31, 2011 and 2010, the Company recorded stock-based compensation expense of $8.3 million and $7.7 million, respectively, net of forfeitures.
 
Compensation expense is recognized only for the portion of stock options that are expected to vest. The Company estimates a forfeiture rate in determining stock-based compensation expense. A significant difference between actual and estimated forfeiture rates could affect the stock-based compensation expense recorded. As of March 31, 2011, total unrecognized compensation cost related to stock-based awards granted to employees and non-employee directors was $17.6 million, net of estimated forfeitures. This cost will be amortized on a ratable basis over a weighted-average vesting period of approximately three years.
 
9.   Stock Option Plan
 
In January 1997, the Board of Directors and stockholders adopted the 1997 stock option plan (the “1997 Plan”) which, as amended, provides for granting incentive stock options (“ISOs”) and nonqualified stock options (“NSOs”) for shares of common stock to employees, directors, and consultants of the Company. In September 2006, the Company’s Board of Directors increased the number of shares authorized and reserved for issuance under the 1997 Plan to 10,513,325 shares of common stock. In accordance with the 1997 Plan, the stated exercise price shall not be less than 100% and 85% of the estimated fair market value of common stock on the date of grant for ISOs and NSOs, respectively, as determined by the Board of Directors. The 1997 Plan provides that the options shall be exercisable over a period not to exceed ten years. Options generally vest ratably over four years from the date of grant. Options granted to certain executive officers are exercisable immediately and unvested shares issued upon exercise are subject to repurchase by the Company at the exercise price (“Class Two Options”). The Company’s repurchase right for such options lapses as the options vest, generally over four years from the date of grant. There were no unvested shares subject to repurchase as of March 31, 2011.
 
In February 2007, the Company adopted the 2007 Equity Incentive Plan (the “2007 Plan”) which, as amended, provides for grants of ISOs, NSOs, restrictive stock units (“RSUs”) and restrictive stock awards (“RSAs”) to employees, directors and consultants of the Company. This plan serves as the successor to the 1997 Plan, which terminated in January 2007. Five million shares of common stock were initially reserved for future issuance in the form of stock options, restricted stock awards or units, stock appreciation rights and stock bonuses. Pursuant to the automatic increase provisions of the 2007 Plan, the Company’s board of directors increased the number of shares authorized and reserved for issuance under the 2007 Plan by 2.2 million in February 2010 and 2.3 million in February 2011.
 
 
13

 
Transactions under the 1997 and 2007 Option Plans are summarized as follows:
 
   
 
   
Options Outstanding
 
(In thousands, except per share data and contractual term)
 
Shares Available for Grant
   
Number of Shares
   
Weighted Average
Exercise Price
   
Weighted Avera ge Remaining Co ntractual Term
(i n Years)
   
Aggregate Intr insic Value
 
Balance at July 1, 2010
    4,510       7,492     $ 4.59    
 
   
 
 
Shares authorized
    2,305                              
Termination of remaining shares available for grant under the 1997 Option Plan and other non-plan options
    (7 )              
 
   
 
 
Granted
    (2,185 )     2,185       6.63    
 
   
 
 
Exercised
          (657 )     2.68    
 
   
 
 
Cancelled, forfeited or expired
    738       (738 )     5.35    
 
   
 
 
Restricted stock units granted (see Note 11)
    (849 )              
 
   
 
 
Restricted stock units cancelled
    289                
 
   
 
 
Balance at March 31, 2011
    4,801       8,282     $ 5.21       6.9     $ 26,318  
Vested and expected to vest at March 31, 2011
            7,575     $ 5.13       6.7     $ 24,696  
Exercisable and vested at March 31, 2011
            3,791     $ 4.37       5.7     $ 15,231  
 
The total pre-tax intrinsic value for options exercised in the nine months ended March 31, 2011 and 2010, was $2.6 million and $1.6 million, respectively, representing the difference between the estimated fair values of the Company’s common stock underlying these options at the dates of exercise and the exercise prices paid. There were 7,000 cancelled options that expired under the 1997 Option Plan due to the termination of that plan.
 
10. Employee Stock Purchase Plan
 
On September 18, 2007, the Board of Directors approved the commencement of offering periods under a previously-approved employee stock purchase plan (the “ESPP”). The ESPP allows eligible employees to purchase shares of Company stock at a discount through payroll deductions. The ESPP consists of six-month offering periods commencing on May 1 st and November 1 st , each year. Employees purchase shares in the purchase period at 90% of the market value of the Company’s common stock at either the beginning of the offering period or the end of the offering period, whichever price is lower.
 
The ESPP was amended in November 2010 to permit employees to purchase shares in the purchase period at 85% of market value of the Company’s common stock at either the beginning of the offering period or the end of the offering period, whichever price is lower, effective for the offering period commencing on and after May 1, 2011.
 
In February of fiscal year 2011 and 2010, pursuant to the automatic increase provisions of the ESPP, the Company’s Board of Directors approved increases to the number of shares authorized and reserved for issuance under the ESPP by 469,980 shares and 449,000 shares, respectively, pursuant to the terms of that plan.
 
As of March 31, 2011, 860,000 shares had been reserved for future issuance.
 
11. Restricted Stock
 
Under the 2007 Plan, the Company can issue restricted stock awards to non-employee directors electing to receive them in lieu of an annual cash retainer.
 
In addition, restricted stock units can be issued under the 2007 Plan to eligible employees, and generally vest 25% at one year or 50% at two years from the date of grant and 25% annually thereafter.
 
Restricted stock award and restricted stock unit activity for the nine months ended March 31, 2011 and 2010 is as follows (in thousands):
 
   
Nine Months Ended
March 31, 2011
   
Nine Months Ended
March 31, 2010
 
Beginning balance
    809       507  
Awarded
    849       359  
Released
    (253 )     (88 )
Forfeited
    (207 )     (27 )
Ending balance
    1,198       751  
 
 
14


            Information regarding restricted stock units outstanding at March 31, 2011 is summarized below:
 
   
Number of Shares (thousands)
 
Weighted Average Remaining Cont ractual Lives
 
Aggregate Intrinsic Value (thousands)
 
Shares outstanding
    1,198  
                        1.79 years
  $ 9,857  
Shares vested and expected to vest
    951  
                        1.66 years
    7,828  
 
12. Litigation, Commitments and Contingencies
 
Litigation — The Company is not a party to any material litigation.
 
The Company could become involved in litigation from time to time relating to claims arising out of the ordinary course of business or otherwise. Any litigation, regardless of outcome, is costly and time-consuming, can divert the attention of management and key personnel from business operations and deter distributors from selling the Company’s products and dissuade potential customers from purchasing the Company’s products.
 
Leases — The Company leases its facilities under noncancelable operating leases which expire at various times through 2018. The leases provide for the lessee to pay all cost of utilities, insurance, and taxes. Future minimum lease payments under the noncancelable leases as of March 31, 2011, are as follows (in thousands):
 
Years Ending June 30,
 
 
 
2011 (remaining three months)
  $ 347  
2012
    1,627  
2013
    2,035  
2014
    1,930  
2015
    1,122  
2016
    866  
Thereafter
    1,571  
Total
  $ 9,498  
 
Lease obligations for the Company’s foreign offices are denominated in foreign currencies, which were converted in the above table to U.S. dollars at the interbank exchange rate on March 31, 2011.
 
Rent expense for the three months ended March 31, 2011 and 2010 was $0.5 million and $0.4 million respectively, and $1.4 million and $1.0 million for the nine months ended March 31, 2011 and 2010, respectively.
 
Purchase commitments —The Company had purchase commitments with contract manufacturers for inventory and with technology firms for usage of software licenses totaling approximately $25.5 million as of March 31, 2011 and $22.9 million as of June 30, 2010.
 
Indemnification — Under the indemnification provisions of the Company’s customer agreements, the Company agrees to indemnify and defend its customers against infringement of any patent, trademark, or copyright of any country or the misappropriation of any trade secret, arising from the customers’ legal use of the Company’s services. The exposure to the Company under these indemnification provisions is generally limited to the total amount paid by the customers under pertinent agreements. However, certain indemnification provisions potentially expose the Company to losses in excess of the aggregate amount received from the customer. To date, there have been no claims against the Company or its customers pertaining to such indemnification provisions and no amounts have been recorded.
 
The Company also has entered into customary indemnification agreements with each of its officers and directors.
 
13. Segment Information
 
The Company is organized as, and operates in, one reportable segment: the development and sale of IP voice communication systems. The Company’s chief operating decision-maker is its Chief Executive Officer. The Company’s Chief Executive Officer reviews financial information presented on a consolidated basis for purposes of evaluating financial performance and allocating resources, accompanied by information about revenue by geographic regions. The Company’s assets are primarily located in the United States of America and not allocated to any specific region and it does not measure the performance of its geographic regions based upon asset-based metrics. Therefore, geographic information is presented only for revenue. Revenue by geographic region is based on the ship to address on the customer order.
 
 
15

 
The following presents total revenue by geographic region (in thousands):
 
   
Three Months Ended
March 31,
   
Nine Months Ended
March 31,
 
   
2011
   
2010
   
2011
   
2010
 
United States
  $ 45,634     $ 33,473     $ 127,255     $ 96,160  
International
    5,943       3,561       16,330       10,081  
Total revenues
  $ 51,577     $ 37,034     $ 143,585     $ 106,241  
 
ITEM 2.
 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this document. 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 above in the section entitled “Risk Factors.”
 
Overview
 
We are a leading provider of IP telecommunications solutions for enterprises. Our solution is comprised of our switches, IP phones and software applications. We were founded in September 1996 and shipped our first system in 1998. We have continued to develop and enhance our product line since that time. We currently offer a variety of models of our switches and IP phones.
 
We sell our products primarily through channel partners that market and sell our systems to enterprises across all industries, including small, medium and large companies and public institutions. We believe our channel strategy allows us to reach a larger number of prospective enterprise customers more effectively than if we were to sell directly. The number of our authorized channel partners has grown to over 975 as of March 31, 2011. Channel partners typically purchase our products directly from us. Our internal sales and marketing personnel support these channel partners in their selling efforts. In some circumstances, the enterprise customer will purchase products directly from us, but in these situations we typically compensate the channel partner for its sales efforts. At the request of the channel partner, we often ship our products directly to the enterprise customer.
 
Most channel partners generally perform installation and implementation services for the enterprises that use our systems. In most cases, our channel partners provide the post-contractual support to the enterprise customer by providing first-level support services and purchasing additional services from us under a post-contractual support contract. For channel partners without support capabilities or that do not desire to provide support, we offer full support contracts to provide all of the support to enterprise customers.
 
We outsource the manufacturing of our products to contract manufacturers. Our outsourced manufacturing model allows us to scale our business without the significant capital investment and on-going expenses required to establish and maintain a manufacturing operation. Our phone and switch products are manufactured by contract manufacturers located in California and in China. Our contract manufacturers provide us with a range of operational and manufacturing services, including component procurement, final testing and assembly of our products. We work closely with our contract manufacturers to manage the cost of components, since our total manufacturing costs are directly tied to component costs. We regularly provide forecasts to our contract manufacturers, and we order products from our contract manufacturers based on our projected sales levels well in advance of receiving actual orders from our enterprise customers. We seek to maintain sufficient levels of finished goods inventory to meet our forecasted product sales and to compensate for unanticipated shifts in sales volume and product mix.
 
Although we have historically sold our systems primarily to small and medium sized enterprises, we expanded our sales and marketing activities to increase our focus on larger enterprise customers. Accordingly, we have a major accounts program whereby our sales personnel assist our channel partners to sell to large enterprise accounts, and we coordinate with our channel partners to enable them to better serve large multi-site enterprises. To the extent we are successful in penetrating larger enterprise customers; we expect that the sales cycle for our products will increase, and that the demands on our sales and support infrastructure will also increase.
 
We are headquartered in Sunnyvale, California and have a sales, customer support, general and administrative and engineering functions in Austin, Texas. The majority of our personnel work at these locations. Sales, engineering, and support personnel are located throughout the United States and, to a lesser extent, in the United Kingdom, Ireland, Germany, Belgium, Spain, Hong Kong, Singapore and Australia . Most of our enterprise customers are located in the United States. Revenue from international sales was 11.5% and 11.4% of our total revenue for the three and nine months ended March 31, 2011 and was less than 10% of total revenues for the three and nine months ended March 31, 2010. Although we intend to focus on increasing international sales, we expect that sales to enterprise customers in the United States will continue to comprise the significant majority of our sales.
 
 
16

 
Key Business Metrics
 
We monitor a number of key metrics to help forecast growth, establish budgets, measure the effectiveness of sales and marketing efforts and measure operational effectiveness.
 
Initial and repeat sales orders. Our goal is to attract a significant number of new enterprise customers and to encourage existing enterprise customers to purchase additional products and support. Many enterprise customers make an initial purchase and deploy additional sites at a later date, and also buy additional products and support as their businesses expand. As our installed enterprise customer base has grown we have experienced an increase in revenue attributable to existing enterprise customers, which currently represents a significant portion of our total revenue.
 
Deferred revenue . Deferred revenue relates to the timing of revenue recognition for specific transactions based on service, support, specific commitments and other factors. Deferred revenue primarily consists of billings or payments received in advance of revenue recognition from our transactions described above and are recognized as the revenue recognition criteria are met. Nearly all system sales include the purchase of post-contractual support contracts with terms of up to five years, and the rate of renewal on these contracts has been high historically. We recognize support revenue on a ratable basis over the term of the support contract. Since we receive payment for support in advance of our recognizing the related revenue, we carry a deferred revenue balance on our consolidated balance sheet. This deferred revenue helps provide predictability to our future support and services revenue. Accordingly, the level of purchases of post-contractual support with our product sales is an important metric for us along with the renewal rates for these services. Our deferred revenue balance at March 31, 2011 was $33.1 million, consisting of $1.5 million of deferred product revenue and $31.6 million of deferred support and services revenues, of which $22.5 million is expected to be recognized within one year.
 
Gross profit. Our gross profit for products is primarily affected by our ability to reduce hardware costs faster than the decline in average overall system prices. We have been able to maintain our product gross profit by reducing hardware costs through product redesign and volume discount pricing from our suppliers. We have also introduced new, lower cost hardware, which has continued to improve our product gross profit. In general, product gross profit on our switches is greater than product gross profit on our IP phones. As the prices and costs of our hardware components have decreased over time, our software components, which have lower costs than our hardware components, have represented a greater percentage of our overall system sales. We consider our ability to monitor and manage these factors to be a key aspect of maintaining product gross profit and increasing our profitability.
 
Gross profit for support and services is slightly lower than gross profit for products, and is impacted primarily by personnel costs and labor related expenses. The primary goal of our support and services function is to ensure maximum customer satisfaction and our investments in support personnel and infrastructure are made with this goal in mind. We expect that as our installed enterprise customer base grows, we will be able to improve gross profit for support and services through economies of scale. However, the timing of additional investments in our support and services infrastructure could materially affect our cost of support and services revenue, both in absolute dollars and as a percentage of support and services revenue and total revenue, in any particular period.
 
Operating expenses. Our operating expenses are comprised primarily of compensation and benefits for our employees and, therefore, the increase in operating expenses has been primarily related to increases in our headcount. We intend to expand our workforce to support our anticipated growth, and therefore our ability to forecast and increase revenue is critical to managing our operating expenses and profitability.
 
Basis of Presentation
 
Revenue. We derive our revenue from sales of our IP telecommunications systems and related support and services. Our typical system includes a combination of IP phones, switches and software applications. Channel partners buy our products directly from us. Prices to a given channel partner for hardware and software products depend on that channel partner’s volume and customer satisfaction metrics, as well as our own strategic considerations. In circumstances where we sell directly to the enterprise customer in transactions that have been assisted by channel partners, we report our revenue net of any associated payment to the channel partners that assisted in such sales. This results in recognized revenue from a direct sale approximating the revenue that would have been recognized from a sale of a comparable system through a channel partner.
 
Support and services revenue primarily consists of post-contractual support, and to a lesser extent revenue from training services, professional services and installations that we perform. Post-contractual support includes software updates which grant rights to unspecified software license upgrades and maintenance releases issued during the support period. Post-contractual support also includes both internet-based and phone-based technical support. Post-contractual support revenue is recognized ratably over the contractual service period.
 
 
17

 
Cost of revenue. Cost of product revenue consists primarily of hardware costs, royalties and license fees for third-party software included in our systems, salary and related overhead costs of operations personnel, freight, warranty costs, amortization of acquired intangible assets and provision for excess inventory. The majority of these costs vary with the unit volumes of product sold. Cost of support and services revenue consists of salary and related costs of personnel engaged in support and services, and are substantially fixed in the near term.
 
Research and development expenses. Research and development expenses primarily include personnel costs, outside engineering costs, professional services, prototype costs, test equipment, software usage fees and facilities expenses. Research and development expenses are recognized when incurred. We are devoting substantial resources to the development of additional functionality for existing products and the development of new products and related software applications.
 
Sales and marketing expenses. Sales and marketing expenses primarily include personnel costs, sales commissions, travel, marketing promotional and lead generation programs, advertising, trade shows, demo equipment, professional services fees and facilities expenses. We plan to continue to invest in development of our distribution channel by increasing the size of our field sales force and the number of our channel partners to enable us to expand into new geographies, including Europe and Asia Pacific, and further increase our sales to large enterprises. In conjunction with channel growth, we plan to increase the investment in our training and support of channel partners to enable them to more effectively sell our products. We also plan to continue investing in our domestic and international marketing activities to help build brand awareness and create sales leads for our channel partners. We expect that sales and marketing expenses will increase in absolute dollars and remain our largest operating expense category.
 
General and administrative expenses. General and administrative expenses relate to our executive, finance, human resources, legal and information technology organizations. Expenses primarily include personnel costs, professional fees for legal, accounting, tax, compliance and information systems, travel, allowance for doubtful accounts, recruiting expense, software amortization costs, depreciation expense and facilities expenses. In addition, as we expand our business, we expect to increase our general and administrative expenses.
 
Other income (expense), net. Other income (expense) primarily consists of interest earned on cash and short-term investments and other miscellaneous income (expenses).
 
Income tax provision. Income tax provision includes federal, state and foreign tax on our income. Historically, we accumulated substantial net operating loss and tax credit carryforwards. We account for income taxes under an asset and liability approach. Deferred income taxes reflect the impact of temporary differences between assets and liabilities recognized for financial reporting purposes and such amounts recognized for income tax reporting purposes, net operating loss carry-forwards and other tax credits measured by applying currently enacted tax laws. Valuation allowances are provided when necessary to reduce deferred tax assets to an amount that is more likely than not to be realized.
 
Critical Accounting Policies and Estimates
 
The preparation of our financial statements and related disclosures in conformity with generally accepted accounting principles in the United States of America, or GAAP, requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. These estimates and assumptions are based on historical experience and various other factors that we believe are reasonable under the circumstances. We consider our accounting policies related to revenue recognition, allowance for doubtful accounts, stock-based compensation, inventory valuation, impairment of goodwill and other long-term assets, and accounting for income tax to be critical accounting policies. A number of significant estimates, assumptions, and judgments are inherent in our determination of when to recognize revenue, how to estimate doubtful accounts, the calculation of stock-based compensation expense, and how we value inventory. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates. Other than the impairment assessment of goodwill and other long-term assets resulting from the acquisition of Agito Networks, Inc., in the second quarter and adoption of the new revenue recognition rules at the beginning of the fiscal year as discussed in Note 2 of the condensed consolidated financial statements included in Part I, Item 1 of this quarterly report on Form 10-Q, management believes there have been no significant changes during the nine months ended March 31, 2011 to the items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2010 Annual Report on Form 10-K filed with the Securities and Exchange Commission. For a description of those accounting policies, please refer to our 2010 Annual Report on Form 10-K.

 
18

 
Results of Operations
 
The following table sets forth selected condensed consolidated statements of operations data for three and nine months ended March 31, 2011 and 2010 (Amounts in thousands, except per share amounts) .
 
   
(Unaudited)
Three Months Ended
March 31,
   
(Unaudited)
Nine Months Ended
March 31,
 
   
2011
   
2010
   
2011
   
2010
 
REVENUE:
 
 
   
 
   
 
   
 
 
Product
  $ 41,248     $ 28,945     $ 114,387     $ 83,685  
Support and services
    10,329       8,089       29,198       22,556  
Total revenue
    51,577       37,034       143,585       106,241  
COST OF REVENUE:
                               
Product (1)
    12,979       10,049       37,593       29,369  
Support and services (1)
    3,515       2,933       9,616       8,323  
Total cost of revenue
    16,494       12,982       47,209       37,692  
GROSS PROFIT
    35,083       24,052       96,376       68,549  
OPERATING EXPENSES:
                               
Research and development (1)
    12,562       8,634       33,396       23,666  
Sales and marketing (1)
    18,920       14,726       54,437       39,653  
General and administrative (1)
    6,377       5,214       19,118       14,596  
Total operating expenses
    37,859       28,574       106,951       77,915  
LOSS FROM OPERATIONS
    (2,776 )     (4,522 )     (10,575 )     (9,366 )
OTHER INCOME (EXPENSE):
                               
Interest income
    105       100       447       296  
Other
    61       (220 )     333       (128 )
Total other income (expense)
    166       (120 )     780       168  
LOSS BEFORE BENEFIT FROM  INCOME TAXES
    (2,610 )     (4,642 )     (9,795 )     (9,198 )
BENEFIT FROM INCOME TAXES
    228       153       77       87  
NET LOSS
  $ (2,382 )   $ (4,489 )   $ (9,718 )   $ (9,111 )
Net loss per share — basic and diluted  (2)
  $ (0.05 )   $ (0.10 )   $ (0.21 )   $ (0.20 )
Shares used in computing net loss per share—basic and diluted  (2)
    46,249       44,941       45,862       44,731  
______________                                
(1) Includes stock-based compensation expense as follows:
                               
Cost of product revenue
  $ 32     $ 34     $ 94     $ 99  
Cost of support and services revenue
    111       207       472       553  
Research and development
    1,086       805       2,688       2,248  
Sales and marketing
    459       911       2,212       2,528  
General and administrative
    1,112       861       2,786       2,320  
Total stock-based compensation expense
  $ 2,800     $ 2,818     $ 8,252     $ 7,748  
(2) Potentially dilutive securities were not included in the computation of diluted net loss per share because to do so would have been anti-dilutive.                                

 
19

          
            The following table sets forth selected condensed consolidated statements of operations data as a percentage of total revenue for each of the periods indicated.
 
   
(Unaudited)
Three Months Ended
March 31,
   
(Unaudited)
Nine Months Ended
March 31,
 
   
2011
   
2010
   
2011
   
2010
 
REVENUE:
 
 
   
 
   
 
   
 
 
Product
    80 %     78 %     80 %     79 %
Support and services
    20 %     22 %     20 %     21 %
Total revenue
    100 %     100 %     100 %     100 %
COST OF REVENUE:
                               
Product
    25 %     27 %     26 %     28 %
Support and services
    7 %     8 %     7 %     8 %
Total cost of revenue
    32 %     35 %     33 %     36 %
GROSS PROFIT
    68 %     65 %     67 %     64 %
Operating expenses:
                               
Research and development
    24 %     23 %     23 %     22 %
Sales and marketing
    37 %     40 %     38 %     37 %
General and administrative
    12 %     14 %     14 %     14 %
Total operating expenses
    73 %     77 %     75 %     73 %
LOSS FROM OPERATIONS
    (5 )%     (12 )%     (8 )%     (9 )%
OTHER INCOME, net
    0 %     0% %     1 %     0 %
LOSS BEFORE BENEFIT FROM INCOME TAXES
    (5 )%     (12 )%     (7 )%     (9 )%
BENEFIT FROM INCOME TAXES
    0 %     0% %     0 %     0 %
NET LOSS
    (5 )%     (12 )%     (7 )%     (9 )%
 
Use of Non-GAAP Financial Measures
 
We believe that evaluating our ongoing operating results may limit the reader’s understanding if limited to reviewing only generally accepted accounting principles (GAAP) financial measures. Many investors and analysts have requested that, in addition to reporting financial information in accordance with GAAP we also disclose certain non-GAAP information because it is useful in understanding our performance as it excludes non-cash and other special charges or credits that many investors and management feel may obscure our true operating performance. Likewise, we use these non-GAAP financial measures to manage and assess the profitability of the business and determine a portion of our employee compensation. We do not consider stock-based compensation expenses, amortization of acquisition-related intangibles and other special charges and related tax adjustments in managing the core operations. These measures are not based on any standardized methodology prescribed by GAAP and are not necessarily comparable to similar measures presented by other companies. Non-GAAP net income (loss) is calculated by adjusting GAAP net income (loss) for stock-based compensation expense, amortization of acquisition-related intangibles, restructuring benefit, executive severance expense and the related tax impacts. Basic and diluted non-GAAP net income (loss) per share is calculated by dividing non-GAAP net income (loss) by the weighted average number of basic and diluted shares outstanding for the period. However, in case of a non-GAAP loss, potentially dilutive securities are not included in the computation of diluted non-GAAP net loss per share as including them would be anti-dilutive. These measures should not be considered in isolation or as a substitute for measures prepared in accordance with GAAP, and because these amounts are not determined in accordance with GAAP, they should not be used exclusively in evaluating our business and operations. We have provided a reconciliation of non-GAAP financial measures in the table below.
 
 
20

 
RECONCILIATION OF GAAP TO NON-GAAP FINANCIAL MEASURES
(Amounts in thousands, except per share amounts)
(Unaudited)
 
   
Three Months Ended
   
Nine Months Ended
 
   
March 31, 2011
   
March 31, 2011
 
   
GAAP
   
Excludes
   
Non-GAAP
   
GAAP
   
Excludes
   
Non-GAAP
 
                                     
Revenue:
                                   
Product
  $ 41,248     $ -     $ 41,248     $ 114,387     $ -     $ 114,387  
Support and services
    10,329       -       10,329       29,198       -       29,198  
Total revenues
    51,577       -       51,577       143,585       -       143,585  
Cost of revenue
                                               
Product
    12,979       (207 )  (a),(c)     12,772       37,593       (410 ) (a),(c)     37,183  
Support and services
    3,515       (111 )  (a)     3,404       9,616       (472 ) (a)     9,144  
Total cost of revenue
    16,494       (318 )     16,176       47,209       (882 )     46,327  
Gross profit
    35,083       318       35,401       96,376       882       97,258  
Gross profit %
    68.0 %             68.6 %     67.1 %             67.7 %
                                                 
Operating expenses:
                                               
Research and development
    12,562       (1,086 )  (a)     11,476       33,396       (2,688 ) (a)     30,708  
Sales and marketing
    18,920       (469 )  (a),(c)     18,451       54,437       (2,231 ) (a),(c)     52,206  
General and administrative
    6,377       (1,112 )  (a)     5,265       19,118       (3,311 ) (a),(b)     15,807  
Total operating expenses
    37,859       (2,667 )     35,192       106,951       (8,230 )     98,721  
Income (Loss) from operations
    (2,776 )     2,985       209       (10,575 )     9,112       (1,463 )
Other income, net
    166       -       166       780       -       780  
Income (Loss) before provision for income taxes
    (2,610 )     2,985       375       (9,795 )     9,112       (683 )
Benefit from income taxes
    228       (1 )  (d)     227       77       (1 ) (d)     76  
Net income (loss)
  $ (2,382 )   $ 2,984     $ 602     $ (9,718 )   $ 9,111     $ (607 )
Net income (loss) per share:
                                               
Basic
  $ (0.05 )   $ 0.06     $ 0.01     $ (0.21 )   $ 0.20     $ (0.01 )
Diluted (e)
  $ (0.05 )   $ 0.06     $ 0.01     $ (0.21 )   $ 0.20     $ (0.01 )
                                                 
Shares used in computing net loss per share:
                                               
Basic
    46,249               46,249       45,862               45,862  
Diluted (e)
    46,249               48,209       45,862               45,862  
                                                 
                                                 
(a)   Excludes stock-based compensation as follows:
                                               
Cost of product revenue
          $ 32                     $ 94          
Cost of support and services revenue