XNAS:DITC Quarterly Report 10-Q Filing - 1/31/2012

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended January 31, 2012

OR

For the transition period from           to               

Commission file number 000-26209

Ditech Networks, Inc.

(Exact name of registrant as specified in its charter)

3099 North First Street

San Jose, California 95134

(Address of principal executive offices) (Zip Code)

(408) 883-3636

(Registrant’s telephone number, including area code)

825 E. Middlefield Road

Mountain View, Ca. 94043

(Former address)

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 past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the 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 x  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):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).  YES o  NO x

As of February 29, 2012, 26,759,143 shares of the Registrant’s common stock were outstanding.

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Ditech Networks, Inc.

FORM 10-Q for the Quarter Ended January 31, 2012

INDEX

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PART I. FINANCIAL INFORMATION

ITEM I. Financial Statements

Ditech Networks, Inc.

Condensed Consolidated Statements of Operations

(in thousands, except per share data)

(unaudited)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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Ditech Networks, Inc.

Condensed Consolidated Balance Sheets

(in thousands, except per share data)

(unaudited)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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Ditech Networks, Inc.

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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DITECH NETWORKS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1.             DESCRIPTION OF BUSINESS

Ditech Networks, Inc. (the “Company”) designs, develops and markets telecommunications equipment and services for use in wireline, wireless, satellite and Internet Protocol (“IP”) telecommunications networks. The Company’s products enhance and monitor voice quality and provide security in the delivery of voice services. In addition, the Company has entered the voice services market of telecommunications by developing and marketing voice products that can be used by phone customers to have voice messages transcribed into textual messages, and which also allows for interaction with web-based applications. The Company has established a direct sales force that sells its products in the U.S. and internationally. In addition, the Company is expanding its use of value added resellers and distributors in an effort to broaden its sales channels. This expanded use of value added resellers and distributors has occurred primarily in the Company’s international markets.

2.             SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated. The accompanying condensed consolidated financial statements as of January 31, 2012, and for the three and nine month periods ended January 31, 2012 and 2011, together with the related notes, are unaudited but include all adjustments (consisting only of normal recurring adjustments) which, in the opinion of management, are necessary for the fair presentation, in all material respects, of the financial position and the operating results and cash flows for the interim date and periods presented. The April 30, 2011 condensed consolidated balance sheet data was derived from audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Results for the interim periods ended January 31, 2012 are not necessarily indicative of results for the entire fiscal year or future periods. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes thereto for the year ended April 30, 2011, included in the Company’s Annual Report on Form 10-K, filed with the Securities and Exchange Commission (“SEC”) on July 28, 2011, file number 000-26209.

Revenue Recognition

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. Also in October 2009, the FASB amended the accounting standards for multiple-deliverable arrangements to (i) provide updated guidance on how the elements in a multiple-deliverable arrangement should be separated, and how the consideration should be allocated; (ii) require an entity to allocate revenue amongst the elements in an arrangement using estimated selling prices (“ESP”) if a vendor does not have vendor-specific objective evidence (“VSOE”) or third-party evidence (“TPE”) of the selling price; and (iii) eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method.

VSOE for elements of an arrangement is based upon the normal pricing and discounting practices for those services when sold separately. In determining VSOE, the Company requires that a substantial majority of the selling prices for an element falls within a reasonably narrow pricing range, generally evidenced by a substantial majority of such historical stand-alone transactions falling within a reasonably narrow range of

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the median rates. In addition, the Company considers major service groups, geographies, customer classifications, and other variables in determining VSOE.

TPE is determined based on competitor prices for similar deliverables when sold separately. The Company is typically not able to determine TPE for the Company’s products or services. Generally, the Company’s go-to-market strategy differs from that of the Company’s peers and the Company’s offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, the Company is unable to reliably determine what similar competitor products’ selling prices are on a stand-alone basis.

When the Company is unable to establish the selling price of its elements using VSOE or TPE, the Company uses ESP in its allocation of arrangement consideration. The objective of ESP is to determine the price at which the Company would transact a sale if the product or service were sold on a stand-alone basis. The Company determines ESP for a product or service by considering multiple factors including, but not limited to, pricing policies, internal costs, gross margin objectives, competitive landscapes, geographies, customer classes and distribution channels.

The Company adopted this accounting guidance at the beginning of its first quarter of the fiscal year ending April 30, 2012 for applicable arrangements originating or materially modified after April 30, 2011. The Company currently only enters into multiple element arrangements within the Voice Quality Enhancement segment as mentioned in Note 10 of these Notes to the Condensed Consolidated Financial Statements. The adoption of these accounting standards has not had a material impact on revenue recognized since adoption.

The Company’s revenue in multiple element arrangements in the Voice Quality Enhancement segment are derived primarily from two sources: (i) product revenue which consists of hardware and software, and (ii) related support and service revenue. The Company’s products are telecommunications hardware with embedded software components such that the software functions together with the hardware to provide the essential functionality of the product. Therefore, the Company’s hardware deliverables are considered to be non-software elements and are excluded from the scope of industry-specific software revenue recognition guidance.

Although the Company cannot reasonably estimate the effect of the adoption on future financial periods as the impact may vary depending on the nature and volume of future sale contracts, this guidance does not generally change the units of accounting for the Company’s revenue transactions. The Company’s hardware (including essential software) products and services qualify as separate units of accounting because they have value to the customer on a stand-alone basis and the Company’s revenue arrangements generally do not include a general right of return relative to delivered products. The Company’s hardware (including essential software) is valued using ESP as mentioned above based on internal pricing policies. The Company’s services (which include annual service maintenance and installation services) are valued using VSOE as mentioned above based upon the contractually stated annual renewal rate. The rest of the Company’s revenue recognition policy is consistent with the policy in the Company’s Annual Report on Form 10-K for the fiscal year ended April 30, 2011.

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Computation of Loss per Share

Basic loss per share is calculated based on the weighted average number of shares of common stock outstanding during the period. Diluted loss per share for the three and nine month periods ended January 31, 2012 and 2011 is calculated excluding the effects of all common stock equivalents, as their effect would be anti-dilutive.  For the three and nine month periods ended January 31, 2012, weighted average common stock equivalents, primarily options and restricted stock units, totaling 5,005,000 shares and 4,613,167 shares, respectively, were excluded from the calculation of diluted loss per share, as their impact would be anti-dilutive. The diluted loss per share for the three and nine months ended January 31, 2012 also excludes the impact of 100,000 shares potentially issuable under the warrant issued as part of the Grid acquisition. See Note 4 of these Notes to the Condensed Consolidated Financial Statements for a further discussion of the Grid transaction. For the three and nine month periods ended January 31, 2011, weighted average common stock equivalents, primarily options, totaling approximately 5,022,000 shares and 5,448,000 shares, respectively, were excluded from the calculation of diluted loss per share, as their impact would be anti-dilutive. The diluted loss per share for the for the three and nine months ended January 31, 2011 also excludes the impact of 1,000,000 shares that had been potentially issuable upon conversion of Simulscribe’s convertible note payable and 100,000 shares potentially issuable under the warrant issued as part of the Grid acquisition.  See Notes 4 and 5 of these Notes to the Condensed Consolidated Financial Statements for a further discussion of the Grid and Simulscribe transactions, respectively.

A reconciliation of the numerator and denominator used in the calculation of the basic and diluted net loss per share follows (in thousands, except per share amounts):

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Comprehensive Loss

For the three and nine month periods ended January 31, 2012 and 2011, there was no difference between reported net loss and comprehensive loss.

Accounting for Stock-Based Compensation

Stock-based compensation expense recognized during the period is based on the fair value of the actual awards vested or expected to vest. Compensation expense for all stock-based payment awards expected to vest is recognized on a straight-line basis. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

The fair value of stock option awards is estimated on the date of grant using an option-pricing model. The Company uses the Black-Scholes option-pricing model to determine the fair value of stock option awards. The value of the portion of the option that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Condensed Consolidated Statement of Operations.

The fair value of restricted stock awards (“RSAs”) and restricted stock units (“RSUs”) is the product of the number of shares granted and the grant date fair value of the Company’s stock. RSAs and RSUs are converted into shares of the Company’s common stock upon vesting on a one-for-one basis. Typically, vesting of RSAs and RSUs is subject to the employee’s continuing service to the Company. RSAs and RSUs generally vest over a period of four years and are expensed ratably on a straight-line basis over their respective vesting period net of estimated forfeitures.

In the periods presented, the Company has issued non-vested stock options and RSUs with performance goals to certain senior members of management. The number of non-vested stock options or non-vested RSUs underlying each award may be determined based on a range of attainment within defined performance goals. The Company is required to estimate the attainment that will be achieved related to the defined performance goals and the number of non-vested stock options or non-vested RSUs that will ultimately be awarded in order to recognize compensation expense over the vesting period. If the Company’s initial estimates of performance goal attainment change, the related expense may fluctuate from quarter to quarter based on those estimates and if the performance goals are not met, no compensation cost will be recognized and any previously recognized compensation cost will be reversed. In the nine months ended January 31, 2012, the Company reversed approximately $0.1 million of previously recognized expense on unvested stock options and RSUs related to certain performance grants, due to the previous chief executive officer’s departure from the Company’s board of directors.

There was no tax benefit from the exercise of stock options related to deductions in excess of compensation cost recognized in the three and nine months ended January 31, 2012 and 2011. The Company reflects the tax savings resulting from tax deductions in excess of expense reflected in its financial statements as a financing cash flow.

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Investments

Investment securities that have maturities of more than three months at the date of purchase but current maturities of less than one year are considered short-term investments. Long-term investment securities include any investments with remaining maturities of one year or more and auction rate securities that failed to settle beginning in fiscal 2008, for which conditions leading to their failure at auction create uncertainty as to whether they will settle in the near-term.

Short term investments consist primarily of certificates of deposit and long-term investments consist of asset backed preferred equity securities. The Company’s investment securities are maintained at a major financial institution, are classified as available-for-sale, and are recorded on the Condensed Consolidated Balance Sheets at fair value, with unrealized gains and losses, if any, included in accumulated other comprehensive income (loss), a component of stockholders’ equity, net of tax. If the Company sells its investments prior to their maturity, it may record a realized gain or loss in the period the sale took place. In the three and nine months ended January 31, 2012 and 2011, the Company realized no gains or losses on its investments.

The Company evaluates its investments periodically for possible other-than-temporary impairment by reviewing factors such as the length of time and the extent to which the fair value has been below cost-basis, the financial condition of the issuer and the Company’s ability to hold the investment for a period of time, which may be sufficient for anticipated recovery of the market value. To the extent that the historical cost of the available for sale security exceeds the estimated fair market value, and the decline in value is deemed to be other-than-temporary, an impairment charge is recorded in the Condensed Consolidated Statements of Operations.

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Impairment of Long-lived Assets

The Company continually monitors events and changes in circumstances that could indicate that carrying amounts of long-lived assets, including intangible assets, may not be recoverable. When such events or changes in circumstances arise, the Company assesses the recoverability of its long-lived assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. If the total of the undiscounted future cash flows is less than the carrying amount of the assets in question, the Company recognizes an impairment loss based on the excess of the carrying amount over the fair value of the assets.

The Company evaluates the recoverability of its amortizable purchased intangible assets based on an estimate of undiscounted future cash flows resulting from the use of the related asset group and its eventual disposition. The asset group represents the lowest level for which cash flows are largely independent of cash flows of other assets and liabilities. Measurement of an impairment loss for long-lived assets that the Company expects to hold and use is based on the difference between the fair value and carrying value of the asset. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.

3.             BALANCE SHEET ACCOUNTS

Inventories

Inventories comprised (in thousands):

Stock-based compensation capitalized in inventories was not material at January 31, 2012 and April 30, 2011, respectively.

Investments

The following table summarizes the Company’s investments as of January 31, 2012 (in thousands):

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The following table summarizes the Company’s investments as of April 30, 2011 (in thousands):

As of April 30, 2011 and January 31, 2012, all of the Company’s short-term investments were held in certificates of deposit and long-term investments were held in asset backed preferred equity securities. The long-term investments are tied to auction rate securities that failed to settle at auction beginning in fiscal 2008, for which there appears to be no near-term market. As of January 31, 2012 and April 30, 2011, the Company continued to hold asset backed preferred equity securities with a par value of $10.0 million and a fair value of $0.1 million.

For the three and nine months ended January 31, 2012 and 2011, no gains or losses were realized on the sale of short-term and long-term investments. There were no unrealized gains or losses included in accumulated other comprehensive loss in the accompanying Condensed Consolidated Balance Sheets as of January 31, 2012 and April 30, 2011.

The accounting guidance on fair value accounting clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, the guidance on fair value accounting establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which requires the Company to develop its own assumptions. This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. On a recurring basis, the Company measures certain financial assets at fair value, including its short-term and long-term investments.

When available, the Company uses quoted market prices to determine fair value of certain of its cash and cash equivalents including money market funds and certain certificates of deposit, which are reported under investments, such items are classified in Level 1 of the fair value hierarchy. At January 31, 2012 and April 30, 2011, there were no active markets for the Company’s asset backed preferred equity securities resulting from converted auction rate securities, or comparable securities due to current market conditions. Therefore, until such a market becomes active, the Company is determining their fair value based on expected discounted cash flows. Such items are classified in Level 3 of the fair value hierarchy.

The following table presents for each of the fair value hierarchy levels, the assets and liabilities that are measured at fair value on a recurring basis as of January 31, 2012 (in thousands):

The following table presents for each of the fair value hierarchy levels, the assets and liabilities that are measured at fair value on a recurring basis as of April 30, 2011 (in thousands):

The following table presents the changes in the Level 3 fair value category for the nine months ended January 31, 2012 (in thousands):

The following table presents the changes in the Level 3 fair value category for the nine months ended January 31, 2011 (in thousands):

(1)                                  Reflects the accretion of interest on the convertible note payable to Simulscribe in conjunction with the Company’s exclusive distribution agreement.  The carrying value of the note payable as of January 31, 2011 of $3.4 million approximates its fair value, based on current market rates.

Other Assets

Other assets comprised (in thousands):

See note 5 of Notes to the Condensed Consolidated Financial Statements for details related to the exclusive distribution intangibles, net.

Accrued expenses

Accrued expenses comprised (in thousands):

Warranty Accrual.

The Company provides for future warranty costs upon shipment of its products. The specific terms and conditions of those warranties may vary depending on the product sold, the customer and the country in which it does business. However, the Company’s hardware warranties generally start from the shipment date and continue for a period of two to five years while the software warranty is generally ninety days to one year.

Because the Company’s products are manufactured to a standardized specification and products are internally tested to these specifications prior to shipment, the Company historically has experienced minimal warranty costs. Factors that affect the Company’s warranty liability include the number of installed units, historical experience and management’s judgment regarding anticipated rates of warranty

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claims and cost per claim. The Company assesses the adequacy of its recorded warranty liabilities every quarter and makes adjustments to the liability, if necessary.

Changes in the warranty accrual, which is included as a component of “Accrued expenses” on the Condensed Consolidated Balance Sheet, were as follows (in thousands):

Reduction in Force.

In July 2011, the Company initiated a reduction in force that was completed by October 31, 2011, in an ongoing attempt to reduce operating expenses. The affected employees were notified in July 2011. As a result, the Company reduced its headcount by approximately 8%, and recorded charges of approximately $130,000 for severance and related charges, $7,000 of which has not been paid as of January 31, 2012, and is included in accrued expenses at January 31, 2012. This amount represents costs for outplacement services available to the affected employees through September 2012. The adjustment in the three and nine months ended January 31, 2011 reflects the reversal of estimated outplacement services originally recorded as a part of the restructuring in the third quarter of fiscal 2010, which expired unused in the third quarter of fiscal 2011.

At April 30, 2011, accrued expense included a balance of $42,000 pertaining to a facility abandonment charge resulting from the reduction in force in November 2009.  The related sublease expired fully on July 31, 2011.

Reduction in force costs for the three and nine month periods ended January 31, 2012 and 2011 were as follows (in thousands):

The Company’s Voice Quality Enhancement segment incurred $120,000 of reduction in force costs during the nine months ended January 31, 2012, and $10,000 was incurred by the Voice Applications segment during that period.

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4.          PURCHASED INTANGIBLES

The carrying value of purchased intangible assets acquired in business combinations is as follows (in thousands):

In February 2010, the Company completed an acquisition of 100% of the outstanding shares of Grid.com, a Company with infrastructure to deliver services with simple credit card billing through the web. The purchase price, net of $0.1 million of cash received from Grid.com, totaled $0.5 million.  This purchase price, which included $35,000 of value attributable to a warrant issued for 100,000 shares of the Company’s common stock at an exercise price of $3.50 per share, based on a Black-Scholes option pricing model, was allocated to identified intangibles through established valuation techniques in the high-technology communications equipment industry.  The warrant expires in February 2013. As a result, the Company recorded an incremental $0.2 million in core technology intangible assets and $0.3 million related to the URL, the latter of which the Company sold in July of 2011 for approximately $0.2 million, net of expenses.

The Company recorded $20,000 and $60,000 during the three and nine months ended January 31, 2012 and 2011, respectively, of amortization of purchased intangible assets.

Estimated future amortization expense for the core technology purchased intangible asset as of January 31, 2012 is as follows (in thousands):

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5.          EXCLUSIVE DISTRIBUTION AGREEMENT

On September 10, 2009, the Company and Simulscribe, entered into a Reseller Agreement pursuant to which Simulscribe will provide, and the Company became the exclusive reseller of, Simulscribe’s voice to text (“VTT”) services to wholesale customers.  Pursuant to the agreement, the Company also assumed all of Simulscribe’s wholesale customers.  The Company paid $3.5 million and issued a two-year promissory note for an additional $3.5 million for the assumption of the wholesale customer relationships and the exclusivity rights.  This promissory note was paid in full in April 2011.  Additionally, the Company will pay a fee for the services provided by Simulscribe, and will pay up to an additional $10 million if the revenues generated from the Simulscribe services meet certain performance milestones within the first three years of the agreement (the “Additional Payments”), subject to acceleration in certain events, such as the Company’s failure to use commercially reasonable efforts to market the services or a change of control of the Company at a time that revenues from these services are on track to result in the payment ultimately being made. For the three and nine months ended January 31, 2011, the Company recognized $42,000 and $125,000, respectively, of interest expense associated with amortizing the $0.3 million discount on the note as a component of other income (expense), net in the Condensed Consolidated Statements of Operations.

The Additional Payments are convertible into the Company’s common stock at Simulscribe’s option, and may be converted into the Company’s common stock at a conversion price of $5.00 per share; provided that if a specified revenue target is met then up to $5.0 million of the Additional Payments can be converted at $4.00 per share. The value of the additional payments has not been recorded as of the date of the transaction pursuant to the accounting guidance related to the issuance of equity-based instruments to non-employees for the purchase of goods or services, as it is not probable of incurrence. In the event that payouts under the Additional Payments provisions of the agreement become probable of occurrence based on an assessment of customer revenue streams and the remaining duration of agreement and/or the conditions of the payout are met, the Company will record the fair value of the Additional Payments at that time.

As a result of this agreement, the Company recorded the total consideration at a fair value of $6.7 million and recorded assets associated with the exclusive distribution rights and transfer of customers.  The value assigned to the intangible assets, which are recorded in other assets on the face of the Condensed Consolidated Balance Sheets, was determined by valuing the discounted potential cash flows associated with each asset over the four year term of the agreement.  The asset associated with the transferred customer relationships will be amortized, on a tax deductible basis, to sales and marketing expense ratably over the four year term of the agreement and the asset associated with the distribution rights will be amortized, on a tax deductible basis, to cost of revenue on a unit of revenue basis, similar to a royalty payment, at the rate of 25% of revenue recognized based on the base level of revenue anticipated in the agreement attributable to the $7.0 million of consideration issued to date.  Subsequent to executing the agreement, the Company hired one of the principle officers of Simulscribe to assume the position of Chief Strategy Officer at the Company.  His primary focus was on expansion of the wholesale market for voice transcription service.  This individual continues to hold a large ownership interest in Simulscribe.  As such, although he may have input into key decisions related to interaction between the Company and Simulscribe, the final decisions rest with the executive management team, of which he is not a member, and/or the Board of Directors.  This individual was also a major shareholder in Grid.com, which the Company acquired in February 2010. In the third quarter of fiscal 2011, the Chief Strategy Officer resigned; however, he continues to provide certain services to the Company as a consultant.

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In the fourth quarter of fiscal 2010, the Company and Simulscribe, entered into an Amendment No. 1 to Reseller Agreement (the “Amendment”), amending the Reseller Agreement previously entered into between the Company and Simulscribe on September 10, 2009. Primarily, the Amendment permits the Company to provide services to all VTT customers, both retail and wholesale. Among other things, the Amendment also contains additional changes to the Reseller Agreement to conform to the new structure, and provides that both the retail and wholesale services will count as “Additional Payments” for purposes of determining what amount, if any, of the $10.0 million contingent consideration will be paid to Simulscribe.  In consideration for the Amendment, the Company agreed to pay an additional $0.3 million in seven equal quarterly installments.  The Company recognized this consideration as an addition to the customer relationship intangible asset, which amount is being amortized over the remainder of the 4 year life assigned to the original customer relationship intangible asset in September 2009. Four of the seven quarterly installments totaling $0.2 million were paid in cash. In April 2011, the promissory note for $3.5 million was paid in full five months early. In exchange for early payment of the promissory note, Simulscribe waived the final three installment payments totaling $0.1 million, due under the Amendment. As of April 30, 2011, this obligation had been paid in full.

The carrying value of the related intangible assets acquired, which are included in other assets, was as follows (in thousands):