MoSys 10-Q 2010
WASHINGTON, DC 20549
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2010
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 000-32929
(Exact name of registrant as specified in its charter)
3301 Olcott Street
Santa Clara, California, 95054
(Address of principal executive office and zip code)
(Registrants 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 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 definitions of large accelerated filer, accelerated filer, and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
As of October 29, 2010, 32,116,539 shares of the Registrants common stock, $0.01 par value, were outstanding.
(In thousands, except par value)
The accompanying notes are an integral part of these condensed consolidated financial statements.
The accompanying notes are an integral part of these condensed consolidated financial statements.
The accompanying notes are an integral part of these condensed consolidated financial statements.
Note 1. The Company and Summary of Significant Accounting Policies
MoSys, Inc., (the Company) was incorporated in California in September 1991, and reincorporated in September 2000 in Delaware. The Company designs, develops, markets and licenses high performance semiconductor memory and high-speed parallel and serial interface intellectual property (IP) used by the semiconductor industry and communications, networking and storage equipment manufacturers. In February 2010, the Company announced the commencement of a new product initiative to develop a family of IC products under the Bandwidth Engine product name. The Bandwidth Engine will combine the Companys high-density embedded memory with its high-speed 10 Gigabits per second interface (I/O) technology and will initially be marketed to networking systems companies.
The accompanying unaudited condensed consolidated financial statements of the Company have been prepared without audit in accordance with the rules and regulations of the Securities and Exchange Commission (SEC). The condensed consolidated balance sheet at December 31, 2009 has been derived from the audited consolidated financial statements at that date. Certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted in accordance with these rules and regulations. The information in this report should be read in conjunction with the Companys consolidated financial statements and notes thereto included in its most recent annual report on Form 10-K and 10-K/A filed with the SEC.
In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary to summarize fairly the Companys financial position, results of operations and cash flows for the interim periods presented. The operating results for the three and nine months ended September 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010 or for any other future period.
Basis of Presentation
The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. The Companys fiscal year is the calendar year.
Use of Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues recognized under the percentage of completion method and expenses recognized during the reported period. Actual results could differ from those estimates.
Cash Equivalents and Investments
The Company has invested its excess cash in money market accounts, certificates of deposit, corporate debt, government agency and municipal debt securities and considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Investments with original maturities greater than three months and remaining maturities less than one year are classified as short-term investments. Investments with remaining maturities greater than one year are classified as long-term investments. Management generally determines the appropriate classification of securities at the time of purchase. All securities are classified as available-for-sale. The Companys available-for-sale short-term and long-term investments are carried at fair value, with the unrealized holding gains and losses reported in accumulated other comprehensive income. Realized gains and losses and declines in the value judged to be other than temporary are included in the other income, net line item in the condensed consolidated statements of operations. The cost of securities sold is based on the specific identification method (see Note 2).
Fair Value Measurements
The Company measures the fair value of financial instruments using a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels, as follows:
Level 1Inputs used to measure fair value are unadjusted quoted prices that are available in active markets for the identical assets or liabilities as of the reporting date.
Level 2Pricing is provided by third party sources of market information obtained through the Companys investment advisors rather than models. The Company does not adjust for or apply any additional assumptions or estimates to the pricing information it receives from advisors. The Companys Level 2 securities include cash equivalents and available-for-sale securities, which consisted primarily of commercial paper, certificates of deposit, corporate debt, and government agency and municipal debt securities from issuers with high quality credit ratings. The Companys investment advisors obtain pricing data from independent sources, such as Standard & Poors, Bloomberg and Interactive Data Corporation, and rely on comparable pricing of other securities because the Level 2 securities it holds are not actively traded and have fewer observable transactions. The Company considers this the most reliable information available for the valuation of the securities.
Level 3Unobservable inputs that are supported by little or no market activity and reflect the use of significant management judgment are used to measure fair value. These values are generally determined using pricing models for which the assumptions utilize managements estimates of market participant assumptions. The determination of fair value for Level 3 investments and other financial instruments involves the most management judgment and subjectivity.
The Company generates revenue from the licensing of its IP, and customers pay fees for licensing, development services, royalties and maintenance and support. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery or performance has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Evidence of an arrangement generally consists of signed agreements. When sales arrangements contain multiple elements (e.g., license and services), the Company reviews each element to determine the separate units of accounting that exist within the agreement. If more than one unit of accounting exists, the consideration payable to the Company under the agreement is allocated to each unit of accounting using either the relative fair value method or the residual fair value method. Revenue is recognized for each unit of accounting when the revenue recognition criteria have been met for that unit of accounting.
Licensing revenue consists of fees earned from license agreements, development services and support and maintenance. For license agreements that do not require significant development, modification or customization, revenues are generally recognized when the revenue recognition criteria have been met. If any of these criteria are not met, revenue recognition is deferred until such time as all criteria have been met.
For license agreements that include deliverables requiring significant production, modification or customization, and where the Company has significant experience in meeting the design specifications involved in the contract and the direct labor hours related to services under the contract can be reasonably estimated, the Company recognizes revenue over the period in which the contract services are performed. For these arrangements, the Company recognizes revenue using the percentage of completion method. Revenue recognized in any period is dependent on the Companys progress toward completion of projects in progress. Significant management judgment and discretion are used to estimate total direct labor hours. These judgmental elements include determining that the Company has the experience to meet the design specifications and estimating the total direct labor hours. The Company follows this method because it can obtain reasonably dependable estimates of the direct labor hours to perform the contract services. The direct labor hours for the development of the licensees design are estimated at the beginning of the contract. As these direct labor hours are incurred, they are used as a measure of progress towards completion. The Company has the ability to reasonably estimate the direct labor hours on a contract-by-contract basis based on its experience in developing prior licensees designs. During the contract performance period, the Company reviews estimates of direct labor hours to complete the contracts as the contract progresses to completion and will revise its estimates of revenue and gross profit under the contract if the Company revises the estimations of the direct labor hours to complete. The Companys policy is to reflect any revision in the contract gross profit estimate in reported income or loss in the period in which the facts giving rise to the revision become known. Under the percentage of completion method, provisions for estimated losses on uncompleted contracts are recorded in the period in which such losses are determined to be likely. For the three and nine months ended September 30, 2010 and 2009, no loss accruals were recorded. If the amount of revenue recognized under the percentage of completion accounting method exceeds the amount of billings to a customer, then the excess amount is recorded as an unbilled contracts receivable.
The Company provides support and maintenance under many of its license agreements. Under these arrangements, the Company provides unspecified upgrades, design rule changes and technical support. No other upgrades, products or other post-contract support are provided. Support and maintenance revenue is recognized at its fair value established by objective evidence, ratably over the period during which the obligation exists, typically 12 months. These arrangements are generally renewable annually by the customer.
Under limited circumstances, the Company also recognizes prepaid pre-production royalties as license revenues. These are lump sum payments made when the Company enters into licensing agreements that cover future shipments of a product that is not commercially available from the licensee. The Company characterizes such payments as license revenues because they are paid as part of the initial license fee and not with respect to products being produced by the licensee. These payments are non-cancelable and non-refundable.
The Companys licensing contracts typically also provide for royalties based on licensees use of the Companys memory technology in their currently shipping commercial products. The Company generally recognizes royalties in the quarter in which it receives the licensees report. Under limited circumstances, the Company may also recognize prepaid post-production royalties as revenue upon execution of the contract, which are paid in a lump sum after the licensee commences production of the royalty-bearing product and applied against future unit shipments regardless of the actual level of shipments by the licensee. The criteria for revenue recognition of prepaid royalties are that a formal agreement with the licensee is executed, no deliverables, development or support services related to prepaid royalties are required, the fees are non-refundable and not contingent upon future product shipments by the licensee, and the fees are payable by the licensee in a time period consistent with the Companys normal billing terms. If any of these criteria are not met, the Company defers revenue recognition until such time as all criteria have been met.
Cost of revenue
Cost of licensing revenue consists primarily of engineering personnel and overhead allocation costs directly related to development services specified in agreements. These services typically include customization of the Companys technologies for the licensees particular integrated circuit design and may include engineering support to assist in the commencement of production of a licensees products. The Company recognizes cost of licensing revenue in the following manner:
· If licensing revenue is recognized using the percentage of completion method, the associated cost of licensing revenue is recognized in the period in which the Company incurs the engineering costs.
· If licensing revenue is recognized using the completed contract method, to the extent that the amount of engineering cost does not exceed the amount of the related licensing revenue, the cost of licensing revenue is deferred on a contract-by-contract basis from the time the Company has established technological feasibility of the product to be developed under the license contract. Technological feasibility is established when the Company has completed all activities necessary to demonstrate that the licensees product can be produced to meet the performance specifications when incorporating its technology. Deferred costs are charged to cost of licensing revenue when the related revenue is recognized.
The Company reviews goodwill for impairment annually in the third quarter and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. The Company uses a two-step impairment test. In the first step, the Company compares the fair value of each reporting unit to its carrying value. For step one, the Company determines the fair value of its reporting unit using the market approach. Under the market approach, the Company estimates the fair value based on the market value of the reporting unit at the entity level. If the fair value of the reporting unit exceeds the carrying value of net assets of the reporting unit, goodwill is not impaired and the Company is not required to perform further testing. If the carrying value of the net assets of the reporting unit exceeds the fair value of the reporting unit, the Company must perform the second step in order to determine the implied fair value of the reporting units goodwill and compare it to the carrying value of the reporting units goodwill. If the carrying value of a reporting units goodwill exceeds its implied fair value, then the Company must record an impairment loss equal to the difference.
The following table summarizes the activity related to the carrying value of goodwill (in thousands):
(1) The balance as of December 31, 2009, as previously reported in the Companys 2009 annual report on Form 10-K, has been adjusted to reflect a $0.2 million decrease in the fair value of the contractual obligation assumed as part of the acquisition of Prism Circuits, Inc. A corresponding adjustment of $0.2 million was made to the balance of deferred revenue. This adjustment had no effect on net loss previously reported.
Purchased Intangible Assets
Intangible assets acquired in business combinations are accounted for based on the fair value of assets purchased and are amortized over the period in which economic benefit is estimated to be received. Identifiable intangible assets relating to business combinations were as follows (dollar amounts in thousands):
The related amortization expense was $0.7 million and $2.1 million for the three and nine months ended September 30, 2010, respectively. The amortization expense was $0.6 million and $0.8 million for the three and nine months ended September 30, 2009, respectively. Amortization expense has been included in research and development expense in the condensed consolidated statements of operations. The estimated aggregate amortization expense to be recognized in future years is approximately $0.7 million for the remainder of 2010, $2.6 million for 2011, $1.6 million for 2012, $0.9 million for 2013, $0.9 million for 2014, and $0.2 million for 2015.
Per Share Amounts
Basic net loss per share is computed by dividing net loss for the period by the weighted-average number of shares of common stock outstanding during the period. Diluted net loss per share gives effect to all potentially dilutive common shares outstanding during the period. Potential common shares are composed of incremental shares of common stock issuable upon the exercise of stock options or restricted stock awards. As of September 30, 2010 and 2009, stock awards for approximately 10,699,000 and 10,271,000 shares, respectively, were excluded from the computation of diluted net loss per share as their inclusion would be anti-dilutive.
Comprehensive loss, as defined, includes all changes in equity (net assets) during a period from non-owner sources. The components of comprehensive loss for the three and nine months ended September 30, 2010 and 2009 were as follows (in thousands):
Recent Accounting Pronouncements
In October 2009, the Financial Accounting Standards Board (FASB) issued guidance for revenue arrangements with multiple deliverables that are outside the scope of software revenue recognition guidance. Under this guidance, when vendor-specific objective evidence or third- party evidence for deliverables in such an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. Additionally, in October 2009 the FASB issued guidance modifying its earlier software revenue recognition guidance to exclude from its scope tangible products that contain both software and non-software components that function together to deliver a products essential functionality. The guidance for both topics will apply to revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption is permitted. The Company is currently evaluating the impact that the adoption of the guidance will have on its consolidated financial statements.
Note 2. Fair Value of Financial Instruments
The estimated fair values of financial instruments outstanding, excluding auction-rate securities of $7.9 million as of December 31, 2009 and a right from UBS Financial Services, Inc. (UBS), were as follows (in thousands):
As of September, 30, 2010 and December 31, 2009, all of the available-for-sale securities with unrealized losses have been in a loss position for less than 12 months. Total fair value of available-for-sale securities with unrealized losses was $5.7 million at September 30, 2010.
Cost and fair value of investments, excluding auction-rate securities, based on two maturity groups were as follows (in thousands):
The Company used the concepts of fair value based on estimated discounted future cash flows to value its auction-rate securities that included the following significant inputs and considerations:
· projected interest income and principal payments through the expected holding period;
· a market risk adjusted discount rate, which was based on actual securities traded in the open market that had similar collateral composition to the auction-rate securities during the period, adjusted for an expected yield premium to compensate for the current lack of liquidity resulting from failing auctions for such securities; and
· no default or collateral value risk adjustments were considered for the discount rate, because most of the issuers were AAA-rated by nationally recognized rating agencies, and the auction-rate securities were collateralized by student loans, the repayments of which were substantially guaranteed by the U.S. Department of Education.
The following table represents the Companys fair value hierarchy for its financial assets (cash equivalents and investments) and for an acquisition-related earn-out liability as of September 30, 2010 (in thousands):
There were no transfers in or out of Level 1 and Level 2 securities during the three and nine months ended September 30, 2010.
The following table provides a summary of changes in fair value of the Companys financial assets measured at fair value using significant unobservable inputs (Level 3) for the period ended September 30, 2010 (in thousands):
On July 1, 2010, UBS purchased the auction-rate securities from the Company at par value, resulting in no realized gains and losses.
The following table provides a summary of changes in fair value of the acquisition-related earn-out liability measured at fair value using significant unobservable inputs (Level 3) for the period ended September 30, 2010 (in thousands):
Note 3. Revision of Prior Period Financial Statements
In the fourth quarter of 2009, the Company identified a calculation error in the third-party software it uses for stock administration. The calculation errors resulted in an understatement of previously reported non-cash stock-based compensation expense and changed the timing of stock-based compensation expense. The effect of this error on the Companys net loss was determined to be immaterial to previously reported annual and quarterly financial results. The Company retroactively corrected the impact of the calculation error on the condensed consolidated financial statements for the three and nine months ended September 30, 2009. The revision had no impact on the Companys total cash flows for the nine months ended September 30, 2009.
The line items within the condensed consolidated financial statements as of and for the three and nine months ended September 30, 2009 that were impacted by the revision are set forth below (in thousands):
Note 4. Acquisitions
In March 2010, the Company acquired all of the outstanding stock of MagnaLynx, Inc. (MagnaLynx), a provider of semiconductor interface technology. Under the terms of the merger agreement, at closing, the Company paid approximately $2.2 million to settle debt and certain other liabilities of MagnaLynx. Remaining closing payments of approximately $1.2 million were made to MagnaLynx shareholders in the second quarter of 2010. An additional $0.5 million, referred to as the indemnification holdback, is payable 18 months after the closing, net of any costs related to indemnification claims that may arise during such 18 month period. In addition, the Company agreed to pay up to an additional $1.0 million to the former shareholders of MagnaLynx, shortly after the first anniversary of the closing date, as earn-out consideration based on MagnaLynx meeting certain contractually agreed-upon development milestones. This earn-out consideration was included in the acquisition price because the Company expects that it is more likely than not that the objectives related to this earn-out will be met.
The Company recorded a total acquisition price as follows (in thousands):
The allocation of the acquisition price for net tangible and intangible assets was as follows (in thousands):
(1) Goodwill represents the excess of the acquisition price of an acquired business over the fair value of the underlying net tangible and intangible assets.
Goodwill represents the excess of the acquisition price of an acquired business over the fair value of the underlying net tangible and intangible assets. Included in the goodwill amount is the value of the acquired workforce, which has significant expertise in low-power interface IP. The Company will assess goodwill for impairment on at least an annual basis or when there is an indicator of impairment. The goodwill recognized is expected to be deductible for income tax purposes.
The value of the identifiable intangible asset was determined by using future cash flow assumptions. The intangible asset, which is considered developed technology, is being amortized on a straight-line basis over its estimated life of five years.
In June 2009, the Company acquired substantially all the assets and business of Prism Circuits, Inc. (Prism Circuits), a provider of semiconductor interface IP. The acquisition significantly expanded the Companys product portfolio by adding high-speed multi-protocol compliant interface IP, which enables communication between semiconductors in a system. With the acquisition, the Company added over 50 engineers experienced in interface IP development and analog/mixed-signal applications.
Under the terms of the acquisition agreement, the Company paid Prism Circuits $15.0 million in cash at closing (offset by approximately $1.4 million of cash acquired), assumed certain liabilities of Prism Circuits as consideration for the acquired assets and paid an additional $6.5 million of cash (the earn-out payment) in July 2010 in satisfaction of a contractual earn-out commitment, as a result of the Company meeting certain objectives relating to the Prism Circuits business during the twelve-month period following the acquisition. In addition, the Company granted options to purchase 3,621,724 shares of the Companys common stock to the newly hired Prism Circuits employees as inducements material to employment in accordance with the terms of the acquisition agreement. The majority of these options are vesting on a straight-line basis over 48 months subject to continued employment requirements.
Because the acquisition agreement provided that 30% of the earn-out payment could be earned by the shareholders of Prism Circuits based on the Companys future employment of individuals, the amount allocated to this objective, or $1.95 million, was not considered to be a component of the acquisition price and was recognized as compensation expense and accrued on a straight-line basis over the one-year period subsequent to the acquisition. For the nine months ended September 30, 2010, the Company recorded $0.8 million of expense and liability for the retention objective. No expense was recorded for the three months ended September 30, 2010. The remaining portion of the earn-out payment, or $4.55 million, was included in the acquisition price because the Company expected that it was more likely than not that the objectives related to this earn-out payment would be met.
The Company recorded a total acquisition price as follows (in thousands):
The allocation of the acquisition price for net tangible and intangible assets was as follows (in thousands):
(1) Goodwill represents the excess of the acquisition price of an acquired business over the fair value of the underlying net tangible and intangible assets. The balance has been adjusted to reflect a decrease of $0.2 million in the fair value of contractual obligations assumed as part of the acquisition.
Note 5. Commitments and Contingencies
In the ordinary course of business, the Company enters into contractual arrangements under which it may agree to indemnify the counterparties from any losses incurred relating to breach of representations and warranties, failure to perform certain covenants, or claims and losses arising from certain events as outlined within the particular contract, which may include, for example, losses arising from litigation or claims relating to past performance. Such indemnification clauses may not be subject to maximum loss clauses. The Company has entered into indemnification agreements with its officers and directors. No material amounts were reflected in the Companys condensed consolidated financial statements for the three and nine months ended September 30, 2010 or 2009 related to these indemnifications.
The Company has not estimated the maximum potential amount of indemnification liability under these agreements due to the limited history of prior claims and the unique facts and circumstances applicable to each particular agreement. To date, the Company has not made any payments related to these indemnification agreements.
The Company is not a party to any material legal proceeding that the Company believes is likely to have a material adverse effect on its consolidated financial position or results of operations. From time to time the Company may be subject to legal proceedings and claims in the ordinary course of business. These claims, even if not meritorious, could result in the expenditure of significant financial resources and diversion of management efforts.
Note 6. Restructuring Charge and Accruals
The restructuring accrual includes costs incurred in 2009 in connection with the Companys exit from the leased facility occupied by Prism Circuits in Santa Clara, California, as well as costs related to closing its China office. The Company does not expect to incur additional restructuring charges related to these restructuring activities. The remaining cash expenditures are expected to be paid by December 31, 2010.
Restructuring activity for the nine months ended September 30, 2010 was as follows (in thousands):
Note 7. Business Segments and Significant Customers
The Company operates in one business segment and uses one measurement of profitability for its business. Revenue attributed to the United States and to all foreign countries is based on the geographical location of the customer.
The Company recognized revenue from licensing of its technologies to customers in North America, Asia and Europe as follows (in thousands):
Customers who accounted for at least 10% of total revenues were as follows:
Five customers accounted for 88% of net accounts receivable at September 30, 2010. Four customers accounted for 97% of net accounts receivable at December 31, 2009.
Note 8. Income Tax Provision
The Company determines deferred tax assets and liabilities based upon the differences between the financial statement and tax bases of the Companys assets and liabilities using tax rates in effect for the year in which the Company expects the differences to affect taxable income. A valuation allowance is established for any deferred tax assets for which it is more likely than not that all or a portion of the deferred tax assets will not be realized. The Company files U.S. federal, state and foreign income tax returns in jurisdictions with varying statutes of limitations. The Company is not currently undergoing any examination of its income tax returns. The 2005 through 2009 tax years generally remain subject to examination by federal, state, and foreign tax authorities. As of September 30, 2010, the Company did not have any unrecognized tax benefits and did not expect its unrecognized tax benefits to change significantly over the next twelve months. The Company recognizes interest related to unrecognized tax benefits in its income tax expense and penalties related to unrecognized tax benefits as other income and expenses. During the three and nine months ended September 30, 2010 and 2009, the Company did not recognize any interest or penalties related to unrecognized tax benefits.
Note 9. Stock-Based Compensation
The Company recorded $0.8 million of stock-based compensation expense for each of the three months ended September 30, 2010 and 2009. The Company recorded $2.3 million and $2.1 million of stock-based compensation expense for the nine months ended September 30, 2010 and 2009, respectively. The expense relating to stock-based awards is recognized on a straight-line basis over the requisite service period, usually the vesting period, based on the grant-date fair value. The unamortized compensation cost, net of expected forfeitures, as of September 30, 2010 was $5.6 million and is expected to be recognized as expense over a weighted average period of approximately 2.6 years.
The Company presents the tax benefits resulting from tax deductions in excess of the compensation cost recognized from the exercise of stock options as financing cash flows in the condensed consolidated statements of cash flows. For the three and nine months ended September 30, 2010 and 2009, there were no such tax benefits associated with the exercise of stock options due to the Companys loss position.
Valuation Assumptions and Expense Information
The fair value of the Companys share-based payment awards for the three and nine months ended September 30, 2010 and 2009 was estimated on the grant date using a Black-Scholes valuation method and an option-pricing model with the following assumptions:
The risk-free interest rate was derived from the Daily Treasury Yield Curve Rates as published by the U.S. Department of the Treasury as of the grant date for terms equal to the expected terms of the options. The expected volatility was based on the combination of: 1) four-year historical volatility and 2) implied volatility of the Companys stock price. The expected term of options granted was derived from historical data based on employee exercises and post-vesting employment termination behavior. A dividend yield of zero is applied because the Company has never paid dividends and has no intention to pay dividends in the near future.
The stock-based compensation expense is calculated based on estimated forfeiture rates. An annualized forfeiture rate has been used as a best estimate of future forfeitures based on the Companys historical forfeiture experience. The stock-based compensation expense will be adjusted in later periods if the actual forfeiture rate is different from the estimate.
A summary of the option and restricted stock unit activity under the Companys 1996 Stock Plan (1996 Plan), Amended and Restated 2000 Stock Option and Equity Incentive Plan (Amended 2000 Plan) and 2010 Equity Incentive Plan (2010 Plan), referred to collectively as the Plans, is presented below (in thousands, except exercise price):
A summary of restricted stock award and restricted stock unit activity for grants outside of the Plans is presented below (in thousands, except fair value):
In April 2010, the Board of Directors of the Company approved the modification of an option previously granted to the Chief Executive Officer to purchase 450,000 shares of common stock to allow him to exercise the option prior to vesting, subject to a right of repurchase by the Company for any shares that subsequently failed to vest in accordance with the terms of a restricted stock purchase agreement. In April 2010, the Chief Executive Officer exercised the option and acquired 337,500 shares that vest over the next 18 months. The modification did not result in any incremental expense to the option. At September 30, 2010, 243,750 shares remain unvested.
On June 30, 2010, the Companys stockholders approved the 2010 Plan, and as a result the Amended 2000 Plan was automatically terminated. No future grants of awards will be made under the Amended 2000 Plan, although the Amended 2000 Plan will continue to govern prior awards granted under that plan, until all such awards granted have been exercised, forfeited, canceled, expired or otherwise terminated in accordance with the terms of such grants. The 2010 Plan authorizes the board of directors or the compensation committee of the board of directors to grant a broad range of awards including stock options, stock appreciation rights, restricted stock, performance-based awards, and restricted stock units. Under the 2010 Plan, 4,000,000 shares were initially reserved for issuance and there will be an automatic annual increase in the share reserve of 500,000 on January 1 of each year. The 2010 Plan provides for annual option grants or other awards to our non-employee directors to acquire up to 40,000 shares and for a one-time grant of an option or other award to a non-employee director to acquire up to 120,000 shares upon his or her initial appointment or election to our board.
The term of options granted under the 2010 Plan may not exceed ten years. The term of all incentive stock options granted to a person who, at the time of grant, owns stock representing more than 10% of the voting power of all classes of the Companys stock may not exceed five years.
The exercise price of stock options granted under the 2010 Plan must be at least equal to the fair market value of the shares on the date of grant. Generally, options granted under the 2010 Plan will vest over a four-year period and will have a six-year term. In addition, the 2010 Plan provides for automatic acceleration of vesting for options granted to non-employee directors upon a change of control of the Company.
The Company also has awarded shares to new employees outside the Plans and may continue to do so outside the 2010 Plan, as a material inducement to the acceptance of employment with the Company. These grants must be approved by the compensation committee of the board of directors, a majority of the independent directors or an authorized executive officer, as determined under the Marketplace Rules of the Nasdaq Stock Market.
A summary of the inducement grant option activity is presented below (in thousands, except exercise price):
The following table summarizes significant ranges of outstanding and exercisable options and inducement grants, excluding restricted stock award and restricted stock unit activity, as of September 30, 2010 (in thousands, except contractual life and exercise price):
As of September 30, 2010, the Company had 9,594,021 shares, excluding restricted stock units, fully vested and expected to vest, after estimated forfeitures, with a remaining contractual life of 4.5 years, weighted average exercise price of $3.94 and aggregate intrinsic value of $14.6 million.
The total fair value of shares, excluding restricted stock units, vested during the nine months ended September 30, 2010 and 2009 calculated using the Black-Scholes valuation method was $1.3 million and $1.1 million, respectively. The total intrinsic value of employee stock options exercised during the nine months ended September 30, 2010 and 2009 was $1.8 million and $17,000, respectively.
Options to purchase 5.0 million and 4.3 million shares were exercisable at September 30, 2010 and 2009, respectively.
Note 10. Related Party
In July 2010, the Company entered into a lease agreement with Mission West Properties, L.P.I. (the Lessor) to lease approximately 47,000 square feet for its corporate headquarters in Santa Clara, California. The lease term is 120 months. The Company has an option to extend the lease for two additional five-year periods at 95% of the then fair market monthly rent rate. After the first two years of the lease, the Company may terminate the lease early in the event that it has signed a lease to move into a facility that is also owned by the Lessor or one of its affiliates and is at least 20% larger. The Company may also terminate the lease at the end of 60 or 90 months if the Company has sold all or substantially all of its assets to an independent buyer or if the Lessor cannot accommodate the Companys future expansion requirements, provided that the Company pays the Lessor an amount equal to the outstanding unamortized balance of the initial improvements. The chief executive officer and chairman of the board of the Lessor is Carl E. Berg. Mr. Berg is a director of the Company and a member of the Companys Compensation and Audit Committees. Mr. Berg beneficially owns approximately 5% of the Companys common stock, and his daughters trust beneficially owns approximately 7% of the Companys common stock.
A related party to one of the Companys executive officers performed construction work at its corporate headquarters. The construction work was completed at a cost of approximately $7,000, which was paid in the third quarter of 2010.
Note 11. Subsequent Events
The Company has evaluated subsequent events through the date the preparation of these unaudited condensed consolidated financial statements are complete and did not identify any material recognizable subsequent events.
This Managements Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the accompanying condensed consolidated financial statements and notes included in this report. This Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which include, without limitation, statements about the market for our technology, our strategy, competition, and expected financial performance, all information disclosed under Item 3 of this Part I, and other aspects of our business identified in our most recent annual report on Form 10-K filed with the Securities and Exchange Commission on March 26, 2010 and in other reports that we file from time to time with the Securities and Exchange Commission. Any statements about our business, financial results, financial condition and operations contained in this Form 10-Q that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words believes, anticipates, expects, intends, plans, projects, or similar expressions are intended to identify forward-looking statements. Our actual results could differ materially from those expressed or implied by these forward-looking statements as a result of various factors, including the risk factors described below in Risk Factors and elsewhere in this report and under Item 1A of our annual report on Form 10-K for the year ended December 31, 2009. We undertake no obligation to update publicly any forward-looking statements for any reason, except as required by law, even as new information becomes available or events occur in the future.
We design, develop, market and license differentiated embedded memory and high-speed parallel and serial interface, or I/O, intellectual property, or IP, for advanced Systems on Chips, or SoC, designs. Our patented memory solutions include 1T-SRAM and 1T-Flash high-density and/or high performance alternatives to traditional volatile and non-volatile embedded memory. Our I/O IP includes physical layer, or PHY, circuitry that allows integrated circuits to talk to each other or to discrete memory devices like DDR3 in the networking, storage, computer and consumer segments. Our PHYs support serial interface technologies such as 10G Base KR, XAUI, PCI Express and SATA as well as parallel interfaces like DDR3.
In February 2010, we announced the commencement of a new product initiative to develop a family of IC products under the Bandwidth Engine product name. The Bandwidth Engine will combine our 1T-SRAM high-density embedded memory with our high-speed 10 Gigabits per second, or Gbps, serial communication I/O technology and will initially be marketed to networking systems companies. The Bandwidth Engine is being designed to increase system performance by using a serial I/O to increase the accesses per second between the processor and memory component in networking systems.
Our customers typically include fabless semiconductor companies, integrated device manufacturers, or IDMs, and foundries. We generate revenue from the licensing of our IP, and our customers pay us fees for one or more of the following: licensing, non-recurring engineering services, royalties and maintenance and support. Royalty revenues are typically earned under our memory license agreements when our licensees manufacture or sell products that incorporate any of our memory technologies. Generally, we expect our total sales cycle, or the period from our initial discussion with a prospective licensee to our receipt of royalties, where applicable, from the licensees use of our technologies, to run from 18 to 24 months. The portion of our sales cycle from the initial discussion to the receipt of license fees may run from 6 to 12 months, depending on the complexity of the proposed project and degree of development services required.
Sources of Revenue
We generate two types of revenue: licensing and royalties.
Licensing. Licensing revenue consists of fees earned from license agreements, development services, prepaid pre-production royalties, and support and maintenance.
Our license agreements involve long sales cycles, which make it difficult to predict when the agreements will be signed. In addition, our licensing revenue fluctuates from period to period, and it is difficult for us to predict the timing and magnitude of such revenue from quarter to quarter. Moreover, we believe that the amount of licensing revenue for any period is not necessarily indicative of results in any future period.
Our licensing revenue consists primarily of fees for providing circuit design, layout and design verification and granting licenses to customers that embed our technology into their products. License fees generally range from $100,000 to several million dollars per contract, depending on the scope and complexity of the development project, and the extent of the licensees rights. The licensee generally pays the license fees in installments at the beginning of the license term and upon the attainment of specified milestones. The vast majority of our contracts allow for milestone billing based on work performed. Fees billed prior to revenue recognition are recorded as deferred revenue.
Royalty. Royalty revenue represents amounts earned under provisions in our memory licensing contracts that require our licensees to report royalties and make payments at a stated rate based on actual units manufactured or sold by licensees for products that include our memory IP. We generally recognize royalties in the quarter in which we receive the licensees report.
Royalty-bearing license agreements provide for royalty payments at a stated rate. We negotiate royalty rates by taking into account such factors as the anticipated volume of the licensees sales of products utilizing our technologies and the cost savings to be achieved by the licensee through the use of our technology. Our license agreements generally require the licensee to report the manufacture or sale of products that include our technology after the end of the quarter in which the sale or manufacture occurs.
As with our licensing revenue, the timing and level of royalties are difficult to predict. They depend on the licensees ability to market, produce and sell products incorporating our technology. Many of the products of our licensees that are currently subject to licenses from us are used in consumer products, such as electronic game consoles, for which demand can be seasonal.
Critical Accounting Policies and Use of Estimates
The discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis we make these estimates based on our historical experience and on assumptions that we consider reasonable under the circumstances. Actual results may differ from these estimates, and reported results could differ under different assumptions or conditions. Our significant accounting policies and estimates are disclosed in Note 1 of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2009. As of September 30, 2010, there have been no material changes to our significant accounting policies and estimates.
Recent Accounting Pronouncements
In October 2009, the Financial Accounting Standards Board (FASB) issued guidance for revenue arrangements with multiple deliverables that are outside the scope of software revenue recognition guidance. Under this guidance, when vendor-specific objective evidence or third- party evidence for deliverables in such an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. Additionally, in October 2009, the FASB issued guidance modifying its earlier software revenue recognition guidance to exclude from its scope tangible products that contain both software and non-software components that function together to deliver a products essential functionality. The guidance for both topics will apply to revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption is permitted. We are currently evaluating the impact that the adoption of the guidance will have on our consolidated financial statements.
Results of Operations
The table below sets forth data concerning licensing revenue for the three and nine months ended September 30, 2010 and 2009:
Licensing revenue increased for the three and nine months ended September 30, 2010, compared with the same periods of 2009, primarily due to an increase in the number and value of license agreements executed in the fourth quarter of 2009 and the first nine months of 2010.
The table below sets forth data concerning royalty revenue for the three and nine months ended September 30, 2010 and 2009:
Royalty revenue increased for the three and nine months ended September 30, 2010, compared with the same period of 2009, primarily due to an increase in royalties received from a major foundry partner and a fabless semiconductor company resulting from higher manufacturing volumes, partially offset by a decrease in shipments from an IDM licensee whose product is used in the Nintendo Wii® game console.
Cost of Net Revenue and Gross Profit.
The table below sets forth data concerning cost of net revenue for the three and nine months ended September 30, 2010 and 2009:
Cost of net revenue consists of personnel costs for engineers assigned to revenue-generating licensing arrangements and related overhead allocation costs.
Cost of net revenue increased for the three and nine months ended September 30, 2010 compared to the same periods of 2009 due to the increase in the number of licensing contracts requiring customizations. Cost of net revenue included stock-based compensation expense of $76,000 and $83,000 for the three months ended September 30, 2010 and 2009, respectively, and $0.2 million for each of the nine months ended September 30, 2010 and 2009.
Gross profit increased to $3.0 million and $9.5 million for the three and nine months ended September 30, 2010, respectively, from $2.7 million and $6.6 million, respectively, from the year ago periods mainly due to the increase in our license revenue. Gross margin percentage increased slightly to 81% for the three months ended September 30, 2010 compared with 80% for the year ago period primarily due to an increase in licensing revenue. Gross margin percentage decreased to 82% for the nine months ended September 30, 2010 compared with 84% for the year ago period primarily due to an increase in licensing contracts requiring more customization and engineering services, combined with a decrease in the portion of total net revenue represented by royalty revenue, which has gross margins of 100%.
Research and Development.
The table below sets forth data concerning research and development expenses for the three and nine months ended September 30, 2010 and 2009:
Our research and development expenses include development and design of variations of our 1T-SRAM and I/O technologies for use in different manufacturing processes used by licensees, development of our 1T-Flash technology solution, costs related to the development of the Bandwidth Engine integrated circuit, and amortization of intangible assets. We expense research and development costs as they are incurred.
The $1.1 million increase for the three months ended September 30, 2010, compared with the same period a year ago, was primarily due to the following:
· $1.2 million mask cost incurred for the Bandwidth Engine product;
· $0.4 million increase in our expanded engineering team working on our I/O and Bandwidth Engine products;
· $0.3 million increase in software tool costs; and
· $0.1 million increase in stock-based compensation.
This increase was partially offset by a $0.5 million decrease in acquisition-related compensation costs and a $0.4 million increase in deferred project costs, which were recorded as a current asset on our condensed consolidated balance sheet as of September 30, 2010.
Research and development expenses included stock-based compensation expense of $0.4 million and $0.3 million for the three months ended September 30, 2010 and 2009, respectively.
The $5.8 million increase for the nine months ended September 30, 2010, compared with the same period a year ago, was primarily due to the following:
· $2.7 million increase in our expanded engineering team working on our I/O and Bandwidth Engine products;
· $1.3 million increase in amortization of acquired intangible assets;
· $1.2 million mask cost incurred for the Bandwidth Engine product;
· $0.7 million increase in consulting expense and other third-party IC development costs;
· $0.9 million increase in software tool costs; and
· $0.2 million increase in other individually minor items.
This increase was partially offset by a $0.3 million increase in allocation to cost of sales, including deferred project costs, which were recorded as a current asset on our condensed consolidated balance sheet as of September 30, 2010, and a $0.9 million savings from the exit of the analog/mixed-signal product lines.
Research and development expenses included stock-based compensation expense of $1.1 million and $0.8 million for the nine months ended September 30, 2010 and 2009, respectively.
We expect that research and development expenses will increase in absolute dollars over the next year as we invest in new product development for the development of our Bandwidth Engine IC.
Selling, General and Administrative.
The table below sets forth data concerning selling, general and administrative, or SG&A, expenses for the three and nine months ended September 30, 2010 and 2009:
SG&A expenses consist primarily of personnel and related overhead costs for sales, marketing, application engineering, finance, human resources and general management.
SG&A expense increased for the three months ended September 30, 2010, compared with the same period of 2009, primarily due an increase in professional service costs, including legal and Sarbanes-Oxley (SOX) Section 404 compliance costs.
Selling, general and administrative expenses included stock-based compensation expense of $0.3 million and $0.4 million for the three months ended September 30, 2010 and 2009, respectively.
The $0.6 million increase for the nine months ended September 30, 2010, compared with the same period a year ago, was primarily due an increase in personnel-related costs, primarily due to higher headcount, higher professional service costs and marketing activities, partially offset by a decrease stock-based compensation expense.
SG&A expenses included stock-based compensation expense of $1.0 million and $1.1 million for the nine months ended September 30, 2010 and 2009, respectively. We expect total selling, general and administrative expenses to increase in absolute dollars due to an increase in sales and field applications personnel and related costs, higher legal costs related to patent and trademark activity and marketing efforts related to the expected introduction of the Bandwidth Engine IC in late 2010.
Other Income, net.
The table below sets forth data concerning other income, net, for the three and nine months ended September 30, 2010 and 2009:
Other income, net primarily consisted of interest income on our investments and other non-operating expenses. Interest income declined for the three and nine months ended September 30, 2010 due to lower interest rates earned on lower average investment balances than during the comparable periods in 2009.
Income Tax Provision.
The table below sets forth data concerning the income tax provision for the three and nine months ended September 30, 2010 and 2009:
The provisions for the three and nine months ended September 30, 2010 were primarily attributable to taxes for our foreign subsidiaries and branches and minimum U.S. state income tax liabilities. We believe that, based on the history of our operating losses and other factors, the weight of available evidence indicates that it is more likely than not that we will not be able to realize the benefit of our net operating losses. Accordingly, a full valuation reserve has been recorded against our net deferred tax assets.
Liquidity and Capital Resources; Changes in Financial Condition
As of September 30, 2010, we had cash, cash equivalents and long and short-term investments of $22.3 million and had total working capital of $12.6 million. Our primary capital requirements are for working capital needs. As of September 30, 2010 we had an accrual of $1.5 million for the earn-out and indemnification holdback resulting from the MagnaLynx acquisition, which is expected to be paid out in 2011.
Net cash used in operating activities was $10.6 million for the first nine months of 2010 and was primarily attributable to our net loss of $17.4 million, partially offset by non-cash charges, including stock-based compensation expense of $2.3 million, and depreciation and amortization expense of $2.9 million.
Net cash used in operating activities was $9.8 million for the first nine months of 2009 and was primarily attributable to our net loss of $14.2 million, partially offset by non-cash charges, including stock-based compensation expense of $2.1 million, depreciation and amortization of $1.4 million and a non-cash restructuring charge of $0.1 million.
In the first nine months of 2010, we invested $3.4 million of net cash for the acquisition of MagnaLynx in March 2010, paid out $4.6 million in acquisition-related earn-out obligations to Prism Circuits and purchased $1.3 million of fixed assets. During the same period of 2009 we invested $13.6 million of net cash in the acquisition of Prism Circuits in June 2009 and $0.9 million for purchases of fixed assets.
Net cash provided by financing activities was $1.7 million for the first nine months of 2010 primarily due to proceeds received from the exercise of employee stock options.
Net cash used in financing activities was $0.9 million for the first nine months of 2009 and was attributable to shares repurchased under a stock repurchase program that was suspended in February 2009.
Our future liquidity and capital requirements are expected to vary from quarter-to-quarter, depending on numerous factors, including:
· level and timing of licensing and royalty revenues;
· cost, timing and success of technology development efforts, including meeting customer design specifications;
· fabrication costs, including mask costs, and the development costs of our Bandwidth Engine ICs and related new technologies;
· market acceptance of our existing and future technologies and products;
· competing technological and market developments;
· cost of maintaining and enforcing patent claims and intellectual property rights;
· variations in manufacturing yields, materials costs and other manufacturing risks;
· costs of acquiring other businesses and integrating the acquired operations; and
· profitability of our business.
Although we expect our cash expenditures to continue to exceed receipts for the next 12 months, as we continue to expand research and development efforts for our 1T-SRAM, I/O and 1T-Flash technologies and the newly introduced Bandwidth Engine IC product line, we expect our existing cash, cash equivalents and investments, along with our existing capital and cash generated from operations, if any, to be sufficient to meet our capital requirements for at least the next 12 months. We cannot be certain, however, that we will not require additional financing at some point in time. Should our cash resources prove inadequate, we may need to raise additional funding through public or private financings. There can be no assurance that such additional funding will be available to us on favorable terms, if at all. The failure to raise capital when needed could have a material adverse effect on our business and financial condition.
The impact that our contractual obligations as of September 30, 2010 are expected to have on our liquidity and cash flow in future periods is as follows (in thousands):