|• 10-Q • EX-31.1 • EX-31.2 • EX-32|
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended July 31, 2012
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)
(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 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 o No x
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 August 31, 2012, 26,894,963 shares of the Registrants common stock were outstanding.
Ditech Networks, Inc.
FORM 10-Q for the Quarter Ended July 31, 2012
Ditech Networks, Inc.
(in thousands, except per share data)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
Ditech Networks, Inc.
(in thousands, except per share data)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
Ditech Networks, Inc.
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
DITECH NETWORKS, INC.
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 Companys 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 Companys 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 July 31, 2012, and for the three month periods ended July 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, 2012, 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 period ended July 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 financial statements and related notes thereto for the year ended April 30, 2012, included in the Companys Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 27, 2012, file number 000-26209.
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 products 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 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 Companys products or services. Generally, the Companys go-to-market strategy differs from that of the Companys peers and the Companys 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 ended 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 9 of these Notes to Condensed Consolidated Financial Statements. The adoption of these accounting standards has not had a material impact on revenue recognized since adoption.
The Companys 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 Companys 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 Companys 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 Companys revenue transactions. The Companys 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 Companys revenue arrangements generally do not include a general right of return relative to delivered products. The Companys hardware (including essential software) is valued using ESP as mentioned above based on internal pricing policies. The Companys 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 Company generally recognizes product revenue, including shipping charges, when: persuasive evidence of a definitive agreement exists; shipment to the customer has occurred; title and all risks and rewards of ownership have passed to the customer; acceptance terms, if any have been fulfilled; no significant contractual obligations remain outstanding; the fee is fixed or determinable; and collection is reasonably assured.
Service revenue includes revenue from maintenance service contracts and revenue from the Companys voice services. Revenue associated with service contracts is deferred and recognized ratably over the term of the contract. Revenue from the Companys voice services is recognized on a monthly basis as services are provided.
In the event that a shipment transaction does not meet all of the criteria for revenue recognition it is recorded as deferred revenue in the condensed consolidated balance sheet. To the extent that the Company has received cash for some or all of a given deferred revenue transaction, the Company reports it in the condensed consolidated balance sheets as deferred revenue. However, to the extent that the Company has not collected cash related to the deferred revenue transaction, the Company reflects the deferred revenue as a reduction in the corresponding account receivable balance.
The Company records transaction-based taxes including, but not limited to, sales, use, value added, and excise taxes, on a net basis in its condensed consolidated statements of operations.
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 month periods ended July 31, 2012 and 2011, is calculated excluding the effects of all common stock equivalents, as their effect would be anti-dilutive. For the three month periods ended July 31, 2012 and 2011, common stock equivalents, primarily options and restricted stock units, totaling 4,490,000 and 4,782,000 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 first quarter of fiscal 2012 and 2011 also excludes the impact of 100,000 shares potentially issuable under the warrant issued as part of the Grid Communication Services, Inc. (Grid), acquisition. See Note 4 of these Notes to the Condensed Consolidated Financial Statements for a further discussion of the Grid transaction.
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):
For the three month periods ended July 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 Companys condensed consolidated statements 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 Companys stock. RSAs and RSUs are converted into shares of the Companys common stock upon vesting on a one-for-one basis. Typically, vesting of RSAs and RSUs is subject to the employees continuing service to the Company. RSAs and RSUs generally vest over three or four year periods 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 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 Companys 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 three months ended July 31, 2012, the Company reversed approximately $0.1 million of previously recognized expense on unvested RSUs related to certain performance grants, due to performance milestones not being met. In the three months ended July 31, 2011, the Company reversed approximately $0.1 million of previously recognized expense on unvested options and RSUs related to certain performance grants, due to the previous chief executive officers departure from the Companys 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 months ended July 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.
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 and long-term investments consist primarily of certificates of deposit and asset backed preferred equity securities. The Companys 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 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. The cost of securities sold is based on the specific identification method. In the three months ended July 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 its cost-basis, the financial condition of the issuer and the Companys 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.
Impairment of Long-lived Assets
The Company evaluates the recoverability of its long-lived assets, including its purchased intangibles and intangible assets related to its exclusive distribution agreement, on an annual basis in the fourth quarter, or more frequently if indicators of potential impairment arise. 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 comprised (in thousands):
Stock-based compensation included in inventories was not material at July 31, 2012, and April 30, 2012, respectively.
The following table summarizes the Companys investments as of July 31, 2012 (in thousands):
The following table summarizes the Companys investments as of April 30, 2012 (in thousands):
As of April 30, 2012, all of our 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 July 31, 2012, and April 30, 2012, 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 months ended July 31, 2012 and 2011, no gains or losses were realized on the sale of short-term and long-term investments. There were no unrealized holding gains or losses included in accumulated other comprehensive loss in the accompanying condensed consolidated balance sheets as of July 31, 2012, and April 30, 2012.
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. Such items are classified in Level 1 of the fair value hierarchy. At July 31, 2012, and April 30, 2012, the Companys Level 2 securities include certificates of deposit which are each individually below the Federal Deposit Insurance Corporation (FDIC)
threshold of $250,000 per account owner and per depository institution. Level 2 pricing is provided by third party sources of market information obtained through the Companys investment advisors. The Company does not adjust for or apply any additional assumptions or estimates to the pricing information it receives from advisors. The Companys investment advisors obtain pricing data from independent sources, such as Standard and Poors and Bloomberg, 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. At July 31,2012, and April 30, 2012, there were no active markets for the Companys 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 Company had no transfers between Level 1 and Level 2 during the three months ended July 31, 2012 and 2011.
There were no liabilities measured at fair value as of July 31, 2012, and April 30, 2012.
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 July 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, 2012 (in thousands):
The following table presents the changes in the Level 3 fair value category for the three months ended July 31, 2012 (in thousands):
The following table presents the changes in the Level 3 fair value category for the year ended April 30, 2012 (in thousands):
Other assets comprised (in thousands):
See Note 5 of Notes to the Consolidated Financial Statements, below for details related to the exclusive distributor intangible assets.
Accrued and other liabilities 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 Companys hardware warranties generally start from the shipment date and continue for a period of one to five years while the software warranty is generally ninety days to one year.
Because the Companys 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 Companys warranty liability include the number of installed units, historical experience and managements judgment regarding anticipated rates of warranty 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 and other liabilities on the Condensed Consolidated Balance Sheet, were as follows (in thousands):
Reduction in force.
In the quarter ended July 31, 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 $122,000 for severance and related charges, $5,000 of which had not been paid as of July 31, 2012, and April 30, 2012, and is included in accrued and other liabilities. This amount represents costs for outplacement services available to the affected employees through September 2012. No such charge was recorded in the quarter ended July 31, 2012.
At July 31, 2011, accrued and other liabilities 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 quarters ended July 31, 2012 and 2011, were as follows (in thousands):
In the three months ended July 31, 2011, the Companys Voice Quality Enhancement segment incurred $112,000 of the reduction in force costs, and $10,000 was incurred by the Voice Applications segment.
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 a small acquisition of 100% of the outstanding shares of Grid, 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 totaled $0.5 million. This purchase price, which included $35,000 of value attributable to a warrant issued for 100,000 shares of the Companys common stock at an exercise price of $3.50 per share, based on a Black-Scholes valuation, 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.
In the three months ended July 31, 2012 and 2011, the Company recorded $21,000 of amortization of acquisition-related intangible assets.
Estimated future amortization expense for the core technology purchased intangible asset as of July 31, 2012, is $40,000 for the remaining nine months of fiscal 2013.
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, Simulscribes voice to text (VTT) services to wholesale customers. Pursuant to the agreement, the Company also assumed all of Simulscribes 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 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 Companys 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.
The Additional Payments are convertible into the Companys common stock at Simulscribes option, and may be converted into the Companys 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 Sheet, 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. The Company recorded amortization expense associated with the distribution rights of approximately $0.4 million and $0.2 million for the three months ended July 31, 2012, and July 31, 2011, respectively; and amortization expense associated with the customer relationships of approximately $0.2 million in each of the three month periods ended July 31, 2012 and 2011, respectively.
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,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.
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 voice to text 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 5 months early. In exchange for early payment of the 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):
Estimated future amortization expense for the customer relationship related intangible asset as of July 31, 2012, is as follows (in thousands):
Since the distribution rights are being amortized based on the level of revenue recognized, the amortization expense cannot be estimated for future periods.
6. STOCKHOLDERS EQUITY
Employee Equity Plans
The Company utilizes a combination of Employee Stock Purchase, Stock Option and Restricted Stock plans as a means to provide equity ownership in the Company for its employees. In the three months ended July 31, 2012, no shares of common stock were issued under the Employee Stock Purchase Plan (ESPP) and 176,280 shares remain available for issuance under that plan as of July 31, 2012. Effective November 30, 2011, the Board of Directors suspended activity under the ESPP.
Activity under the stock option and restricted stock plans was as follows (in thousands, except exercise price amounts):
(1) Shares available for grant include shares from the 2005 New Recruit Stock Plan and the 2006 Equity Incentive Plan that may be issued as either stock options, restricted stock awards or restricted stock units. Shares issued under the 2006 Equity Incentive Plan as stock bonus awards, stock purchase awards, stock unit awards, or other stock awards in which the issue price is less than the fair market value on the date of grant of the award count as the issuance of 1.3 shares for each share of common stock issued pursuant to these awards for purposes of the share reserve.
The weighted average remaining contractual term for outstanding options as of July 31, 2012, is 5.82 years.
The following is a summary of options vested and expected to vest, and exercisable at July 31, 2012, comprised (in thousands, except term and exercise price):
All granted restricted stock awards were fully vested as of July 31, 2012.
Restricted stock units (RSUs) are converted into shares of the Companys common stock upon vesting on a one-for-one basis. Typically, vesting of RSUs is subject to the employees continuing service to the Company. RSUs generally vest over a period of 3 or 4 years and are expensed ratably on a straight-line basis over their respective vesting period net of estimated forfeitures. The fair value of RSUs granted pursuant to the Companys 2005 New Recruit Stock Option Plan and the 2006 Equity Incentive Plan is the product of the number of shares granted and the grant date fair value of our common stock.
A summary of activity of RSUs for the three months ended July 31, 2012, is presented below:
For the three months ended July 31, 2012 and 2011, the total fair value of restricted shares that vested was $121,000 and $7,500, respectively.
As of July 31, 2012, there was approximately $1.0 million of total unrecognized compensation cost related to stock options and RSUs that is expected to be recognized over a weighted-average period of 2.07 years for stock options and 2.20 years for RSUs.
The key assumptions used in the fair value model and the resulting estimates of weighted-average fair value per share used to record stock-based compensation during the three months ended July 31, 2012 and 2011, for options and restricted stock granted and for employee stock purchases under the ESPP, are as follows:
(1) The Company has no history or expectation of paying dividends on its common stock.
(2) The Company estimates the volatility of its common stock at the date of grant based on the historic volatility of its common stock for a term consistent with the expected life of the awards affected at the time of grant.
(3) The risk-free interest rate is based on the U.S. Treasury yield for a term consistent with the expected life of the awards in affect at the time of grant.
(4) The expected life of stock options granted under the stock option plans is based on historical exercise patterns, which the Company believes are representative of future behavior. The expected life of grants under the ESPP represents the amount of time remaining in the 12-month offering window.
(5) Assumptions for the ESPP use a weighted average of all enrollments during the fiscal year. Effective November 30, 2011, the Board of Directors suspended activity under the Purchase Plan.
7. INCOME TAXES
The guidance on Accounting for Uncertainty in Income Taxes prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The liability for uncertain tax positions, if recognized, will decrease the Companys tax expense. The Company does not anticipate that the amount of liability for uncertain tax positions existing at July 31, 2012, will change significantly within the next 12 months. Interest and penalties related to the liability for uncertain tax positions are included in the provision for income taxes.
The Company files income tax returns in the U.S. and various state and foreign jurisdictions. Most U.S. and foreign jurisdictions have 3 to 10 years of open tax years. However, all the Companys tax years since fiscal 1998 will be open to examination by the U.S. federal and certain state tax authorities due to the Companys overall net operating loss and/or tax credit carryforward position.
The Company has experienced continuous operating losses for the past several years, and therefore has incurred minimal tax expense or benefit in the periods presented. The Companys effective tax rate was less than 1% at both July 31, 2012 and 2011, and reflects the effects of a full valuation allowance against the federal and state net operating loss and tax credit carryforwards due to uncertainty as to the recoverability of those items due to the Companys continuing operating losses. The minimal tax benefit and provision for the quarters ended July 31, 2012 and 2011, respectively, is attributable to certain state and foreign jurisdictions in which the Company operates.
8. COMMITMENTS AND CONTINGENCIES
The Company is not a party to any material legal proceedings. 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 managements attention.
The Companys lease commitments comprise a facility lease, office equipment leases and a colocation facility. The Company leases its principal office facilities of approximately 20,100 square feet, in San Jose, California under a non-cancelable operating lease expiring on April 30, 2017. The lease contains a one time early expiration option after 31 months of occupancy. To exercise this option, the Company must comply with various provisions, and pay an expiration fee which is comprised of the unamortized portion of any commissions, legal fees, free rent and leasehold improvements. The Company is responsible for taxes, insurance and maintenance expenses related to the leased facilities. We also had purchase commitments of approximately $0.7 million as of July 31, 2012, compared to approximately $1.0 million as of April 30, 2012.
At July 31, 2012, future minimum payments under the Companys current operating leases are as follows (in thousands):
Guarantees and Indemnifications
As is customary in the Companys industry and as required by law in the U.S. and certain other jurisdictions, certain of the Companys contracts provide remedies to its customers, such as defense, settlement, or payment of judgment for intellectual property claims related to the use of the Companys products. From time to time, the Company indemnifies customers against combinations of losses, expenses, or liabilities arising from various trigger events related to the sale and the use of the Companys products
and services. In addition, from time to time the Company also provides protection to customers against claims related to undiscovered liabilities, additional product liability or environmental obligations. In the Companys experience, claims made under such indemnifications are rare.
As permitted or required under Delaware law and to the maximum extent allowable under that law, the Company has certain obligations to indemnify its current and former officers and directors for certain events or occurrences while the officer or director is, or was serving at the Companys request, in such capacity. These indemnification obligations are valid as long as the director or officer acted in good faith and in a manner that a person reasonably believed to be in or not opposed to the best interests of the Company, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his or her conduct was unlawful. The maximum potential amount of future payments the Company could be required to make under these indemnification obligations is unlimited; however, the Company has a director and officer insurance policy that limits the Companys exposure and enables the Company to recover a portion of any future amounts paid. As a result of the Companys insurance policy coverage, the Company believes the estimated fair value of these indemnification obligations is minimal.
9. REPORTABLE SEGMENTS AND GEOGRAPHIC INFORMATION
The Company is a global telecommunications equipment supplier for voice networks. The Company develops, produces and sells voice quality enhancement solutions as well as voice applications solutions to telecommunication service providers worldwide. The Companys voice quality enhancement solutions enable service providers to deliver consistently clear, end-to-end communications to their subscribers. The Companys revenues are organized along two main product categories: products; and services, which are comprised of the Companys new voice applications offerings as well as services in support of its voice quality enhancement solutions. The Company currently operates in two business segments: the voice quality enhancement segment, which includes service revenues related to delivery of these solutions; and the voice applications segment. The segments are determined in accordance with how management views and evaluates the Companys business and based on the criteria as outlined in the authoritative guidance. A description of the types of products and services provided by each reportable segment is as follows:
Voice Quality Enhancement Segment
The Company designs, develops, and markets stand-alone and system-based voice quality products for circuit-switched and Voice over internet Protocol (VoIP) mobile networks throughout the world. The Companys products feature high-capacity, high-availability hardware systems coupled with a sophisticated array of voice optimization and measurement software to enhance the quality of voice communications. In addition to the hardware systems that comprise this segment, the Company also includes services such as maintenance, training and installation which support the hardware system sales.
Voice Applications Segment
Voice services includes a range of applications and services with the common goal of utilizing the human voice to interface with various aspects of day to day life which have been historically limited to keyboard interface. The products include voice-to-text transcription services, voice-based interface with the web and web-based applications.
Segment Revenue and Contribution Margin
Segment contribution margin includes all product line segment revenues less the related cost of sales, marketing and engineering expenses directly identifiable to each segment. Management allocates corporate manufacturing costs and some infrastructure costs such as facilities and information technology costs in determining segment contribution margin. Contribution margin is used, in part, to evaluate the performance of, and allocate resources to, each of the segments. Certain operating expenses are not allocated to segments because they are separately managed at the corporate level. These unallocated costs include sales costs, marketing costs other than direct marketing, general and administrative costs, such as legal and accounting, stock-based compensation expenses, acquisition-related integration costs, amortization and impairment of purchased intangible assets, restructuring costs, interest and other income (expense), net.
The results of the reportable segments are derived directly from the Companys management reporting system. The results are based on the Companys method of internal reporting and are not necessarily in conformity with accounting principles generally accepted in the United States. The Company measures the performance of each segment based on several metrics, including contribution margin.
Asset data, with the exception of inventory, is not reviewed by management at the segment level. All of the products and services within the respective segments are generally considered similar in nature, and therefore a separate disclosure of similar classes of products and services below the segment level is not presented.
Financial information for each reportable segment is as follows as of July 31, 2012, and April 30, 2012, and for the three months ended July 31, 2012 and 2011 (in thousands):
The reconciliation of segment information to the Companys condensed consolidated totals is as follows (in thousands):
Geographic revenue information comprises (in thousands):
Sales for the three months ended July 31, 2012, included three customers that represented greater than 10% of total revenue (30%, 15% and 10%). Sales for the three months ended July 31, 2011, included two customers that represented greater than 10% of total revenue (38% and 17%). As of July 31, 2012, the Company had two customers that represented greater than 10% of gross accounts receivable (43% and 10%). The Companys gross accounts receivable were concentrated in one customer at April 30, 2012, (representing 46% of receivables).
The Company maintained substantially all of its property and equipment in the United States at July 31, 2012, and April 30, 2012.
The following discussion and analysis should be read in conjunction with our Condensed Consolidated Financial Statements and Notes thereto included in this Quarterly Report on Form 10-Q, and the Consolidated Financial Statements and Notes thereto for the year ended April 30, 2012, included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 27, 2012. The discussion in this Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, such as statements of our expected future financial operating results, plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed here. See Future Growth and Operating Results Subject to Risk at the end of this Item 2 for factors that could cause future results to differ materially.
We provide voice technologies for the telecommunications market. We design, develop and market telecommunications equipment for use in enhancing voice quality and canceling echo in voice calls over wireline, wireless and internet protocol (IP) telecommunications networks. Our products monitor and enhance voice quality and provide transcoding in the delivery of voice services. We have continued to refine our echo cancellation products to meet the needs of the ever-changing telecommunications marketplace. Our TDM-based (time division multiplexing) product introductions have leveraged the processing capacity of our newer hardware platforms to offer not only echo cancellation but also enhanced Voice Quality Assurance (VQA) features including noise reduction, acoustic echo cancellation, voice level control and noise compensation through enhanced voice intelligibility. We have also introduced products to support carriers that are deploying voice over internet protocol, or VoIP, technologies which offer all the voice capabilities of our TDM-based products along with codec transcoding to meet the new challenges faced by carriers deploying VoIP technologies.
We also design, develop and market telecommunications software and services. We have built a software-centric extension to our voice quality offerings which provides VQA as well as other voice technologies such as mixing and keyword spotting, enabling the next generation of voice application. We also market and develop voice-to-text applications, based on our exclusive reseller agreement with Simulscribe. Voice-to-text utilizes much of the same core expertise in voice processing that underlies VQA. The current primary market for voice-to-text is voicemail-to-text. In the voicemail to text area we offer a broad spectrum of services, under the brand PhoneTag, including fully automated transcription services as well as transcription services that include human touch-up. Using the same infrastructure we also offer transcription services for conference calls and other audio sources.
We sell our products primarily to wireline and wireless carriers. We have experienced ebbs and flows in the level of demand from these carriers due to their level of network expansion, adoption of new technologies in their networks and the impacts of merger and other consolidation in the industry. During the last three years, the downturn in business volume we have experienced seems to have been driven by three main factors: technology transitions; budgetary constraints; and the global economic crisis.
The technology transition has impacted us on two fronts. First and foremost, carriers have been extremely cautious to invest in legacy second generation (2G) technology, historically our primary source of revenue, for fear of stranding some or all of their investments by moving to newer third/fourth generation technology (3G/4G). The hesitancy to invest in 2G equipment has resulted in protracted purchase cycles and smaller deployments to mitigate perceived risks, while still addressing needed improvements in voice quality in 2G networks. The second impact has been felt on the 3G/4G investment, which has been far slower to develop than was first predicted by industry experts. Instead of wholesale deployment of VoIP technologies, we have experienced a much more cautious entrance into this technology by many of the carriers with which we have historically done business, with the key by-product being that they are buying
much smaller systems than would have been expected from their historical buying pattern and in some cases even deciding to limit investment in 3G technology in lieu of even newer fourth generation technologies that are currently in development.
On the budgetary side, for the last several years we have seen tighter budgetary spending on capital equipment in many regions of the world, but most importantly with our large domestic customers. Spending on capital equipment appears to have been primarily targeted at equipment that can show a direct correlation with revenue generation as opposed to our historical product offerings, which although not a direct source of revenue for carriers is critical to the overall call experience and therefore to customer satisfaction, which in our opinion can ultimately translate into call revenue.
Lastly, we believe that the current market conditions around the world have altered the pattern of purchasing decisions as carriers tighten their capital investment activity due to internal budget constraints and as tighter credit hampers their ability to borrow to facilitate network expansion and/or upgrades.
Despite the previously mentioned budget constraints and uncertainty around network architecture, we continue to believe that in the United States our continued focus on voice quality in the competitive wireless services landscape and the continued expansion of wireless networks, primarily using 3G/4G technologies and to a lesser degree 2G technologies, will be key factors in our ability to add new customers and drive opportunities for revenue growth. Although we continue to believe that 2G technology will continue to play a major role in technology utilized in the international regions of the world, we do believe that there is a growing interest in certain of these regions in shifting to 3G technologies. Our Packet Voice Processor (PVP) product is designed for use in 3G/4G networks and has been moderately deployed over the last three years. Over the past several years, we have witnessed a reluctance by the carriers to invest heavily in any new large scale network expansion. However, we are poised to support the deployment of our PVP product in 3G/4G networks internationally, should demand for the 3G/4G technology grow internationally. The development of our VQA feature set, which was originally targeted at the international Global System for Mobile Communications (GSM) market, has seen growing importance in the domestic market as well. We continue to focus sales and marketing efforts on international and domestic mobile carriers that might best apply our VQA solution. We have continued to invest in customer trials domestically and internationally, where the size of the opportunities justify the costs we must invest in the trial, in an attempt to better avail ourselves of these opportunities as they arise.
In the last three fiscal years we have been focusing our development efforts to product offerings that leverage off our expertise in voice technology. We are undertaking these new opportunities in an effort to not only diversify our product offerings but also our customer base. We believe that these products could help generate a more predictable revenue base, which we believe is less susceptible to our customers decisions on the timing and nature of the network expansions than our legacy product offerings have experienced on a stand alone basis.
In fiscal 2010, we entered into an exclusive worldwide distribution agreement with Simulscribe. In conjunction with this agreement we obtained the exclusive right to market Simulscribes voice-to-text transcription services to customers around the world. We have invested in the enhancement of the voice-to-text offering to support conversion of additional languages as well to scale the capabilities of our services platform.
Due to softened demand for our products over the last few years, we have undertaken a number of cost cutting measures in an attempt to better align our spending with our revenue levels while still investing in the future of the company by means of development projects, like our voice services products which leverage our core strengths in the voice technology and provide for more stable revenue streams in the future. The focus of our cost cutting efforts has not only been on reducing headcount, but also on targeted spending reductions on discretionary spending areas such as travel, marketing campaigns and trade shows.
We intend to continue to monitor our spending and intend to take further steps if needed to balance our spending with the revenue opportunities we see ahead of us.
Reseller Agreement. In September 2009, we entered into a Reseller Agreement with Simulscribe pursuant to which we became the exclusive reseller of Simulscribes voice-to-text services to wholesale customers. Pursuant to the agreement, we also assumed all of Simulscribes wholesale customers. We paid $3.5 million and issued a two-year promissory note for an additional $3.5 million for the assumption of the wholesale customer contracts and the exclusivity right. In April 2011, the promissory note was paid in full. Additionally, Ditech agreed to pay a fee for the services provided by Simulscribe, and will pay up to an additional $10.0 million if the revenues generated from the Simulscribe services meet certain performance milestones within the first three years of the agreement (the Additional Payments), which period ends September 10, 2012, subject to acceleration in certain events, such as our failure to use commercially reasonable efforts to market the services or a change of control of our company at a time that revenues from these services are on track to result in the payment ultimately being made. Based upon current revenues generated, we do not expect any of the Additional Payments to be earned. The Additional Payments, should any be paid, are convertible into our common stock at Simulscribes option. The Additional Payments may be converted into our 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. In the fourth quarter of fiscal 2010, we amended our agreement with Simulscribe that extended our exclusive distribution rights to all customers, not just wholesale customers. The agreement, and the related amendment, were accounted for as an asset acquisition and the value of the consideration given was allocated to the assets received as part of the transaction.
Our Customer Base. Historically, the majority of our sales have been to customers in the United States. Domestic customers accounted for approximately 85% and 90% of our revenue during the three months ended July 31, 2012 and 2011, respectively, and 82% of our revenue during fiscal 2011. The geographic mix of revenue reflects domestic demand for our legacy TDM business and our VoIP business, as well as the vast majority of our voice service product revenue being generated from domestic customers. Our international business for the quarter ended July 31, 2012, was primarily concentrated in Asia. However, sales to some of our U.S. customers may result in our products purchased by these customers eventually being deployed internationally, especially in the case of any original equipment manufacturer that distributes overseas. To date, the vast majority of our international sales have been export sales and denominated in U.S. dollars. Our international revenue has been largely driven by demand from customers in South East Asia, Northern Africa, the Middle East and Latin America. We expect our international demand for voice quality products to continue to be heavily influenced by these markets as they are experiencing the highest level of growth and commonly have the most need for cost effective solutions to address voice quality in their growing networks. However, we expect that international demand for our voice service products may be more heavily influenced by demand from Europe and Latin America which tend to be earlier adopters of new phone services than other international regions into which we have historically sold product.
Our revenue historically has come from a small number of customers. Our largest customer in the three months ended July 31, 2012 and 2011, a domestic VoIP-based conference call provider, accounted for approximately 30% and 38% of our revenue, respectively. Our five largest customers accounted for approximately 60% and 68% of our revenue in the three months ended July 31, 2012 and 2011, respectively. Consequently, the loss of, or significant decline in purchases by any one of our largest customers, without an offsetting increase in revenue from existing or new customers, would have a negative and substantial effect on our business. This customer concentration risk was evidenced over the last few fiscal years as sudden delays and/or declines in purchases by our large customers resulted in significant declines in our overall revenues and ultimately resulted in net losses for those periods.
Critical Accounting Policies and Estimates
The preparation of our financial statements requires us to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosures. We evaluate these estimates on an ongoing basis, including those related to our revenue recognition, investments, inventory valuation allowances, cost of warranty, impairment of long-lived assets, accounting for stock-based compensation and accounting for income taxes. Estimates are based on our historical experience and other assumptions that we consider reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual future results may differ from these estimates in the event that facts and circumstances vary from our expectations. If and when adjustments are required to reflect material differences arising between our ongoing estimates and the ultimate actual results, our future results of operations will be affected. We believe that the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our consolidated financial statements.
Our significant accounting policies are more fully described in Item 7 of our Annual Report on Form 10-K for the year ended April 30, 2012, and have not changed since that time.
Recent Accounting Guidance
In September 2011, the Financial Accounting Standards Board (FASB) issued an update to existing guidance on the assessment of goodwill impairment. This amendment is intended to reduce the cost and complexity of the annual goodwill impairment test by providing entities an option to perform a qualitative assessment to determine whether further impairment testing is necessary. If an entity concludes that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, the two-step goodwill impairment test is required. Otherwise, the two-step goodwill impairment test is not required. This standard is effective for reporting periods beginning on or after December 15, 2011. We adopted this standard in the first quarter of fiscal year 2013 and did not experience a material impact on the condensed consolidated financial position, results of operations or cash flows from the adoption.
In June 2011, the FASB issued a new accounting standard to improve the comparability and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income. The new standard requires companies to present the components of net income and other comprehensive income either as one continuous statement or as two separate but consecutive statements. It eliminates the option to report other comprehensive income and its components as part of the statement of changes in shareholders equity. This standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. We adopted this standard in the first quarter of fiscal year 2013 and did not experience a material impact on the condensed consolidated financial position, results of operations or cash flows from the adoption.
In May 2011, the FASB issued a revised accounting standard. This amendment provides a consistent definition of fair value and ensures that the fair value measurement and disclosure requirements are similar between Generally Accepted Accounting Principles and International Financial Reporting Standards. The amendment clarifies the application of existing fair value measurements and disclosures, and changes certain principles or requirements for fair value measurements and disclosures. The amendment changes certain fair value measurement principles and enhances the disclosure requirements particularly for level 3 fair value measurements. The standard is effective for reporting periods beginning on or after December 15, 2011. We adopted this standard in the first quarter of fiscal year 2013 and did not experience a material impact on the condensed consolidated financial position, results of operations or cash flows from the adoption.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the components of the results of operations, as reflected in our statement of operations, as a percentage of sales.
THREE MONTHS ENDED JULY 31, 2012 AND 2011.
The decrease in revenue during the three months ended July 31, 2012, as compared to the three months ended July 31, 2011, was largely due to a decrease in sales of our legacy product and services of approximately 25%, or $0.7 million. This was largely offset by an increase of approximately $0.5 million, or 51%, in voice services revenue.
We sell our legacy products primarily to wireline and wireless carriers. We have experienced ebbs and flows in the level of demand from these carriers due to their level of network expansion, adoption of new technologies in their networks and the impacts of merger and other consolidation in the industry. Additionally, we believe the decline in legacy product revenue is at least partially due to customary volatility in the timing of transactions for legacy TDM (Time-Division Multiplexing) and VoIP products, which we have historically experienced with our legacy product line. Although we believe that we have a number of meaningful opportunities for our legacy products, the process to convert these opportunities to revenue continues to be protracted and volatile. As our legacy product business is characterized by a relatively small number of high value transactions per quarter, the shift in the timing of a single transaction can materially impact our revenue for a period.
The increase in our voice services revenue is primarily due to the addition to our customer base of a tier one carrier in the second quarter of fiscal 2012. Additionally, the expansion of our voice services sales team in fiscal 2012 has yielded additional growth to our voice to text customer base, resulting in increased revenues.
For the three months ended July 31, 2012, three customers accounted for more than 10% of total revenue (30%, 15% and 10%) with our largest customer being a VoIP conference call provider. For the three months ended July 31, 2011, two customers accounted for more than 10% of total revenue (38% and 17%) with our largest customer being an international wireless provider.
Cost of Revenue and Gross Profit.
Cost of revenue consists of direct material costs, personnel costs for test, configuration and quality assurance, costs of licensed technology incorporated into our products, post-sales installation costs, subcontracted service provider costs, provisions for inventory and warranty expenses and other indirect costs.
The decrease in cost of revenue was primarily driven by the decrease in business volume during the three months ended July 31, 2012, as compared to the three months ended July 31, 2011. Our discussion of gross margin below discusses the other factors which are impacting cost of revenue and resulting in the net decline in the gross margin.
Our gross margin increased slightly, approximately 1.5 percentage points, during the quarter ended July 31, 2012, as compared to July 31, 2011. Although revenue from our product and service mix is more heavily weighted to lower margin voice service revenue in the three months ended July 31, 2012, than in the three months ended July 31, 2011, the slight improvement in margin reflects the result of cost cutting measures targeted at our fixed manufacturing costs for our VQA products, as well as preliminary success in reducing our voice-to-text service costs. In fiscal 2013 we expect to continue to look for and drive towards improvement in our margins.
Sales and Marketing.
Sales and marketing expenses primarily consist of personnel costs, including commissions and costs associated with customer service, customer trials, travel, trade shows and outside consulting services. The increase in sales and marketing expense in the three months ended July 31, 2012, was primarily due to increased investment in the voice to text business of approximately $0.3 million in customer trials and $0.1 million in expanding the sales team. These increases were partially offset by headcount reductions and other cost savings in the legacy VQA business of approximately $0.2 million, primarily reflecting reductions in our international sales and support teams.
Research and Development.
Research and development expenses primarily consist of personnel costs, contract consultants, materials and supplies used in the development of voice processing products. Research and development costs increased in the three months ended July 31, 2012, as compared to the three months ended July 31, 2011, primarily due to an increase in development expenses related to both voice to text services and VQA product development. The increased investment was primarily made in capital equipment, cloud computing expense and outsourced development costs.
General and Administrative.
General and administrative expenses primarily consist of personnel costs for corporate officers, finance and human resources personnel, as well as insurance, legal, accounting and consulting costs. The increase in general and administrative expenses was primarily due to increased corporate and other activities requiring increased outside services.
Stock-based compensation expense recognized in the three months ended July 31, 2012 and 2011, was as follows:
The increase in stock based compensation is primarily due to the reversal in the three months ended July 31, 2011, of previously recognized expense on unvested options and restricted stock units, related to certain performance grants, due to the previous chief executive officers departure from our board of directors.
Other Income (Expense), Net.
Other income (expense), net generally consists of interest income on our invested cash and cash equivalent balances, impairment charges on our long-term investments and foreign currency activities. The increase in other income (expense), net was due primarily to the sale of an intangible asset resulting in a one time loss of approximately $25,000 during the three months ended July 31, 2011. We expect that the returns on our cash and investments will continue to experience marginal declines as we continue to use cash as a result of our anticipated operating losses in the second quarter of the fiscal year ended April 30, 2013. It is possible that we will experience further impairment charges on our remaining investment in preferred equity securities converted from auction rate securities, although we do not expect them to be material as there is only $0.1 million of carrying value remaining as of July 31, 2012.
Income taxes consist of federal, state and foreign income taxes. The effective tax rate in the three months ended July 31, 2012 and 2011, was less than 1%. This effective tax rate reflects our establishment of a full valuation allowance against our deferred tax assets, including our net operating loss carryforwards. As a result of this valuation allowance, our tax expense for the three months ended July 31, 2012 and 2011, is limited to certain minor state and foreign tax jurisdictions where we report limited profits.
LIQUIDITY AND CAPITAL RESOURCES
As of July 31, 2012, and April 30, 2012, we had cash and cash equivalents and investments totaling $21.0 million and $22.9 million, respectively. As of July 31, 2012, we had cash and cash equivalents of $18.9 million as compared to $20.4 million at April 30, 2012. Additionally we had $1.9 million and $2.4 million of short-term investments as of July 31, 2012, and April 30, 2012, respectively, and $0.1 million of long-term investments at both July 31, 2012, and April 30, 2012.
The net use of cash in operations for the three months ended July 31, 2012, was primarily attributable to the $3.2 million net loss experienced for the quarter, which was largely driven by softness in demand for our products as compared to our historical levels. Further contributing to the net use of cash in operations was a $0.2 million increase in inventory and a $0.1 million increase in other current assets during the three months ended July 31, 2012. Offsetting the negative impacts on cash flow from operations due to our continued operating losses, were non-cash operating expenses of $0.8 million related to depreciation and amortization and stock-based compensation which contribute to our operating loss but does not result in a use of cash, a decrease in accounts receivable of $0.5 million, and an increase in accounts payable and accrued and other liabilities of $0.6 million.
Our accounts receivable days sales outstanding at July 31, 2012, was approximately 51 days compared to 40 days at April 30, 2012.
We expect cash flows from operations to continue to be a use due to our continued operating losses.
We generated approximately $0.1 million in cash in our investing activities during the three months ended July 31, 2012. The cash generated was attributable to the net liquidation of short-term investments in the quarter ended July 31, 2012.
The limited cash flow from financing activities in the three months ended July 31, 2012 and 2011, was due to the limited level of option exercises during those periods largely due to a large portion of the options being out-of-the-money or only marginally in-the-money due to the decline in our stock price.
We expect that cash flows from financing activities will continue to reflect negligible levels of stock option exercises due to the current price of our stock.
We have no material commitments other than obligations under operating leases, particularly our facility lease, a colocation services agreement, normal purchases of inventory, capital equipment and operating expenses, such as materials for research and development and consulting. We also have an earn out obligation under the Simulscribe agreement, which could be as much as $10 million depending on the level of revenues achieved during the three-year term of the agreement. The three-year term expired on September 10, 2012, and no amounts will be paid out under this earn-out. We lease our principal office facilities of approximately 20,100 square feet, in San Jose, California under a non-cancelable operating lease expiring on April 30, 2017. The lease contains a one time early expiration option after 31 months of occupancy. To exercise this option, we must comply with various provisions, and pay an expiration fee which comprises the unamortized portion of any commissions, legal fees, free rent and leasehold improvements. We are responsible for taxes, insurance and maintenance expenses related to the leased facilities. We also had purchase commitments of approximately $0.7 million as of July 31, 2012, compared to approximately $1.0 million as of April 30, 2012.
We believe that we will be able to satisfy our cash requirements for at least the next twelve to eighteen months from our existing cash and short-term investments. The ability to fund our operations beyond the next twelve to eighteen months will depend on the overall demand for our products and services. Should we continue to experience significantly reduced levels of customer demand for our products compared to historical levels of purchases, we could need to find additional sources of cash during fiscal 2013 or be forced to further reduce our spending levels to protect our cash reserves.
Future Growth and Operating Results Subject to Risk
Our business and the value of our stock are subject to a number of risks, which are set out below. If any of these risks actually occur, our business, financial condition or operating results could be materially adversely affected, which would likely have a corresponding impact on the value of our common stock. These risk factors should be carefully reviewed.
WE DEPEND ON A LIMITED NUMBER OF CUSTOMERS, THE LOSS OF ANY ONE OF WHICH COULD CAUSE OUR REVENUE TO DECREASE.
Our revenue historically has come from a small number of customers. Our five largest customers accounted for approximately 60% of our revenue in the first three months of fiscal 2013 and 63% and 67% of our revenue in fiscal 2012 and 2011, respectively. Our largest customer in the first quarter of fiscal 2013 accounted for approximately 30% of our revenue, as compared to our largest customers in fiscal 2012 and 2011, which accounted for 29% and 28% of our revenue, respectively. A customer may stop buying our products or significantly reduce its orders for our products for a number of reasons, including the acquisition of a customer by another company, a delay in a scheduled product introduction, completion of a network expansion or upgrade, or a change in technology or network architecture. If this happens, our revenue could be greatly reduced, which would materially and adversely affect our business, including but not limited to exposing us to excess inventory levels due to declines in anticipated sales levels.
DELAYS IN TRANSITIONS IN OUR CUSTOMERS TECHNOLOGIES OR INFRASTRUCTURES MAY CAUSE DELAYS OR IMPEDIMENTS TO PURCHASING OUR PRODUCTS.
We have experienced changes in buying patterns due to carrier transitions from their legacy TDM/networks to VoIP networks and the impact of the world-wide economic and credit crisis. These more recent factors have directly impacted the timing and magnitude of carriers buying patterns, as they are closely watching their capital spending and are looking to minimize their investments in their legacy network configurations but have been slow to deploy large scale VoIP networks. Until carrier transition strategies from legacy TDM/networks to newer 3G and 4G networks get clarified and the economic and credit markets return to a more normal state, our revenue could be more volatile due to timing issues around large customer purchases.
THE WORLDWIDE MARKET TURMOIL MAY ADVERSELY AFFECT OUR CUSTOMERS WHICH DIRECTLY IMPACTS OUR BUSINESS AND RESULTS OF OPERATIONS.
Our operations and performance depend on our customers having adequate resources to purchase our products and services. The unprecedented turmoil in the global markets and the global economic downturn generally continues to adversely impact our customers and potential customers. These market and economic conditions have continued to deteriorate despite government intervention globally, and may remain volatile and uncertain for the foreseeable future. Customers have altered and may continue to alter their purchasing and payment activities in response to deterioration in their businesses, lack of credit, economic uncertainty and concern about the stability of markets in general, and these customers may reduce, delay or terminate purchases of, and payment for, our products and services. If we are unable to adequately respond to changes in demand resulting from deteriorating market and economic conditions, our financial condition and operating results may be materially and adversely affected.
IN PERIODS OF WORSENING ECONOMIC CONDITIONS, OUR EXPOSURE TO CREDIT RISK AND PAYMENT DELINQUENCIES ON OUR ACCOUNTS RECEIVABLE SIGNIFICANTLY INCREASES.
A substantial majority of our outstanding accounts receivables are not secured. In addition, our standard terms and conditions permit payment within a specified number of days following the receipt of our product. While we have procedures to monitor and limit exposure to credit risk on our receivables, there can be no assurance such procedures will effectively limit our credit risk and avoid losses. As economic conditions deteriorate, certain of our customers have faced and may face liquidity concerns and have delayed and may delay or may be unable to satisfy their payment obligations, which would have a material adverse effect on our financial condition and operating results. This exposure to credit risk is enhanced by our customer concentration; for example, 53% of our accounts receivable balance at July 31, 2012, was from two customers.
OUR CASH AND CASH EQUIVALENTS AND OUR SHORT AND LONG-TERM INVESTMENTS COULD BE ADVERSELY AFFECTED IF THE FINANCIAL INSTITUTIONS IN WHICH WE HOLD THESE FUNDS FAIL.
We maintain the cash and cash equivalents and our short and long-term investments with reputable major financial institutions. Deposits with these banks exceed FDIC insurance limits. While we monitor daily the cash balances in the operating accounts and adjust the balances as appropriate, these balances could be impacted if one or more of the financial institutions with which we deposit fails or is subject to other adverse conditions in the financial or credit markets. To date we have experienced no loss or lack of access to our invested cash or cash equivalents (other than our preferred equity securities that were converted from auction rate securities, which are classified as long-term investments); however, we can provide no assurance that access to our invested balances will not be impacted by adverse conditions in the financial and credit markets.
DESPITE OUR ENTRANCE INTO THE VOICE SERVICES MARKET, IN THE NEAR TERM WE CONTINUE TO REMAIN RELIANT PRIMARILY ON OUR VOICE QUALITY BUSINESS TO GENERATE REVENUE GROWTH AND PROFITABILITY, WHICH COULD LIMIT OUR RATE OF FUTURE REVENUE GROWTH.
We expect that, at least through fiscal 2013, our primary business will be the design, development and marketing of voice processing products. However, the relatively small size of the overall echo cancellation portion of the voice market, which is where we have derived the majority of our revenue to date, limits the rate of growth of this portion of our business. In addition, certain telecommunication service providers may utilize different technologies, such as VoIP, which would further limit demand for the products we have sold in the last few fiscal years, which are deployed in mobile and wireline networks. Our Packet Voice Processor (PVP), targeted at the VoIP market, generated 32% of total revenue in the three months ended July 31, 2012, and 36% of total revenue in fiscal 2012. Sales of our PVP product have been volatile from quarter to quarter. As such, there is no guarantee that we will continue to be successful in selling the PVP in volume into those VoIP networks
IF WE DO NOT SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS, OUR PRODUCTS MAY BECOME OBSOLETE WHICH COULD CAUSE OUR SALES TO DECLINE.
We operate in an industry that experiences rapid technological change, and if we do not successfully develop and introduce new products and our existing products become obsolete, our revenues will decline. Even if we are successful in developing new products, we may not be able to successfully produce or market our new products in commercial quantities, or increase our overall sales levels. These risks are of particular concern when a new generation product is introduced. If our new products do not receive substantial commercial acceptance, the ability to grow our business will be adversely impacted. In addition, although we have experienced substantial revenue from our VQA products over the last few fiscal years, there is no guarantee that our VQA products will continue to meet the expectations of new potential customers or that customers will continue to invest heavily in traditional TDM/wireline network infrastructure. As such, the timing of our realization of any additional revenues from the VQA platforms could be delayed or not materialize at all.
We must devote a substantial amount of resources in order to develop and achieve commercial acceptance of our new products. Our new and/or existing products may not be able to address evolving demands in the telecommunications market in a timely or effective way. Even if they do, customers in these markets may purchase or otherwise implement competing products.
AS WE MODIFY OUR CORE ALGORITHMS FOR USE IN OTHER ELEMENTS OF COMMUNICATIONS NETWORKS, THERE IS NO GUARANTEE THAT WE WILL BE SUCCESSFUL IN CAPTURING MARKET SHARE OR THAT IT WILL NOT ADVERSELY IMPACT THE SALE OF OUR EXISTING PRODUCTS.
We are working with equipment providers for other elements of communications networks, in an effort to license our voice algorithms for use in their devices. Although we believe that porting our algorithms to these new devices will not be a material undertaking, there is no guarantee that we will be successful in the porting efforts or that we will gain market acceptance. In addition, as the barriers to entry related to technology embedded in communication network devices are low, there is no guarantee that our competitors, who may have more resources and/or market presence, will not enhance their offerings to compete directly with our technology. Further, there is no guarantee that if and when our algorithms become adopted in other portions of the communications network that they will not reduce the demand for our existing voice processing platforms, which could adversely impact our revenues and increase the risk for excess or obsolete inventory in our existing platforms.
OUR TRANSCRIPTION CUSTOMERS RELY ON OUR PROVIDING A SECURE PRODUCT THAT PROVIDES REASONABLE ASSURANCE OF CONFIDENTIAL TREATMENT OF THEIR TRANSCRIBED MESSAGES.
Providing a secure transcription product that provides reasonable assurance of maintaining customer confidentiality is critical to the success of our distribution of transcription services and ultimately our overall voice services product offering. Although we believe that the procedures and systems we have put in place provide for a secure environment, there is no guarantee that these efforts will continue to provide the same level of security given the constantly changing nature of technology. Any failure to maintain a secure environment, including a perception of not maintaining a secure environment for transcription services, could adversely impact customer adoption and use of our transcription services and therefore our growth opportunities.
VOICE SERVICE PRODUCTS MAY NOT ACHIEVE WIDESPREAD MARKET ACCEPTANCE, OR BE SOLD AT PROFITABLE PRICE POINTS, WHICH COULD LIMIT OUR ABILITY TO GROW OUR VOICE SERVICES BUSINESS.
We have invested, through both internal development effort and our exclusive distribution agreement with Simulscribe, in the burgeoning voice services market. We believe that this market will provide a key to the growth opportunity for telecommunication carriers and therefore providers of voice service products. However, the market for speech technologies is relatively new and rapidly evolving. Our ability to grow and diversify our revenue depends in large measure on the acceptance of our voice services products and the ability to sell them at profitable price points. In the event that our customers do not embrace voice services as a viable source of revenue growth or they adopt the technology more slowly than we anticipate, or they are not willing to purchase them at prices providing the company with a profit, it could adversely impact our ability to grow our revenues and we may not be able to recover the costs associated with our investment in our voice business, including the costs invested in our distribution relationship with Simulscribe.
SIMULSCRIBES VOICE-TO-TEXT BUSINESS, FOR WHICH WE BECAME THE SOLE WORLD-WIDE DISTRIBUTOR, HAS HISTORICALLY BEEN A LOW MARGIN BUSINESS. IF WE CAN NOT IMPROVE THE COST MODEL, WHILE WE IMPROVE THE VOLUME OF REVENUE GENERATED FROM THIS BUSINESS, IT COULD DETERIORATE OUR OVERALL MARGINS AS THIS BUSINESS BECOMES A LARGER PERCENTAGE OF REVENUE.
While we are focused on growing our customer base in the voice-to-text market, we have also been focusing on implementing cost reduction efforts to improve on the historically low margins that the business has experienced. In the event that we are unsuccessful in executing on our cost reduction efforts, although we might experience growth in our gross profit due to increased revenue, we might experience a decline in our gross margin, as the voice-to-text revenue becomes a larger percentage of overall revenue.
WE ACT AS THE SOLE DISTRIBUTOR OF SIMULSCRIBE TRANSCRIPTION SERVICES, AND THE MAJORITY OF THE TRANSCRIPTION CUSTOMER AGREEMENTS HAVE PERFORMANCE LEVEL REQUIREMENTS WHICH INCLUDE PENALTY CLAUSES FOR FAILURE TO MEET THOSE PERFORMANCE LEVELS.
We have an exclusive world-wide distribution agreement with Simulscribe to sell their transcription services to customers (including but not limited to wireline and wireless carriers, and voice mail service providers). As part of our agreement with Simulscribe, we have assumed management responsibility of the third party manual transcription centers. The vast majority of our customer agreements for transcription services include service level requirements, which provide for penalties should the contract service levels not be maintained. We believe we have put in adequate redundancy features to mitigate the risks of failing to meet our service level obligations and have not incurred any significant penalties to date for failure to meet these service level commitments. However, if we or our third party manual transcription providers fail to meet the service level requirements, it could not only adversely impact our transcription service revenue but could also adversely impact our other voice services product revenues, should voice services customers lose confidence in our overall service offering.
MANY OF OUR OPERATING EXPENSES ARE RELATIVELY FIXED AND, AS A RESULT, CHANGES IN OUR REVENUES SIGNIFICANTLY AFFECTS OUR OPERATING RESULTS, WHICH HAS CAUSED OUR OPERATING RESULTS TO HAVE FLUCTUATED SIGNIFICANTLY IN THE PAST, AND WE ANTICIPATE THAT THEY MAY CONTINUE TO DO SO IN THE FUTURE, WHICH COULD ADVERSELY AFFECT OUR STOCK PRICE.
Our quarterly operating results have fluctuated significantly in the past and may fluctuate in the future as a result of several factors, some of which are outside of our control. If revenue significantly declines, as we experienced over the last few years, our operating results will be adversely affected because many of our expenses are relatively fixed. In particular, sales and marketing, research and development and general and administrative expenses do not change significantly with variations in revenue in a quarter. Adverse changes in our operating results could adversely affect our stock price. For example, we have experienced delays in customers finalizing contracts and/or issuing purchase orders, which have resulted in revenues slipping out of the quarter in which we had expected to recognize them. This resulted in revenue shortfalls from investor expectations during several quarters over the last few years and ultimately resulted in us experiencing declines in our stock price following the announcement of these revenue shortfalls.
OUR REVENUE MAY VARY FROM PERIOD TO PERIOD.
Factors that could cause our revenue to fluctuate from period to period include:
· changes in capital spending in the telecommunications industry and larger macroeconomic trends, including but not limited to the impacts of the current world-wide economic crisis;
· the timing or cancellation of orders from, or shipments to, existing and new customers;
· the loss of, or a significant decline in orders from, a customer;
· delays outside of our control in obtaining necessary components from our suppliers;
· delays outside of our control in the installation of products for our customers;
· the timing of new product and service introductions by us, our customers, our partners or our competitors;
· delays in timing of revenue recognition, due to new contractual terms with customers;
· competitive pricing pressures;
· variations in the mix of products offered by us; and
· variations in our sales or distribution channels.
Sales of our products typically come from our major customers ordering large quantities when they deploy a switching center. Consequently, we may get one or more large orders in one quarter from a customer and then no orders in the next quarter. As a result, our revenue may vary significantly from quarter to quarter.
Our customers may delay or rescind orders for our existing products in anticipation of the release of our or our competitors new products, due to merger and acquisition activity or if they are unable to secure sufficient credit to enable their purchases. Further, if our or our competitors new products substantially replace the functionality of our existing products, our existing products may become obsolete, which could result in inventory write-downs, and/or we could be forced to sell them at reduced prices or even at a loss.
In addition, the sales cycle for our products is typically lengthy. Before ordering our products, our customers perform significant technical evaluations, which typically last up to 90 days or more for our base echo cancellation systems and up to 180 days or more for our newer VQA and PVP product offerings. Our newer voice services product offerings are also subject to free evaluation periods of up to 60 days to allow potential customers a chance to trial the product to determine if it meets their needs. Once an order is placed, delivery times can vary depending on the product ordered and the timing of installations or product acceptance may be delayed by our customers. As a result, revenue forecasted for a specific customer for a particular quarter may not occur in that quarter. Further, in a fiscal quarter for which we enter the quarter with a small backlog relative to our revenue target, we are at heightened risk for the factors noted above as we are more dependent on the generation of new orders within the quarter to meet the revenue targets. Because of the potentially large size of our customers orders, this would adversely affect our revenue for the quarter.
WE OPERATE IN AN INDUSTRY EXPERIENCING RAPID TECHNOLOGICAL CHANGE, WHICH MAY MAKE OUR PRODUCTS OBSOLETE.
Our future success will depend on our ability to develop, introduce and market enhancements to our existing products and to introduce new products in a timely manner to meet our customers requirements. The markets we target are characterized by:
· rapid technological developments;
· frequent enhancements to existing products and new product introductions;
· changes in end user requirements; and
· evolving industry standards.
WE MAY NOT BE ABLE TO RESPOND QUICKLY AND EFFECTIVELY TO RAPID TECHNOLOGICAL CHANGES IN OUR INDUSTRY.
The emerging nature of these products and their rapid evolution will require us to continually improve the performance, features and reliability of our products, particularly in response to competitive product offerings. We may not be able to respond quickly and effectively to these developments. The introduction or market acceptance of products incorporating superior technologies or the emergence of alternative technologies and new industry standards could render our existing products, as well as our products currently under development, obsolete and unmarketable. In addition, we may have only a limited amount of time to penetrate certain markets, and we may not be successful in achieving widespread acceptance of our products before competitors offer products and services similar or superior to our products. We may fail to anticipate or respond on a cost-effective and timely basis to technological developments, changes in industry standards or end user requirements. We may also experience significant delays in product development or introduction. In addition, we may fail to release new products or to upgrade or enhance existing products on a timely basis.
WE MAY NEED TO MODIFY OUR PRODUCTS AS A RESULT OF CHANGES IN INDUSTRY STANDARDS.
The emergence of new industry standards, whether through adoption by official standards committees or widespread use by service providers, could require us to redesign our products. If these standards become widespread, and our products are not in compliance with these standards, our current and potential customers may not purchase our products. The rapid development of new standards increases the risk that our competitors could develop and introduce new products or enhancements directed at new industry standards before us.
WE ANTICIPATE THAT AVERAGE SELLING PRICES FOR OUR PRODUCTS WILL DECLINE IN THE FUTURE, WHICH COULD ADVERSELY AFFECT OUR ABILITY TO BE PROFITABLE.
We expect that the price we can charge our customers for our products will decline as new technologies become available, as we expand the distribution of products through value-added resellers and distributors internationally and as competitors lower prices either as a result of reduced manufacturing costs or a strategy of cutting margins to achieve or maintain market share. If this occurs, our operating results will be adversely affected. While we intend to reduce our cost of revenue in an attempt to maintain our margins, we may not execute these programs on schedule. In addition, our competitors may drive down prices faster or lower than our planned cost reduction programs. Even if we can reduce our cost of revenue, many of our operating costs will not decline immediately if revenue decreases due to price competition.
In order to respond to increasing competition and our anticipation that average-selling prices will decrease, we are attempting to reduce the cost of revenue of our new and existing products. If we do not reduce the cost of revenue and average selling prices decrease, our operating results will be adversely affected.
WE USE PRIMARILY ONE CONTRACT MANUFACTURER TO MANUFACTURE OUR PRODUCTS, AND IF WE LOSE THE SERVICES OF THIS MANUFACTURER THEN WE COULD EXPERIENCE INCREASED MANUFACTURING COSTS AND PRODUCTION DELAYS
We currently outsource manufacturing primarily to one contract manufacturer. We believe that our current contract manufacturing relationship provides us with competitive manufacturing costs for our products. If we or this contract manufacturer terminates our relationship, or if we otherwise establish new relationships, we may encounter problems in the transition of manufacturing to another contract manufacturer, which could temporarily increase our manufacturing costs and cause production delays.
IF WE LOSE THE SERVICES OF ANY OF OUR KEY MANAGEMENT OR KEY TECHNICAL PERSONNEL, OR ARE UNABLE TO RETAIN OR ATTRACT ADDITIONAL TECHNICAL PERSONNEL, OUR ABILITY TO CONDUCT AND EXPAND OUR BUSINESS COULD BE IMPAIRED.
We depend heavily on key management and technical personnel for the conduct and development of our business and the development of our products. However, there is no guarantee that if we lost the services of one or more of these people for any reason, that it would not adversely affect our ability to conduct and expand our business and to develop new products. We believe that our future success will depend in large part upon our continued ability to attract, retain and motivate highly skilled technical employees. However, we may not be able to do so.
WE FACE INTENSE COMPETITION, WHICH COULD ADVERSELY AFFECT OUR ABILITY TO MAINTAIN OR INCREASE SALES OF OUR PRODUCTS.
The markets for our products are intensely competitive, continually evolving and subject to rapid technological change. Our competitors include companies with significantly greater financial, technical and marketing resources than we have. These competitors are likely to be able to respond more rapidly than we can to new or emerging technologies or changes in customer requirements. They may also devote greater resources to the development, promotion and sale of their products than we do. We may not be able to compete successfully against current or future competitors. Certain of our customers also have the ability to internally produce the equipment that they currently purchase from us. In these cases, we also compete with their internal product development capabilities. We expect that competition will increase in the future. We may not have the financial resources, technical expertise or marketing, manufacturing, distribution and support capabilities to compete successfully.
We face competition for our voice quality products from voice switch manufacturers. These switch manufacturers do not sell voice processing products or compete in the stand-alone voice processing product market specifically, but they integrate voice processing functionality within other products, either as hardware modules or as software running on internal processors. The other competition in these markets comes from two direct manufacturers of stand-alone voice processing products, Tellabs and Dialogic Communications. A more widespread adoption of internal voice processing solutions would present an increased competitive threat to us, if the net result was the elimination of demand for our voice processing system products.
AT&T, Microsoft, Google, Yahoo, Nuance, and other smaller companies are our competitors in the voice services business. Independent software vendors could develop competing applications. These independent software companies have access to the necessary technology to develop competing applications. In addition, some of these independent software vendors have more experience with voice recognition technology. One of the largest competitors in the voice transcription market, Nuance, merged subsequent to our becoming the exclusive distributor of Simulscribes transcription service to wholesale customers.
Although we believe we have certain technological advantages to certain of the transcription services offered by the combined company, the merger may impact our ability to close certain business opportunities that we believe exist in the transcription market. In addition, since a large portion of our voice services customers are direct retail customers, we also face the risk that carriers, including some of our wholesale customers, could offer competitive alternatives which would lure our retail customers away from us and adversely impact our voice services revenue.
Many of our competitors and potential competitors have long-standing relationships with our existing and potential customers, and have substantially greater name recognition and technical, financial and marketing resources than we do. These competitors may undertake more extensive marketing campaigns, adopt more aggressive pricing policies and devote substantially more resources to developing new products than we will.
WE DO NOT HAVE THE RESOURCES TO ACT AS A SYSTEMS INTEGRATOR, WHICH MAY BE REQUIRED TO WIN DEALS WITH SOME LARGE U.S. AND INTERNATIONAL TELECOMMUNICATIONS SERVICES COMPANIES.
When implementing significant technology upgrades, large U.S. and international telecommunications services companies often require one major equipment supplier to act as a systems integrator to ensure interoperability of all the network elements. Normally the system integrator would provide the most crucial network elements and also take responsibility for the interoperation of their own equipment with the equipment provided by other suppliers. We are not in a position to take such a lead system integrator position and therefore we may have to partner with a system integrator (other, much larger, telecommunication equipment supplier) to have a chance to win business with certain customers. As a result, we may experience delays in revenue because it could take a long time to agree to terms with the necessary system integrator and the terms may reduce our profitability for that transaction. Moreover, there is no guarantee that we will reach agreement with a system integrator.
IF INCUMBENT AND EMERGING COMPETITIVE SERVICE PROVIDERS AND THE TELECOMMUNICATIONS INDUSTRY AS A WHOLE EXPERIENCE A DOWNTURN OR REDUCTION IN GROWTH RATE, THE DEMAND FOR OUR PRODUCTS WILL DECREASE, WHICH WILL ADVERSELY AFFECT OUR BUSINESS.
Our success will continue to depend in large part on development, expansion and/or upgrade of voice and communications networks. We are subject to risks of growth constraints due to our current and planned dependence on U.S. and international telecommunications service providers. These potential customers may be constrained for a number of reasons, including their limited capital resources, economic conditions, changes in regulation and mergers or consolidations which we have seen in North America since calendar year 2004. New service providers (e.g., Google and Yahoo) are competing against our traditional customers with new business models that are substantially reducing the prices charged to end users. This competition may force network operators to reduce capital expenditures, which could reduce our revenue.
WE MAY EXPERIENCE UNFORESEEN PROBLEMS AS WE DIVERSIFY OUR INTERNATIONAL CUSTOMER BASE, WHICH WOULD IMPAIR OUR ABILITY TO GROW OUR BUSINESS.
Historically, we have sold mostly to customers in North America. We are continuing to execute on our plans to expand our international presence. We may still be required to hire additional personnel for the overseas market, may invest in markets that ultimately generate little or no revenue, and may incur other unforeseen expenditures related to our international expansion. To date our expansion overseas has met with success in only a few markets and there is no guarantee of future success.