Item 1. Business
Our Company
We are a leading provider of communications platforms and technology that enable developers and service providers to build and deploy innovative applications without concern for the complexities of the communication medium or network. We specialize in providing products and solutions that enhance the mobile communications experience. Our technology impacts over two billion mobile subscribers and our network solutions carry more than 15 billion minutes of traffic per month.
Wireless and wireline service providers use our products to transport, convert and manage data and voice traffic while enabling VoIP and other multimedia services. These service providers also utilize our underlying technology to provide innovative revenue-generating value-added services such as messaging, SMS, voice mail and conferencing which are also increasingly becoming video-enabled. Enterprises rely on our innovative products to enable the integration of IP and wireless technologies and endpoints into existing communication networks, and to enable applications that serve businesses, including unified communication applications, contact center and IVR/ IVVR.
We sell our products to both enterprise and service provider customers and sell both directly and indirectly through distribution partners such as TEMs, VARs and other channel partners. Our customers build their enterprise communications solutions, their networks, or their value-added services on our products.
We were incorporated in Delaware on October 18, 2001 as Softswitch Enterprises, Inc., and subsequently changed our name to NexVerse Networks, Inc. in 2001, Veraz Networks, Inc. in 2002 and Dialogic Inc. in 2010. Companies we have acquired have been providing products and services for nearly 25 years.
Debt Arrangements
We have related party long-term debt under a Term Loan Agreement and Stockholder Loans, and bank indebtedness with a Revolving Credit Agreement.
On March 22, 2012, Dialogic Corporation entered into a third amended and restated credit agreement, or the Term Loan Agreement, with Obsidian, LLC, as agent, and Special Value Expansion Fund, LLC, Special Value Opportunities Fund, LLC and Tennenbaum Opportunities Partners V, LP, as lenders, or, together, the Term Lenders. As of March 22, 2012, an aggregate of approximately $92.8 million of principal was outstanding under the Term Loan, or the Term Loans. In addition, the Term Lenders have at their discretion the ability to provide additional loans to Dialogic Corporation up to $10 million on the same terms of the Term Loans. As of April 5, 2012, we have received $1.0 million under this provision. The Term Loans bear interest, payable quarterly in cash, at a rate per annum of 10%, except that, in 2012 and thereafter if certain minimum cash requirements are not met, interest may be paid at the rate of 5% in cash with the remaining 5% added to principal and paid in kind. Upon the occurrence and continuance of an event of default, the term loans will bear interest at a default rate equal to the applicable interest rate plus 2%.
As of December 31, 2011, Dialogic Corporation had $4.8 million in long-term debt payable to certain of our stockholders, including our Chief Executive Officer and members of our Board of Directors, or, collectively, the Related Party Lenders, bearing interest at an annual rate of 20% compounded monthly in form of a payment in kind, and repayable six months from the maturity date of the Term Loan Agreement, which, as of December 31, 2011 would have been March 2014, and under the third amended and restated Term Loan Agreement, would be in September 2015.
Dialogic Corporation also has a working capital facility pursuant to a credit agreement dated as of March 5, 2008, as amended, or the Revolving Credit Agreement, with Wells Fargo Foothill ULC, as administrative agent and as a lender, or the Revolving Credit Lender. On March 22, 2012, Dialogic Corporation entered into a Consent and Seventeenth Amendment, or the Seventeenth Amendment, relating to the Revolving Credit Agreement. Under the Seventeenth Amendment, the Revolving Credit Lender waived the events of default existing under the Revolving Credit Agreement as of March 22, 2012 and agreed to certain amendments to the Revolving Credit Agreement.
Pursuant to the Seventeenth Amendment, the Revolving Credit Agreement maturity date was amended and extended to the earlier of (i) March 31, 2015 and (ii) expiration of the Term Loan Agreement. Dialogic Corporation may borrow, repay and reborrow revolving credit loans from time to time provided that the aggregate principal amount of revolving credit loans outstanding at any time does not exceed the lesser of (i) $25.0 million, which is referred to as the “maximum revolver amount” or (ii) 85% of the aggregate amount of eligible accounts receivable, reduced by certain reserves and offsets and subject to certain caps in the case of accounts
receivable owed to Dialogic Corporation and certain guarantors of the Revolving Credit Agreement, which is referred to as the “borrowing base.”
Recent Financing Activity
On April 11, 2012, we entered into a securities purchase agreement, or the Purchase Agreement, with accredited investors, including certain related parties, or the Investors, pursuant to which we issued and sold $39.5 million aggregate principal amount of convertible promissory notes, or the Notes, and one share of our Series D-1 Preferred Stock, par value $0.001 per share, or the Series D-1 Preferred Share, to the Investors in a private placement, or the Private Placement.
The Investors in the Private Placement included the Term Lenders and Related Party Lenders. The Term Lenders purchased $34.5 million aggregate principal amount of Notes in exchange for the cancellation of (i) $33.0 million in outstanding principal under the Term Loan Agreement, $3.0 million of which represents accrued but unpaid interest that was capitalized under the Term Loan Agreement on March 22, 2012, or the Interest Amount, and (ii) a prepayment premium of $1.5 million triggered by the cancellation of the outstanding debt described above. The Related Party Lenders purchased the remaining $5.0 million aggregate principal amount of Notes in exchange for the cancellation of outstanding debt.
The Notes bear interest at the rate of 1% per annum, compounded annually, and are convertible into shares of our common stock. The conversion price of the Notes is generally $1.00 per share, provided that the Notes issued to the Term Lenders in exchange for the cancellation of the Interest Amount will have a conversion price of $0.87 per share, in each case as adjusted for any stock split, reverse stock split, stock dividend, recapitalization, reclassification, combination or other similar transaction. Under the terms of the Notes, the principal and all accrued but unpaid interest will automatically convert into shares of our common stock upon stockholder approval of the Private Placement.
Pursuant to the Purchase Agreement, we have agreed to call a meeting of the stockholders by June 30, 2012 to approve the Private Placement. If stockholder approval and the resulting conversion of the Notes do not occur by June 30, 2012, the outstanding principal amount and all accrued and unpaid interest under the Notes shall become due and payable on such date; however, amounts due under the Notes cannot be repaid before amounts outstanding under the Term Loan Agreement and Revolving Credit Agreement. The Notes are subordinated to our outstanding loans under the Term Loan Agreement and the Revolving Credit Agreement. We may not prepay such Notes prior to June 30, 2012 without the consent of the Term Lenders and Revolving Credit Lender.
Concurrently with the Private Placement, Dialogic Corporation, the Company and certain of our subsidiaries entered into a First Amendment to the Term Loan Agreement, or the First Amendment, with the Term Loan Lenders and an Eighteenth Amendment to Revolving Credit Agreement, or the Eighteenth Amendment, with the Revolving Credit Lender.
Pursuant to the First Amendment, the Term Loan Agreement was amended to permit the conversion of $33.0 million of outstanding debt under the Term Loan Agreement in exchange for the Notes as described above and the Series D-1 Preferred Share, subject to payment of a prepayment premium of $1.5 million, which we also paid through the issuance of Notes. The Term Loan Agreement was also amended to permit us to issue the remaining Notes sold in the Private Placement. Pursuant to the Eighteenth Amendment, the Revolving Credit Agreement was also amended to permit us to issue the Notes.
We issued the Series D-1 Preferred Share to Tennenbaum Opportunities Partners V, LP, one of the Term Lenders, a principal stockholder of the Company and an affiliate of Rajneesh Vig, a member of our Board of Directors, in exchange for cancellation of $100 in outstanding principal under the Term Loan Agreement. The Certificate of Designation of the Series D-1 Preferred Stock, or the Certificate, authorizes one share of Series D-1 Preferred Stock, which, except as set forth below, is non-voting and is not convertible into other shares of our capital stock. However, following stockholder approval of the Private Placement, if it occurs, the holder of the Series D-1 Preferred Share, or the Holder, has the right to designate certain members of the Board as follows:
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four directors to the Board (each director to the Board designated and elected pursuant by the Holder, a Series D-1 Director, and all such directors, the Series D-1 Directors) at any time while the Holder (together with its affiliates) beneficially owns in the aggregate at least 45% of the then issued and outstanding shares of Common Stock (assuming (x) the exercise in full of all warrants then exercisable by the Holder and any affiliates thereof and (z) conversion or exercise, as applicable, of any other securities of the Company that by their terms are convertible or exercisable into shares of Common Stock that are held by the Holder, or, collectively, the Fully Diluted Common Stock);
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three Series D-1 Directors at any time while the Holder (together with its affiliates) beneficially owns in the aggregate at least 30% and less than 45% of the Fully Diluted Common Stock;
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two Series D-1 Directors at any time while the Holder (together with its affiliates) beneficially owns in the aggregate at least 10% and less than 30% of the Fully Diluted Common Stock; or
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one Series D-1 Director at any time while the Holder (together with its affiliates) beneficially owns in the aggregate at least three percent and less than 10% of the Fully Diluted Common Stock.
At any time when the Holder has the right to designate two or more directors, one such director will be the chairman of the Board.
The Certificate further provides that we must obtain the Holder’s consent to, among other things, (i) take any action that alters or changes the rights, preferences or privileges of the Series D-1 Preferred; (ii) convert the Company into any other organizational form; (iii) change the size of the Board of Directors; (iii) appoint or remove the chairman of the Board of Directors; or (iv) establish, remove or change the authority of any committee of the Board of Directors or appoint or remove members thereof.
Business Combination with Dialogic Corporation
On October 1, 2010, we completed our business combination with Dialogic Corporation, a British Columbia corporation, in accordance with the terms of an acquisition agreement dated May 12, 2010. We acquired all of Dialogic Corporation’s outstanding common and preferred shares in exchange for an aggregate of approximately 22.1 million shares of our common stock, after giving effect to the stock split described below and, accordingly, Dialogic Corporation became our wholly-owned subsidiary. All outstanding options to purchase Dialogic Corporation common shares were cancelled and new options to purchase shares of our common stock were granted. After taking into account the issuance of stock options to purchase our common stock in exchange for Dialogic Corporation options at October 1, 2010, the former Dialogic Corporation shareholders and optionholders held approximately 70% and our existing stockholders held approximately 30% of our outstanding securities following the combination. As of October 1, 2010, there were approximately 31.0 million shares of our common stock issued and outstanding, after taking into account the effect of the one-for-five reverse stock split approved by the our stockholders on September 30, 2010. As of October 1, 2010, we changed our name from Veraz Networks, Inc. to Dialogic Inc. and on October 4, 2010, our common stock began trading on The NASDAQ Global Market under the symbol “DLGC”. Our business combination with Dialogic Corporation was accounted for as a reverse acquisition under the acquisition method of accounting whereby Dialogic Corporation was considered the accounting acquirer in accordance with U.S. generally accepted accounting principles, or U.S. GAAP.
Industry Background
The telecommunications industry has traditionally been highly regulated. However, in recent years regulatory barriers to entry have been removed and service providers with telephone, cable, and wireless networks have expanded their offerings to voice, data, and video services over a single broadband platform, increasing competition in the industry.
This increase in competition has also led to steep price reductions, which have in turn caused the revenues of incumbent telecom operators to decline. At the same time, the demand for IP-based technologies increased due to the need to reduce costs and the need to diversify revenue streams. In developed countries, services are increasingly bundled; for example, Internet access is often bundled with voice telephony and television channels. Service providers and enterprises either maintain their legacy networks or steadily plan on migrating telecom systems from PSTN to a single IP network to deliver video calls, text messaging, and location-based services and other high-demand services.
Our products allow service providers to deploy services smoothly over disparate networks. We offer a softswitch that allows new services to be implemented securely and dynamically throughout the entire network along with routing, billing, and number portability for operational savings. Our media servers enable creation of value-added communications services. Our media gateways interconnect multimedia streams and include bandwidth and codec optimization. We also offer optimization of wireless communication streams in the backhaul network. Our video gateway converts pictures and video streams from different compression formats seamlessly enabling the delivery of video between different network generations and multiple types and sizes of devices and screens. We also offer a session border controller with a secure proxy architecture that is transparent to the end-to-end flow of signaling messages, enabling a reduction in the time and cost of deploying new services.
Our products meet specific customer requirements and industry standards, and are subject to various laws, restrictions and regulations, including, but not limited to, environmental protection, import-export controls, and political and economic boundaries, which are more fully discussed in “Item 1A.
Item 1A. Risk Factors
Our business faces significant risks, some of which are set forth below to enable readers to assess, and be appropriately apprised of, many of the risks and uncertainties applicable to the forward-looking statements made in this Annual Report on Form 10-K. You should carefully consider these risk factors as each of these risks could adversely affect our business, operating results and financial condition. If any of the events or circumstances described in the following risks actually occurs, our business may suffer, the trading price of our common stock could decline and our financial condition or results of operations could be harmed. Given these risks and uncertainties, you are cautioned not to place undue reliance on forward-looking statements. These risks should be read in conjunction with the other information set forth in this Annual Report on Form 10-K. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us, or that we currently believe to be immaterial, may also adversely affect our business.
We have received a letter regarding an informal inquiry by the SEC, and cooperation with such governmental inquiry may cost significant amounts of money and require a substantial amount of management resources.
On March 28, 2011, we received a letter from the SEC informing us that the SEC was conducting an informal inquiry, or the SEC Informal Inquiry, and requesting that we preserve certain categories of records in connection with the SEC Informal Inquiry. In a follow up discussion with the SEC on March 30, 2011, the SEC informed us that the inquiry related to allegations of improper revenue recognition and potential violations of the Foreign Corrupt Practices Act of 1977, as amended, by the former Veraz Networks Inc. business during periods prior to completion of our business combination with Dialogic Corporation. Our Board of Directors, or the Board, appointed a committee to review these issues, with the aid of counsel, and to make recommendations to the Board as to what, if any, remedial actions would be appropriate. The committee engaged Sheppard Mullin Richter & Hampton LLP, or Sheppard Mullin, as outside counsel to the committee, The Board has taken the remedial actions recommended by Sheppard Mullin and the committee and we have updated and improved our compliance procedures. In addition, the Company produced documents to the Department of Justice, or DOJ, relating to the SEC Informal Inquiry. With our counsel, we continue to fully cooperate with the SEC and DOJ, in connection with the SEC Informal Inquiry. We have incurred and may continue to incur significant costs related to the SEC Informal Inquiry, which will have a material adverse effect on our financial condition and results of operations. Further, the SEC Informal Inquiry has caused and may continue to cause a diversion of management’s time and attention which could also have a material adverse effect on our financial condition and results of operations.
The SEC Informal Inquiry may turn into a formal investigation and result in charges filed against us and in fines or penalties.
The SEC and/or DOJ may decide to turn the SEC Informal Inquiry into a formal investigation. Should they do so, criminal or civil charges could be filed against us and we could be required to pay significant fines or penalties in connection with such investigation or other governmental investigations. Any criminal or civil charges by the SEC or other governmental agency or any fines or penalties imposed by the SEC could materially harm our business, results of operations, financial position and cash flows.
We have not sustained profits and our losses could continue. Without sufficient additional capital to apply to repay our indebtedness, we may be required to significantly scale back our operations, significantly reduce our headcount, seek protection under the provisions of the U.S. Bankruptcy Code, and/or discontinue many of our activities which could negatively affect our business and prospects. Our current capital raising efforts may not be successful in raising additional capital on favorable terms, or at all.
We have experienced significant losses in the past and never sustained profits. For the years ended December 31, 2011, 2010 and 2009, we recorded net losses of approximately $54.8 million, $46.7 million and $37.6 million, respectively. As of December 31, 2011, we had $107.2 million in total debt outstanding, we were not in compliance with any of the financial covenants then in effect under the Term Loan Agreement and we were also in default under the Revolving Credit Agreement. Although existing defaults were waived in connection with the third amended and restated Term Loan Agreement and Seventeenth Amendment, if we fail to comply with the covenants under such agreements, the maturity date of our outstanding indebtedness may be accelerated. In addition, under the terms of the Notes, if stockholder approval and the resulting conversion of the Notes do not occur by June 30, 2012, the outstanding principal amount and all accrued and unpaid interest under the Notes shall become due and payable on such date; provided that amounts due under the Notes cannot be repaid prior to amounts outstanding under the Term Loan Agreement and Revolving Credit Agreement.
While we believe that our current cash resources, together with anticipated product and services revenues, will be sufficient to fund our operations, including interest payments, in 2012, they may not be sufficient to fund both our operations and repayment of principal on our outstanding indebtedness in 2013 or beyond. Further, we do not anticipate having sufficient cash and cash equivalents to repay the debt should the Revolving Credit Lender or the Term Lenders accelerate the maturity date of outstanding debt or if the Notes become due and payable, and we would be forced to seek alternative sources of financing. In light of these circumstances, we are currently seeking additional capital through public or private debt or equity financings or development financings.
However, there are no assurances that those efforts will be successful or that additional capital will be available on terms that do not adversely affect our existing stockholders or restrict our operations, if it is available at all. If we raise additional funds through the issuance of debt securities, these securities could have rights that are senior to holders of our common stock and could include different financial covenants, restrictions and financial ratios other than what we currently operate under. The conversion of the Notes, if it occurs, will result in substantial dilution to our stockholders and any additional equity financing would also likely be substantially dilutive to our stockholders, particularly in light of the prices at which our common stock has been recently trading. In addition, if we raise additional funds through the sale of equity securities, new investors could have rights senior to our existing stockholders. The terms of any future financings may restrict our ability to raise additional capital, which could delay or prevent the further development or marketing of our products and services. Our need to raise capital before the repayment of our debt becomes due may require us to accept terms that may harm our business or be disadvantageous to our current stockholders, particularly in light of the current illiquidity and instability in the global financial markets.
In the event of an acceleration of our obligations under the Term Loan Agreement or Revolving Credit Agreement and our failure to pay the amounts that would then become due, the Revolving Credit Lender or Term Lenders could seek to foreclose on our assets. As a result of this, or if our stockholders do not approve the Private Placement and the Notes become due and payable, we would likely need to seek protection under the provisions of the U.S. Bankruptcy Code and/or our affiliates might be required to seek protection under the provisions of applicable bankruptcy codes. In that event, we could seek to reorganize our business, or we or a trustee appointed by the court could be required to liquidate our assets. In either of these events, whether the stockholders receive any value for their shares is highly uncertain. If we needed to liquidate our assets, we might realize significantly less from them than the value that could be obtained in a transaction outside of a bankruptcy proceeding. The funds resulting from the liquidation of our assets would be used first to pay off the debt owed to secured creditors, including the Term Lenders, Revolving Credit Lender, followed by any unsecured creditors such as the holders of the Notes, before any funds would be available to pay our stockholders. If we are required to liquidate under the federal bankruptcy laws, it is unlikely that stockholders would receive any value for their shares.
Our substantial level of indebtedness could adversely affect our ability to react to changes in our business, and the terms of our debt facilities limit our ability to take a number of actions that our management might otherwise believe to be in our best interests. In addition, if we fail to comply with our covenants, the maturity date of our outstanding indebtedness could be accelerated.
Our level of indebtedness could have significant consequences to us and our investors, such as:
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requiring substantial amounts of cash to be used for debt service, rather than other purposes, including operations;
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limiting our ability to plan for, or react to, changes in our business and industry;
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limiting our ability to obtain additional financing we may need to fund future working capital, capital expenditures, product development, acquisitions or other corporate requirements;
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requiring the dedication of a substantial portion of our cash flow from operations to the payment of principal and interest on our debt, which would reduce the availability of cash flow to fund working capital, capital expenditures, product development, acquisitions and other corporate requirements;
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increasing the risk of our failing to satisfy our obligations with respect to our debt instruments and/or to comply with the financial and operating covenants;
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influencing investor, vendor, and customer perceptions about our financial stability and limiting our ability to obtain financing, obtain optimal payment terms and discounts with vendors or maintain and acquire customers
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limiting our ability to meet payment obligations as set out in our agreements; and
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increasing our vulnerability to adverse economic conditions in our industry or the economy in general.
In addition, the instruments governing our debt contain financial and other restrictive covenants, which limit our operating flexibility and could prevent us from taking advantage of business opportunities. If we fail to comply with these covenants it could result in events of default under our debt instruments that, if not cured or waived, could result in an acceleration of our debt. In the event of the acceleration of an acceleration of our obligations under our debt instruments, we do not anticipate having sufficient cash and cash equivalents to repay such debt and we would be forced to seek alternative sources of financing. If we fail to pay amounts that become due under our debt instruments, our lenders could seek to foreclose on our assets, as a result of which we would likely need to seek protection under the provisions of the U.S. Bankruptcy Code as described above.
We are dependent on revenue from mature products, including TDM products. Our success depends in large part on continued migration to IP network architecture for sales of our newer IP and IP enabled products portfolio. If the migration to IP networks does not occur or if it occurs more slowly than we expect or if sales of our newer products do not develop as expected our operating results would be harmed.
Currently, we derive a significant portion of our product revenue from TDM media processing boards. These products connect to and interact with an enterprise or service provider-based circuit switched network and support some or all of a suite of media processing features, including echo cancellation, DTMF detection, voice play and record, conferencing, fax, modem, speech integration, and monitoring. This business has been declining as networks increasingly deploy IP-based technology. This technology migration resulted in a decrease in sales of our TDM products over the last several years. If we are unable to develop substantial revenue from our newer IP-based product lines, our business and results of operations will suffer. Although we have developed a migration path to IP-based products, the TDM products remain a sizable portion of our revenue. If our migration path to IP products is unsuccessful, we may not be able to mitigate the revenue loss due to the decrease in sales of our TDM products.
Our IP and IP-enabled products are used by service providers and enterprises to deliver communications over IP networks. Our success depends on the continued migration of customers to a single IP network architecture, which depends on a number of factors outside of our control. For example, service providers may not see the value in our new mobile backhaul bandwidth optimization products or session bandwidth controller and may decide to delay or forgo making purchases altogether. Further, existing networks include switches and other equipment that may have remaining useful lives of 20 or more years, and therefore may continue to operate reliably for a lengthy period of time. Other factors that may delay or speed the migration to IP networks include service providers’ concerns regarding initial capital outlay requirements, available capacity on legacy networks, competitive and regulatory issues, and the implementation of an enhanced services business and video model. As a result, customers may defer investing in products such as ours that are designed to migrate communications to IP networks. If the migration to IP networks does not occur for these or other reasons, or if it occurs more slowly than we expect, our operating results will be harmed.
If we fail to maintain compliance with the continued listing requirements of The NASDAQ Global Market, our common stock may be delisted and the price of our common stock and our ability to access the capital markets could be negatively impacted.
Our common stock is currently listed on The NASDAQ Global Market. To maintain the listing of our common stock on The NASDAQ Global Market we are required to meet the continued listing requirements of The NASDAQ Global Market, or the NASDAQ Listing Standards, including, but not limited to, a minimum closing bid price of $1.00 per share, or the Bid Price Rule, and a market value of publicly held shares of at least $15.0 million, or the Market Value Rule.
On March 5, 2012, we announced that we had received a letter, dated February 28, 2012, from the NASDAQ Listing Qualifications Staff, or the Staff, notifying us that, for the last 30 consecutive business days, the bid price for our common stock had closed below the minimum $1.00 per share requirement for continued listing on The NASDAQ Global Market pursuant to the Bid Price Rule. In accordance with NASDAQ Listing Standards, we have been given 180 calendar days, or until August 27, 2012, to regain compliance. To regain compliance, the bid price for our common stock must close at $1.00 or more for a minimum of 10 consecutive business days. If we do not regain compliance with the Bid Price Rule by August 27, 2012, but apply for listing on The NASDAQ Capital Market by such date, provided we meet the initial inclusion and continued listing requirements of that market other than the $1.00 per share bid price requirement, and provide the Staff with written notice of our intention to cure the deficiency, we will be granted an additional 180 calendar day compliance period.
On March 5, 2012, we also announced that we had received a letter, dated February 28, 2012, from the Staff notifying us that, for the last 30 consecutive business days, the market value of our publicly held shares had been below the minimum $15.0 million requirement for continued listing on The NASDAQ Global Market pursuant to the Market Value Rule. In accordance with the NASDAQ Listing Standards, we were given 180 calendar days, or until August 27, 2012, to regain compliance with the Market Value Rule. To regain compliance, the market value of our publicly held shares must close at $15.0 million or more for a minimum of 10 consecutive business days.
If we do not regain compliance with the Bid Price Rule by August 27, 2012, and are not eligible for an additional compliance period at that time, and if we do not regain compliance with the Market Value Rule by August 27, 2012, the Staff will provide us a written notification that our common stock is subject to delisting. At that time, we may either apply for listing on The NASDAQ Capital Market, provided we meet the initial inclusion and continued listing requirements of that market, or appeal the Staff’s delisting determination to a Hearings Panel, or the Panel. We would remain listed pending the Panel’s decision. There can be no assurance that, if we do appeal the delisting determination by the Staff to the Panel, that such appeal would be successful.
If we continue to fail to comply with the NASDAQ Listing Standards, we may consider transferring to The NASDAQ Capital Market, provided we meet the initial inclusion and continued listing requirements of that market, which is a lower tier market, or our
common stock may be delisted and traded on the over-the-counter bulletin board network. Moving our listing to The NASDAQ Capital Market could adversely affect the liquidity of our common stock. If our common stock were to be delisted by NASDAQ, we could face significant material adverse consequences, including:
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a limited availability of market quotations for our common stock;
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a reduced amount of news and analyst coverage for us;
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a decreased ability to issue additional securities or obtain additional financing in the future;
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reduced liquidity for our stockholders;
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potential loss of confidence by partners and employees; and
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loss of institutional investor interest and fewer business development opportunities.
We cannot take certain fundamental actions without the consent of the Holder of the Series D-1 Preferred Share.
For as long as the Series D-1 Preferred Share is outstanding, the Holder will be have a number of rights, including the right to approve certain changes to the size and composition of the Board and its committees. It is possible that the interests of the Holder and the holders of our common stock may be inconsistent, resulting in the inability to obtain the consent of the Holder to matters that may be in the best interests of the common stockholders.
The price of our common stock has been highly volatile due to factors that will continue to affect the price of our stock.
Our common stock traded as high as $5.25 and as low as $0.93 per share during 2011. Some of the factors leading to this volatility include:
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fluctuations in our quarterly revenue and operating results;
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announcements of product releases by us or our competitors;
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announcements of acquisitions and/or partnerships by us or our competitors;
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increases in outstanding shares of our common stock upon exercise or conversion of derivative securities such as stock options and restricted stock units and the subsequent sale of such stock relating to the payment of taxes;
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delays in producing finished goods inventory for shipment;
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market conditions in the telecommunications industry;
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issuance of new or changed securities analysts’ reports or recommendations;
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deviations in our operating results from the estimates of analysts;
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additions or departures of key personnel;
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the small public float of our outstanding common stock in the marketplace; and
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concerns about our degree of leverage, our liquidity and whether we will be able to comply with the covenants under our Term Loan Agreement and Revolving Credit Agreement and to pay debt service when due, each as discussed in greater detail under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” below.
The price of our common stock may continue to be volatile in the future.
The demand for our solutions depends in large part on continued capital spending in the telecommunications equipment industry. A decline in demand, or a decrease or delay in capital spending by service providers, could have a material adverse effect on our results of operations.
We are exposed to the risks associated with the volatility of the U.S. and global economies, including specifically the continued volatility in certain global markets, such as Portugal, Italy, Greece, Russia and Spain where we have historically successfully sold our products. The difficulty in obtaining credit in these markets and decreased visibility regarding whether or when there will be sustained growth periods for sales of our products in these and other markets and uncertainty regarding the amount of sales, since our customers may rely on lending arrangements and/or have limited resources to finance capital technology expenditures, may have an adverse effect on our business and operations. In addition, it is expected that this recent economic turmoil and the resulting economic uncertainty will result in decreased consumer spending, which will likely reduce the need for our products from customers. Slow or negative growth in the global economy may continue to materially and adversely affect our business, financial condition, and results of operations for the foreseeable future. Our results of operations would be further adversely affected if we were to experience lower-
than-anticipated order levels, cancellations of orders in backlog, extended customer delivery requirements, or pricing pressure as a result of the slowdown.
In addition to the potential decline in capital spending resulting from the volatility markets, capital spending in the telecommunications equipment industry has in the past, and may in the future, fluctuate significantly based on numerous factors, including:
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capital spending levels of service providers;
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competition among service providers;
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pricing pressures in the telecommunications equipment market;
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end user demand for new services;
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service providers’ emphasis on generating revenues from traditional infrastructure instead of migrating to emerging networks and technologies;
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lack of or evolving industry standards;
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consolidation in the telecommunications industry; and
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changes in the regulation of communications services.
We cannot make assurances of the rate or extent to which the telecommunications equipment industry will grow, if at all. Demand for our solutions and our IP products in particular will depend on the magnitude and timing of capital spending by service providers as they extend and migrate their networks. Furthermore, industry growth rates may not be as forecast, resulting in spending on product development well ahead of market requirements. The telecommunications equipment industry from time to time has experienced, and appears to be currently experiencing, a downturn. In response to the current downturn, service providers have slowed their capital expenditures, and may also cancel or delay new developments, reduce their workforces and inventories and take a cautious approach to acquiring new equipment and technologies, which could have a negative impact on our business. A continued downturn in the telecommunications industry may cause our operating results to fluctuate from period to period, which also may increase the volatility of the price of our common stock and harm our business.
Although we have undertaken a concerted effort to reduce costs, including restructuring efforts, to streamline our operations and to reduce our overall cash burn rate, we have not had sustained profits and our losses could continue.
For the year ended December 31, 2011, we used cash of $10.5 million to fund our operating activities. We have made significant efforts to reduce costs and reduce headcount and streamline operations for the last several years and continued to focus on reducing costs during 2011. In doing so we reduced head count by 60 and 59 individuals during the years ended December 31, 2011 and 2010, respectively, and reduced our number of subcontractors from five down to two. We successfully reduced quarterly operating costs from $38.6 million to $33.2 million (excluding restructuring charges) per quarter between the first quarter of 2011 and the fourth quarter of 2011. However, we may not be able to continue to reduce spending as planned and unanticipated costs may occur. Any restructuring efforts to focus on key products may not prove successful due to a variety of factors, including risks that a smaller workforce may have difficulty successfully completing research and development efforts and adequately monitoring our development and commercialization efforts. In addition, we may, in the future, decide to restructure operations and further reduce expenses by taking such measures as additional reductions in our workforce and reductions in other spending. Any restructuring places a substantial strain on remaining management and employees and on operational resources, and there is a risk that our business will be adversely affected by the diversion of management time to the restructuring efforts. There can be no assurance that following this restructuring we will have sufficient cash resources to allow us to fund our operations or repay our outstanding indebtedness as planned.
We have no internal hardware manufacturing capabilities and depend exclusively upon contract manufacturers to manufacture our hardware products. Our failure to successfully manage our relationships with our contract manufacturers would impair our ability to deliver our products in a manner consistent with required volumes or delivery schedules, which would likely cause us to fail to meet the demands of our customers and damage our customer relationships. We have reduced our number of contract manufacturers from five down to two in 2011.
We outsource the manufacturing of all of our hardware products to two subcontractors, namely Plexus Corporation and Flextronics (Israel) Limited. These contract manufacturers provide comprehensive manufacturing services, including the assembly of our products and the procurement of materials and components. Each of our contract manufacturers also builds products for other companies and may not always have sufficient quantities of inventory available or may not allocate their internal resources to fill our orders on a timely basis. Moreover, although the reduction in number of our contract manufacturers has consolidated product builds and reduced costs, it increases the risk of a greater number of orders being unfulfilled should problems occur at either subcontractor.
We have supply contracts in place with each of these subcontractors and have done our best to negotiate terms which protect our business. However, all of these contracts can be terminated by subcontractors following a reasonable notice period pursuant to the terms of each individual contract.
We do not have internal manufacturing capabilities to meet our customers’ demands and cannot assure you that we will be able to develop or contract for additional manufacturing capacity on acceptable terms on a timely basis or at all if it is needed. An inability to manufacture our products at a cost comparable to our historical costs could impact our gross margins or force us to raise prices, affecting customer relationships and our competitive position.
Qualifying a new contract manufacturer and commencing commercial scale production is expensive and time consuming and could result in a significant interruption in the supply of our products. If our contract manufacturers are not able to maintain our high standards of quality, increase capacity as needed, or are forced to shut down a factory, our ability to deliver quality products to our customers on a timely basis may decline, which would damage our relationships with customers, decrease our revenues and negatively impact our growth.
Our disclosure controls and internal control over financial reporting do not guarantee the absence of error or fraud.
Disclosure controls are procedures designed to ensure that information required to be disclosed in reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls are also designed to ensure that the information is accumulated and communicated to our management, including the chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Internal controls over financial reporting, or Internal Controls, are procedures which are designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. GAAP and includes those policies and procedures that: (1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on its financial statements.
Management, with the participation of our principal executive officer and principal financial officer, has conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework set forth in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission as of December 31, 2011. Based on this evaluation, management concluded that the material weakness identified in connection with its evaluation of our internal controls as of December 31, 2010 had not yet been remediated. The material weakness identified as of December 31, 2010 related to a lack of sufficient accounting and finance personnel with technical accounting expertise to apply accounting requirements to non-routine and complex transactions and to perform in-depth analysis and review of accounting matters within the timeframes set by management for finalizing financial statements. While management did hire several new accounting and finance personnel during 2011 and did establish certain new processes and controls as more fully described below, as a result of the timing of when these controls were put in place in the fourth quarter of 2011, management determined that these controls were not in place for a sufficient period of time to conclude that they were operating effectively. Accordingly, management has concluded that we did not maintain effective internal control over financial reporting as of December 31, 2011 based on criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework.
Management has taken measures to remediate the material weakness previously identified. These measures are broadly grouped into the following categories: (a) improving finance staff, (b) implementing appropriate internal control processes and procedures, and (c) training.
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Improving finance staff: During 2011, the finance department was enhanced by the hiring of a new Chief Financial Officer (October 2011) with significant industry and U.S. public company experience; a new Director of Financial Reporting with specific responsibility for improving internal controls and overseeing SEC reporting; and a new Corporate Tax Director with significant experience in federal, state and international tax. In addition, we promoted a divisional controller with significant industry and revenue recognition experience to Corporate Controller. We continue to evaluate our personnel needs and hire talented and qualified employees as appropriate and as needed.
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Implementing appropriate internal control processes and procedures: We have steadily made improvements in our internal control processes during 2011, with more significant actions taken in the fourth quarter of 2011. Such process improvements have included, but are not limited to, the establishment of a centralized electronic database of key contracts, accounting records and related documentation, increased uniformity and consistency with respect to customer contracts, accounting records and
related documentation, and increased level of management review of key processes, particularly the revenue cycle and sales process. In addition, we have implemented more detailed management reviews of period-end account reconciliations and analyses in the areas of accruals, inventory, revenue and related reserves, accounts receivable and stock-based compensation. During the fourth quarter, we also established a more timely and efficient financial close schedule and integrated two instances of our Oracle ERP system into one, which we expect will enhance our reporting capabilities in 2012.
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Training: In 2011, we held a controllers’ conference that provided opportunities for professional development and technical accounting education in areas such as revenue recognition, impairments, restructuring and debt. Our finance team members participate in other relevant and available courses to enhance their technical skills. We have also instituted regular weekly finance team calls to discuss accounting and finance matters and to align our goals and objectives. Further, we provide cross-training amongst members of our finance team to ensure critical processes and controls can be performed by more than one individual.
Further, management has engaged an outside consultant to further review the design effectiveness of our internal controls and perform sufficient testing to determine the operating effectiveness of internal control over financial reporting for the year ended December 31, 2012.
Our management, including our chief executive officer and chief financial officer, do not expect that our disclosure controls or Internal Controls will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and we cannot make assurances that any design will succeed in achieving our stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
We face intense competition from the leading telecommunications networking companies in the world as well as from emerging companies. If we are unable to compete effectively, we might not be able to achieve sufficient market penetration, revenue growth, or profitability.
Competition in the market for our products is intense. This market has historically been dominated by established telephony equipment providers such as Alcatel-Lucent. We also face competition from other telecommunications and networking companies, including Acme Packet, Inc., Audiocodes Ltd., Cisco Systems, Inc. Genband Inc., Radisys Corporation, Metaswitch Networks and Sonus Networks, Inc., among others. While some of the established competitors are exiting the market, we are seeing increasingly intense competition from Huawei Technologies Co. Ltd., which leverages its broad product portfolio and significant financial resources to compete with us for our switching business.
Many of our current and potential competitors have significantly greater selling and marketing, technical, manufacturing, financial, governmental, and other resources available to them, allowing them to offer a more diversified bundle of products and services. In some cases, our competitors have undercut the pricing of our products or provided more favorable financing terms, which has made us uncompetitive or forced us to reduce our average selling prices, negatively impacting our margins. Further, some of our competitors sell significant amounts of other products to our current and prospective customers. In addition, some potential customers when selecting equipment vendors to provide fundamental infrastructure products prefer to purchase from larger, established vendors. Our competitors’ broad product portfolios, coupled with already existing relationships, may cause our customers or potential customers to buy our competitors’ products or harm our ability to attract new customers.
To compete effectively, we must deliver innovative products that:
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offer edge-based connection and security infrastructure products for IP networks;
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enable fixed and mobile value-added services, including video-based services;
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provide extremely high reliability, compression rates, and voice quality;
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scale and deploy easily and efficiently;
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interoperate with existing network designs and other vendors’ equipment;
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support existing and emerging industry, national, and international standards;
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provide effective network management;
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are accompanied by comprehensive customer support and professional services; and
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provide a cost-effective and space efficient solution for service providers.
Some of our competitors and potential competitors may have a number of significant advantages over us, including:
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a longer operating history;
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greater name recognition and marketing power;
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preferred vendor status with our existing and potential customers;
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significantly greater financial, technical, marketing and other resources, which allow them to respond more quickly to new or changing opportunities, technologies and customer requirements; and
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lower cost structures.
If we are unable to compete successfully against our current and future competitors, we could experience reduced gross profit margins, price reductions, order cancellations, and loss of customers and revenues, each of which would adversely impact our business. Furthermore, existing or potential competitors may establish cooperative relationships with each other or with third parties or adopt aggressive pricing policies to gain market share.
As a result of increased competition, we could encounter significant pricing pressures and/or suffer losses in market share. These pricing pressures could result in significantly lower average selling prices for its products. We may not be able to offset the effects of any price reductions with an increase in the number of customers, cost reductions or otherwise.
Our quarterly operating results have fluctuated significantly in the past and may continue to fluctuate in the future, which could lead to volatility in the price of our common stock.
Our quarterly revenues and operating results have fluctuated significantly in the past and they may continue to fluctuate in the future due to a number of factors, many of which are outside of our control and any of which may cause our stock price to fluctuate. From our experience, customer purchases of telecommunications equipment have been unpredictable and these purchases are made as customers build out their networks, rather than regular, recurring purchases. The primary factors that may affect our quarterly revenues and results include the following:
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fluctuation in demand for our products and the timing and size of customer orders;
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the length and variability of the sales cycle for our products;
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new product introductions and enhancements by our competitors and us;
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our ability to develop, introduce, and ship new products and product enhancements that meet customer requirements in a timely manner;
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the mix of products sold such as between NGN sales and sales of bandwidth optimization products or between service provider and enterprise markets;
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our ability to obtain sufficient supplies of sole or limited source components;
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our ability to attain and maintain production volumes and quality levels for our products;
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costs related to acquisitions of complementary products, technologies, or businesses;
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changes in our pricing policies, the pricing policies of our competitors, and the prices of the components of our products;
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the timing of revenue recognition, amount of deferred revenues, and receivables collections;
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difficulties or delays in deployment of customer IP networks that would delay anticipated customer purchases of additional products and services;
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general economic conditions, as well as those specific to the telecommunications, networking, and related industries;
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consolidation within the telecommunications industry, including acquisitions of or by our customers; and
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the failure of certain of our customers to successfully and timely reorganize their operations, including emerging from bankruptcy.
In addition, we may be unable to recognize all of the revenue associated with certain customer contracts in the same period as the costs associated with those contracts are expensed, which could cause our quarterly gross margins, particularly of IP gross margins, to fluctuate significantly. Further, U.S. GAAP may require that revenue related to certain customer contracts be delayed for periods of a year or more. This delay may cause spikes in our revenue in quarters when it is recognized and may result in deferred revenue to revenue conversion taking longer than anticipated.
A significant portion of our operating expenses are fixed in the short term. If revenues for a particular quarter are below expectations, we may not be able to reduce operating expenses proportionally for that quarter. Therefore, any such revenue shortfall would likely have a direct negative effect on our operating results for that quarter. For these and other reasons, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance.
We believe it possible that in some future quarters, our operating results may be below the expectations of public market analysts and investors, which may adversely affect our stock price. A decline in the market price of our common stock could cause our stockholders to lose some or all of their investment and may adversely impact our ability to attract and retain employees and raise capital. In addition, such a decline in our stock price may cause stockholders to initiate securities class action lawsuits. Whether or not meritorious, litigation brought against us could result in substantial costs and diversion of time and attention of our management. Our insurance to cover claims of this sort, if brought, may not be adequate.
The ownership of our common stock is highly concentrated, and your interests may conflict with the interests of our existing stockholders.
Our executive officers, directors (or former directors), and certain of our affiliates beneficially owned or controlled approximately 50% of our outstanding common stock as of December 31, 2011. If the stockholders approve the Private Placement and the Notes convert into shares of our common stock, such individuals and entities will beneficially own approximately 81% of our outstanding common stock (assuming conversion of the Notes at the current conversion price and exercise of outstanding warrants to purchase our common stock). Accordingly, these stockholders, acting as a group, could have significant influence over the outcome of corporate actions requiring stockholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transaction. The significant concentration of stock ownership may adversely affect the trading price of our common stock due to investors’ perception that conflicts of interest may exist or arise.
The largest customers in the telecommunications industry have substantial negotiating leverage, which may require that we agree to terms and conditions that are less advantageous to us than the terms and conditions of our existing customer relationships, or risk limiting our ability to sell our products to these large service providers, thereby harming our operating results.
Large telecommunications service providers have substantial purchasing power and leverage negotiating contractual terms and conditions relating to their purchase of our products. As we seek to sell more products to these large telecommunications providers, we may be required to agree to less favorable terms and conditions to complete such sales, which may result in lower margins, affect the timing of the recognition of the revenue derived from these sales, and the amount of deferred revenues, each of which may have an adverse effect on our business and financial condition.
In addition, our future success depends in part on our ability to sell our products to large service providers operating complex networks that serve large numbers of subscribers and transport high volumes of traffic. The communications industry historically has been dominated by a relatively small number of service providers. While deregulation and other market forces have led to an increasing number of service providers in recent years, large service providers continue to constitute a significant portion of the market for communications equipment. If we fail to sell additional IP products to our large customers or to expand our customer base to include additional customers that deploy our products in large-scale networks serving significant numbers of subscribers, our revenue growth will be limited.
Consolidation or downturns in the telecommunications industry may affect demand for our products and the pricing of our products, which could limit our growth and may harm our business.
The telecommunications industry, which includes all of our customers, has experienced increased consolidation in recent years, and we expect this trend to continue. Consolidation among our customers and prospective customers may cause delays or reductions in capital expenditure plans and/or increased competitive pricing pressures as the number of available customers declines and their relative purchasing power increases in relation to suppliers. The occurrence of any of these factors, separately or in combination, may lead to decreased sales or slower than expected growth in revenues and could harm our business and operations.
The communications industry is cyclical and reactive to general economic conditions. In the recent past, worldwide economic downturns, pricing pressures, and deregulation have led to consolidations and reorganizations. These downturns, pricing pressures and restructurings have been causing delays and reductions in capital and operating expenditures by many service providers. These delays
and reductions, in turn, have been reducing demand for communications products like ours. A continuation or subsequent recurrence of these industry patterns, as well as general domestic and foreign economic conditions and other factors that reduce spending by companies in the communications industry, could harm our operating results in the future.
If we fail to anticipate and meet specific customer requirements, or if our products fail to interoperate with our customers’ existing networks or with existing and emerging industry, national, and international standards, we may not be able to retain our current customers or attract new customers.
We must effectively anticipate and adapt our business, products and services in a timely manner to meet customer requirements. We must also meet existing and emerging industry, national and international standards to meet changing customer demands. Prospective customers may require product features and capabilities that are not included in our current product offerings. The introduction of new or enhanced products also requires that we carefully manage the transition from our older products to minimize disruption in customer ordering patterns and ensure that adequate supplies of our new products can be delivered to meet anticipated customer demand. If we fail to develop products and offer services that satisfy customer requirements, or if we fail to effectively manage the transition from our older products to our new or enhanced products, our ability to create or increase demand for our products would be seriously harmed and we may lose current and prospective customers, thereby harming our business.
Many of our customers will require that our products be designed to interface with their existing networks or with existing or emerging industry, national, and international standards, each of which may have different and unique specifications. Issues caused by a failure to achieve homologation to certain standards or an unanticipated lack of interoperability between our products and these existing networks may result in significant warranty, support, and repair costs, divert the attention of our engineering personnel from our hardware and software development efforts, and cause significant customer relations problems. If our products do not interoperate with our customers’ respective networks or applicable standards, installations could be delayed or orders for our products could be cancelled, which would seriously harm our gross margins and result in the loss of revenues and/or customers.
If we do not respond rapidly to technological changes or to changes in industry standards, our products could become obsolete.
The market for IP infrastructure products and services is characterized by rapid technological change, frequent new product introductions and evolving standards. We may be unable to respond quickly or effectively to these developments. We may experience difficulties with software development, hardware design, manufacturing, marketing, or certification that could delay or prevent our development, introduction, or marketing of new products and enhancements. The introduction of new products by our competitors, the market acceptance of products based on new or alternative technologies or the emergence of new industry standards could render our existing or future products obsolete. If the standards adopted are different from those that we have chosen to support, market acceptance of our products may be significantly reduced or delayed. If our products become technologically obsolete, we may be unable to sell our products in the marketplace and generate revenues, and our business could be adversely affected. Because our products are sophisticated and designed to be deployed in complex environments and in multiple locations, they may have errors or defects that we find only after full deployment. If these errors lead to customer dissatisfaction or we are unable to establish and maintain a support infrastructure and required support levels to service these complex environments, our business may be seriously harmed.
Because of the nature of some of our products, they can only be fully tested when substantially deployed in very large networks with high volumes of traffic. Some of our customers have only recently begun to commercially deploy our products or deploy our products in larger configurations and they may discover errors or defects in the software or hardware, the products may not operate as expected, or our products may not be able to function in the larger configurations required by certain customers. If we are unable to correct errors or other performance problems that may be identified after full deployment of our products, we could experience:
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cancellation of orders or other losses of or delays in revenues;
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loss of customers and market share;
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harm to our reputation;
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a failure to attract new customers or achieve market acceptance for our products;
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increased service, support, and warranty costs and a diversion of development resources;
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increased insurance costs and losses to our business and service provider customers; and
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costly and time-consuming legal actions by our customers
If we experience warranty failures that indicate either manufacturing or design deficiencies, we may suffer damages.
If we experience warranty failures we may be required to recall units in the field and/or stop producing and shipping such products until the deficiency is identified and corrected. In the event of such warranty failures, our business could be adversely affected
resulting in reduced revenue, increased costs and decreased customer satisfaction. Because customers often delay deployment of a full system until they have tested the products and any defects have been corrected, we expect these revisions may cause delays in orders by our customers for our systems. Because our strategy is to introduce more complex products in the future, this risk will intensify over time. Service provider customers have discovered errors in our products. If the costs of remediating problems experienced by our customers exceed our expected expenses, which historically have not been significant, these costs may adversely affect our operating results.
In addition, because our products are deployed in large and complex networks around the world, our customers expect us to establish a support infrastructure and maintain demanding support standards to ensure that their networks maintain high levels of availability and performance. To support the continued growth of our business, our support organization will need to provide service and support at a high level throughout the world. This will include hiring and training customer support engineers both at our primary corporate locations as well as our smaller offices in new geographies, such as Central and South America and Russia. If we are unable to provide the expected level of support and service to our customers, we could experience:
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loss of customers and market share;
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a failure to attract new customers in new geographies;
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increased service, support, and warranty costs and a diversion of development resources; and
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network performance penalties
The long and variable sales and deployment cycles for our products may cause our operating results to vary materially, which could result in a significant unexpected revenue shortfall in any given quarter.
Our products, particularly IP switching products, have lengthy sales cycles, which typically extend from three to 12 months and may take up to two years. A customer’s decision to purchase our products often involves a significant commitment of the customer’s resources and a product evaluation and qualification process that can vary significantly in length. The length of our sales cycles also varies depending on the type of customer to which we are selling, the product being sold and the type of network in which our product will be utilized. We may incur substantial sales and marketing expenses and expend significant management effort during this time, regardless of whether we make a sale.
Even after making the decision to purchase our products, our customers may deploy our products slowly. Timing of deployment can vary widely among customers and among product types. The length of a customer’s deployment period will impact our ability to recognize revenue related to such customer’s purchase and may also directly affect the timing of any subsequent purchase of additional products by that customer. As a result of these lengthy and uncertain sales and deployment cycles for our products, it is difficult for us to predict the quarter in which our customers may purchase additional products or features from us, and our operating results may vary significantly from quarter to quarter, which may negatively affect our operating results for any given quarter.
We rely on channel partners for a significant portion of our revenue. Our failure to effectively develop and manage these third-party distributors, systems integrators, and resellers specifically and our indirect sales channel generally, or disruptions to the processes and procedures that support, our indirect sales channels, could adversely affect our ability to generate revenues from the sale of our products.
We rely on third-party distributors, systems integrators, and resellers for a significant portion of our revenue. Our revenues depend in large part on the performance of these indirect channel partners. Although many aspects of our partner relationships are contractual in nature, our arrangements with our indirect channel partners are not exclusive. Accordingly, important aspects of these relationships depend on the continued cooperation between the parties.
Many factors out of our control could interfere with our ability to market, license, implement or support our products with any of our partners, which in turn could harm our business. These factors include, but are not limited to, a change in the business strategy of one of our partners, the introduction of competitive product offerings by other companies that are sold through one of our partners, potential contract defaults by one of our partners, or changes in ownership or management of one of our distribution partners. Some of our competitors may have stronger relationships with our distribution partners than we do, and we have limited control, if any, as to whether those partners implement our products rather than our competitors’ products or whether they devote resources to market and support our competitors’ products rather than our offerings. In addition, we recognize a portion of our revenue based on a sell-through model using information provided by our partners and recognize a significant portion on a sell-in basis, particularly when selling in to established VARs, independent software vendors, technology equipment manufacturers and other partners with whom we have a significant history. If those partners provide us with inaccurate or untimely information, the amount or timing of our revenues could be adversely impacted and our operating results may be harmed.
Moreover, if we are unable to leverage our sales and support resources through our distribution partner relationships, we may need to hire and train additional qualified sales and engineering personnel. We cannot assure you, however, that we will be able to hire additional qualified sales and engineering personnel in these circumstances, and our failure to do so may restrict our ability to generate revenue or implement our products on a timely basis. Even if we are successful in hiring additional qualified sales and engineering personnel, we will incur additional costs and our operating results, including our gross margin, may be adversely affected. The loss of or reduction in sales by these resellers could reduce our revenues. If we fail to maintain relationships with these third-party resellers, fail to develop new relationships with third-party resellers in new markets, fail to manage, train, or provide incentives to existing third-party resellers effectively or if these third party resellers are not successful in their sales efforts, sales of our products may decrease and our operating results would suffer.
Maintaining and improving our financial controls and the requirements of being a public company may strain our resources, divert management’s attention and affect our ability to attract and retain qualified board members.
As a public company, we are subject to the reporting requirements of the Exchange Act, the Sarbanes-Oxley Act and NASDAQ Listing Standards. The requirements of these rules and regulations will increase our legal and financial compliance costs, make some activities more difficult, time-consuming or costly and may also place undue strain on our personnel, systems and resources. The Exchange Act requires, among other things, that we file annual, quarterly and current reports with respect to our business and financial condition. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and internal control over financial reporting. As a public company, our systems of internal controls over financial reporting will be required to be periodically assessed and reported on by management and may be subject to annual audits by our independent auditors. During the course of our evaluation, we may identify areas requiring improvement, and may be required to design enhanced processes and controls to address issues identified through this review. This could result in significant delays and cost to us and require us to divert substantial resources, including management time, from other activities. As of December 31, 2011, we have identified a material weakness in our Internal Controls. Moreover, effective internal controls are necessary for us to produce reliable financial reports and are important to help prevent fraud. As a result, our failure to satisfy the requirements of Section 404 on a timely basis could result in the loss of investor confidence in the reliability of our financial statements, which in turn could harm the market value of our common stock. Any failure to maintain effective internal controls also could impair our ability to manage our business and harm our financial results.
Under the Sarbanes-Oxley Act and NASDAQ Listing Standards, we are required to maintain an independent board. We also expect these rules and regulations will make it more difficult and more expensive for us to maintain directors’ and officers’ liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to maintain coverage. If we are unable to maintain adequate directors’ and officers’ insurance, our ability to recruit and retain qualified directors, especially those directors who may be deemed independent for purposes of NASDAQ Listing Standards, and officers will be significantly curtailed.
Our international operations expose us to additional political and economic risks not faced by businesses that operate only in the United States.
We are a multinational company based in the United States with branch offices and representative offices located in many countries around the world. Our logistics group is located in Israel, the United States and Ireland and we utilize various subcontractors in the United States and Israel. We have development locations in Canada, the United States, Ireland, Israel and Germany and we have sales offices in many other countries, including China, India, Brazil, Russia, Israel, Singapore, Malaysia, Australia, Hong Kong, Japan, the United Kingdom, France, Spain, the Netherlands, Belgium and Slovenia. Approximately half of our sales are generated in markets outside of the Americas and we see our largest market growth occurring in foreign countries such as India, Brazil, Russia and China. As a result of all these international activities we are subject to worldwide economic and market condition risks generally associated with global trade, such as fluctuating exchange rates, tariff and trade policies, domestic and foreign tax policies, foreign governmental regulations, political unrest, wars and other acts of terrorism and changes in other economic conditions. In addition our insurance on receivables applies to a lesser base of accounts due to the difficulties in obtaining coverage for accounts in some of these regions.
We may face risks associated with our international sales that could impair our ability to grow our revenues.
For the fiscal years ended December 31, 2011 and 2010, revenues from outside of the Americas were approximately $105.9 million and $90.7 million, respectively, or 54% and 51% of our total revenues, respectively. We intend to continue selling into our existing international markets and expand into additional international markets where we currently do not do business. If we are unable to continue to sell products effectively in these existing international markets and expand into additional new international markets, our ability to grow our business will be adversely affected. Some factors that may impact our ability to maintain our international operations and sales and/or cause our results from operations in these international markets to differ from expectations include:
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difficulty enforcing contracts and collecting accounts receivable in foreign jurisdictions, leading to longer collection periods;
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certification and qualification requirements relating to our products, including, by way of example, export licenses that must be obtained from the U.S. Department of Commerce;
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the impact of recessions in economies outside the United States;
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unexpected changes in foreign regulatory requirements, including import and export regulations, and currency exchange rates;
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certification and qualification requirements for doing business in foreign jurisdictions including both specific requirements imposed by the foreign jurisdictions and protectionist trade legislation in either the United States or other countries, such as a change in the current tariff structures, export compliance laws, trade restrictions resulting from war or terrorism, or other trade policies could adversely affect our ability to sell or to manufacture in international markets as well as U.S. federal and state agency restrictions imposed by the Buy American Act or the Trade Agreement Act that may apply to our products manufactured outside the United States;
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inadequate protection for intellectual property rights in certain countries;
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less stringent adherence to ethical and legal standards by prospective customers in certain foreign countries, including compliance with the Foreign Corrupt Practices Act of 1977, as amended;
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potentially adverse tax or duty consequences;
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unfavorable foreign exchange movements, particularly the continued devaluation of the U.S. dollar, which could result in decreased revenues; and
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political and economic instability.
Additionally, as many of our customers are conducting business in emerging markets that can be unpredictable at times due to rapidly changing political and economic conditions, the judgment of management is a significant factor in determining whether an increase in the allowance for uncollectible accounts is warranted. Management considers various factors in making such judgments, including the customer-specific circumstances as well as the general political environment, economic conditions and other relevant matters in determining the collectability of the receivables. We will record a reversal of the allowance if there is significant improvement in collection rates. Historically, the allowance has been adequate to cover the actual losses from uncollectible accounts. Such reversals may negatively impact our results of operations.
If we lose the services of one or more members of our current executive management team or other key employees, or if we are unable to attract additional executives or key employees, we may not be able to execute on our business strategy.
Our future success depends in large part upon the continued service of our executive management team and other key employees. In particular, Nick Jensen, the chairman of the Board and chief executive officer, Kevin Cook, our president and chief operating officer, Anthony Housefather, our executive vice president corporate affairs and general counsel and chief compliance officer, and John Hanson, our executive vice president and chief financial officer are critical to the overall management of our business as well as to the development of our culture and our strategic direction. To be successful, we must also hire, retain and motivate key employees, including those in managerial and technical, finance, marketing, and sales positions. In particular, our product generation efforts depend on hiring and retaining qualified engineers. Experienced management and technical, sales, finance, marketing and support personnel in the telecommunications and networking industries are in high demand and competition for their talents is intense.
The loss of services of any of our executives, one or more other members of our executive management or sales team or other key employees, could seriously harm our business.
We and our contract manufacturers rely on single or limited sources for the supply of some components of our products and if we fail to adequately predict our manufacturing requirements or if our supply of any of these components is disrupted, we will be unable to ship our products on a timely basis, which would likely cause us to fail to meet the demands of our customers and damage our customer relationships.
We and our contract manufacturers currently purchase several key components of our products, including commercial digital signal processors, from single or limited sources. We purchase these components on a purchase order basis. If we overestimate our component requirements, we could have excess inventory, which would increase our costs and result in write-downs harming our operating results. If we underestimate our requirements, we may not have an adequate supply, which could interrupt manufacturing of our products and result in delays in shipments and revenues.
We currently do not have long-term supply contracts with all of our component suppliers and many of them are not required to supply us with products for any specified periods, in any specified quantities, or at any set price, except as may be specified in a particular purchase order. Because the key components and assemblies of our products are complex, difficult to manufacture and
require long lead times, in the event of a disruption or delay in supply, or inability to obtain products, we may not be able to develop an alternate source in a timely manner, at favorable prices, or at all. In addition, during periods of capacity constraint, we are disadvantaged compared to better capitalized companies, as suppliers may in the future choose not to do business with us or may require higher prices or less advantageous terms. A failure to find acceptable alternative sources could hurt our ability to deliver high-quality products to our customers and negatively affect our operating margins. In addition, reliance on our suppliers exposes us to potential supplier production difficulties or quality variations. Our customers rely upon our ability to meet committed delivery dates, and any disruption in the supply of key components would seriously adversely affect our ability to meet these dates and could result in legal action by our customers, loss of customers, or harm our ability to attract new customers, any of which could decrease our revenues and negatively impact our growth.
Failure to manage expenses and inventory risks associated with meeting the demands of our customers may adversely affect our business or results of operations.
To ensure that we are able to meet customer demand for our products, we place orders with our contract manufacturers and suppliers based on our estimates of future sales. If actual sales differ materially from these estimates because of inaccurate forecasting or as a result of unforeseen events or otherwise, our inventory levels and expenses may be adversely affected and our business and results of operations could suffer. In addition, to remain competitive, we must continue to introduce new products and processes into our manufacturing environment. There cannot be any assurance, however, that the introduction of new products will not create obsolete inventories related to older products.
If we are not able to obtain necessary licenses of third-party technology at acceptable prices, or at all, our products could become obsolete.
We have incorporated third-party licensed technology into our current products. From time to time, we may be required to license additional technology from third parties to develop new products or product enhancements. Third party licenses may not be available or continue to be available to us on commercially reasonable terms or at all. The inability to maintain or re-license any third party licenses required in our current products, or to obtain any new third-party licenses to develop new products and product enhancements, could require us to obtain substitute technology of lower quality or performance standards or at greater cost, and delay or prevent us from making these products or enhancements, any of which could seriously harm the competitiveness of our products.
Failures by our strategic partners or by us in integrating our products with those provided by our strategic partners could seriously harm our business.
Our solutions include the integration of products supplied by strategic partners, who offer complementary products and services. We expect to further integrate our IP Products with such partner products and services in the future. We rely on these strategic partners in the timely and successful deployment of our solutions to our customers. If the products provided by these partners have defects or do not operate as expected, if we do not effectively integrate and support products supplied by these strategic partners, or if these strategic partners fail to be able to support products, we may have difficulty with the deployment of our solutions, which may result in:
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a loss of or delay in recognizing revenues;
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increased service, support, and warranty costs and a diversion of development resources; and
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network performance penalties.
In addition to cooperating with our strategic partners on specific customer projects, we also may compete in some areas with these same partners. If these strategic partners fail to perform or choose not to cooperate with us on certain projects, in addition to the effects described above, we could experience:
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a loss of customers and market share; and
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a failure to attract new customers or achieve market acceptance for our products.
If we are unable to protect our intellectual property, we may lose a valuable competitive advantage or be forced to endure costly litigation.
We are a technology dependent company, and our success depends on developing and protecting our intellectual property. We rely on a combination of patent, copyright, trademark, and trade secret laws and restrictions on disclosure to protect our intellectual property rights. At the same time, our products are complex and are often not patentable in their entirety. We also license intellectual property from third parties and rely on those parties to maintain and protect their technology. We cannot be certain that our actions will protect our proprietary rights. Due to the nature of some of our patents and our industry, we may be unable to detect whether our
patents or other IP are being infringed by third parties. Any patents owned by us may be invalidated, reexamined, circumvented or challenged. Any of our patent applications may be challenged and not issued with the scope of the claims we seek, if at all. Our current level of indebtedness and need to raise additional capital could impact our existing and future patent and IP rights in various ways, including by resulting in some of our existing patents and patent applications being abandoned or sold, causing us to file for fewer future patent applications and/or to delay filing certain future patent applications, or causing us to be unable to enforce our patent and other IP rights to an extent that would otherwise be desired.
Changes in either patent laws or in interpretations of patent laws in the United States and other countries may materially diminish the value of our intellectual property or narrow the scope of our patent protection. For example, the Leahy-Smith America Invents Act, or the Leahy-Smith Act, was signed into law in September 2011 and includes a number of changes to United States patent law, including changes related to how patent applications are prosecuted, and may also affect patent defense, litigation, and enforcement. The U.S. Patent and Trademark Office is currently developing regulations and procedures to govern administration of the Leahy-Smith Act, and many of the substantive changes to patent law associated with the Leahy-Smith Act will not become effective until up to 18 months after its enactment. Accordingly, it is not clear what, if any, impact the Leahy-Smith Act will have on the operation of our business and the protection and enforcement of our intellectual property. However, the Leahy-Smith Act and its implementation could increase the uncertainties and costs surrounding the prosecution of our patent applications and the enforcement or defense of our issued patents, all of which could have a material adverse effect on our business and financial condition.
If we are unable to adequately protect our technology, or if we are unable to continue to obtain or maintain licenses for protected technology from third parties, it could have a material adverse effect on our results of operations and significant impairment of intangible assets. In addition, some of our products are now designed, manufactured and sold outside of the United States and Canada. Despite the precautions we take to protect our intellectual property, this international exposure may reduce or limit protection of our intellectual property, which is more prone to design piracy outside of the United States and Canada. We also rely on trade secrets to protect our technology, especially where we do not believe patent protection is appropriate or obtainable. However, trade secrets are difficult to maintain and do not protect technology against independent developments made by third parties.
Possible third-party claims of infringement of proprietary rights against us could have a material adverse effect on our business, results of operation or financial condition.
The telecommunications industry generally and the market for IP telephony products in particular are characterized by a relatively high level of litigation based on allegations of infringement of proprietary rights. We have received in the past, and may receive in the future, inquiries from other patent holders and may become subject to claims that we infringe their intellectual property rights. We cannot assure you that we do not or might not infringe third party patents. Any parties claiming that our products infringe upon their proprietary rights, regardless of the merits of the claims and/or the underlying rights, could cause us to take action that results in expenditures of time and money to defend or settle the claims on our behalf and/or that of our customers or contract manufacturers. We may also be required to indemnify our customers and contract manufacturers for damages they suffer as a result of such infringement claims, if proven or settled. These claims, and any resulting settlement, licensing arrangement or lawsuit, if successful, could subject us to significant royalty payments or liability for damages and invalidation of our proprietary rights. Any potential intellectual property litigation also could force us to do one or more of the following:
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stop selling, importing, incorporating, or using our products that use the challenged intellectual property in some or all regions where we would otherwise sell, import, incorporate or use such products;
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obtain from the owner of the infringed intellectual property right a license to sell or use the relevant technology, which license may not be available on reasonable terms, in certain territories, or at all; or
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redesign those products that use any allegedly infringing technology.
Any lawsuits regarding intellectual property rights, regardless of their success, would be time consuming, expensive to resolve, and would divert our management’s time and attention.
Regulation of the telecommunications industry could harm our operating results and future prospects.
The telecommunications industry is highly regulated and our business and financial condition could be adversely affected by the changes in the regulations relating to the telecommunications industry. Currently, there are few laws or regulations that apply directly to access to, or delivery of, voice services on IP networks. We could be adversely affected by regulation of IP networks and commerce in any country, including the United States, where we operate. Such regulations could include matters such as VoIP or using IP, encryption technology, and access charges for service providers. The adoption of such regulations could decrease demand for our products, and at the same time increase the cost of selling our products, which could have a material adverse effect on our business, operating result, and financial condition.
Compliance with regulations and standards applicable to our products may be time consuming, difficult and costly, and if we fail to comply, our product sales will decrease.
To achieve and maintain market acceptance, our products must continue to meet a significant number of regulations and standards. In the United States, our products must comply with various regulations defined by the Federal Communications Commission and Underwriters Laboratories. As these regulations and standards evolve, and if new regulations or standards are implemented, we will be required to modify our products or develop and support new versions of our products, and this will increase our costs. The failure of our products to comply, or delays in compliance, with the various existing and evolving industry regulations and standards could prevent or delay introduction of our products, which could harm our business. User uncertainty regarding future policies may also affect demand for communications products, including our products. Moreover, distribution partners or customers may require us, or we may otherwise deem it necessary or advisable, to alter our products to address actual or anticipated changes in the regulatory environment. Our inability to alter our products to address these requirements and any regulatory changes could have a material adverse effect on our business, financial condition, and operating results.
Failure of our hardware products to comply with evolving industry standards and complex government regulations may prevent our hardware products from gaining wide acceptance, which may prevent us from growing our sales.
The market for network equipment products is characterized by the need to support industry standards as different standards emerge, evolve, and achieve acceptance. We will not be competitive unless we continually introduce new products and product enhancements that meet these emerging standards. Our products must comply with various domestic regulations and standards defined by agencies such as the Federal Communications Commission, in addition to standards established by governmental authorities in various foreign countries and the recommendations of the International Telecommunication Union. If we do not comply with existing or evolving industry standards or if we fail to obtain timely domestic or foreign regulatory approvals or certificates, we will not be able to sell our products where these standards or regulations apply, which may harm our business.
Production and marketing of products may subject us to environmental and other regulations. Legislation may be passed requiring our products to use environmentally friendly components, with periodic updates and modification to the requirements. For example, the European Union has adopted the Restriction of the use of certain Hazardous Substances in electrical and electronic equipment (RoHS) Directive (2002/95/EC), the RoHS recast (2011/65/EU, effective 1 Jan 2013) and periodic addition and removal of exemption to the requirements. Similar legislation has been enacted in China, Korea, and Japan and is being developed in other countries, including the United States (H.R. 2420). Our products currently meet the requirements in countries where this type of legislation is in place.
In addition, legislation may be passed that makes us responsible for the safe disposal of products at their end of life. The regulations may be a ‘take-back system’ whereby the customer can return the product to us and we must recycle/dispose of it in an environmentally safe manner or a ‘funded system’ whereby we contribute to a fund for recycling/disposing of the product by a third party. The European Union has adopted the Waste Electrical and Electronic Equipment, or WEEE Directive (2002/96/EC), which mandates funding, collection, treatment, recycling, and recovery of WEEE by producers. This legislation applies to ‘Covered Products,’ which currently include consumer electronics products. As such, our products are not subject to the current legislation. However, the catalogue of “Covered Products” may be extended and our products may become subject to such regulations. To the extent that the definition of “Covered Products” is expanded to include any products we sell, we would have to undertake considerable expense to comply. Similar legislation has been enacted by several states in the United States, China, Korea, and Japan, and is being developed in other countries.
If we fail to comply with these regulations, we may not be able to sell our products in jurisdictions where these regulations apply, which would have a material adverse effect on our results of operations.
Future interpretations of existing accounting standards could adversely affect our operating results.
U.S. GAAP is subject to interpretation by the Financial Accounting Standards Board, the SEC, and various other bodies formed to promulgate and interpret appropriate accounting principles. A change in these principles or interpretations could have a significant effect on our reported financial results, and could affect the reporting of transactions consummated before the announcement of a change.
For example, we recognize our product software license revenue in accordance with Software Revenue Recognition literature or other accounting standards. The standards may change and the standards setters may continue to issue interpretations and guidance for applying the relevant accounting standards to a wide range of sales contract terms and business arrangements that are prevalent in software licensing arrangements. Future interpretations of existing accounting standards or changes in our business practices could result in future changes in our revenue recognition accounting policies that have a material adverse effect on our results of operations. We may be required to delay revenue recognition into future periods, which could adversely affect our operating results. In the past
we have had to defer recognition of revenue, and may have to do so again in the future. Such deferral may be as a result of several factors, including whether a transaction involves:
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software arrangements that include undelivered elements for which we do not have vendor specific objective evidence of fair value;
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requirements that we deliver services for significant enhancements and modifications to customize our software for a particular customer;
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material acceptance criteria or other identified product-related issues; or
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payment terms extending beyond our customary terms.
Because of these factors and other specific requirements under U.S. GAAP for software revenue recognition, we must have very precise terms in our software arrangements to recognize revenue when we initially deliver software or perform services. Negotiation of mutually acceptable terms and conditions can extend our sales cycle, and we sometimes accept terms and conditions that do not permit revenue recognition at the time of delivery.
Our ability, as well as our contract manufacturers’ ability, to meet customer demand depends largely on our ability to obtain raw materials and a reduction or disruption in the availability of raw materials could negatively impact our business.
The continued global economic contraction has caused many of our component suppliers to reduce their manufacturing capacity. As the global economy improves, our component suppliers are experiencing and will continue to experience supply constraints until they expand capacity to meet increased levels of demand. These supply constraints may adversely affect the availability and lead times of components for our products. Increased lead times mean we may have to forsake flexibility in aligning its supply to customer demand changes and increase our exposure to excess inventory since we may have to order material earlier and in larger quantities. Further, supply constraints will likely result in increased overall procurement costs as we attempt to meet customer demand requirements. In addition, these supply constraints may affect our ability, as well as our contract manufacturers’ ability, to meet customer demand and thus result in missed sales opportunities and a loss of market share, negatively impacting revenues and our overall operating results.
Our failure to develop and introduce new products on a timely basis could harm our ability to attract and retain customers.
Our industry is characterized by rapidly changing technology, frequent product introductions and ongoing demands for greater speed and functionality. Therefore, we must continually design, develop and introduce new products with improved features to be competitive. To introduce these products on a timely basis we must:
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design innovative and performance-improving features that differentiate our products from those of our competitors;
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identify emerging technological trends in our target markets, including new standards for our products;
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accurately define and design new products to meet market needs;
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anticipate changes in end-user preferences with respect to our customers’ products;
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rapidly develop and produce these products at competitive prices;
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respond effectively to technological changes or product announcements by others; and
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provide effective technical and post-sales support for these new products as they are deployed.
If we are not able to introduce such products on a timely basis, we may not be able to attract and retain customers, which could decrease our revenues and negatively impact our growth.
Not all new product designs ramp into production, and even if ramped into production, the timing of such production may not occur as we or our customers had estimated, or the volumes derived from such projects may not be as significant as we had estimated, each of which could have a substantial negative impact on our anticipated revenues and profitability.
Our revenue growth expectations for our next-generation products are highly dependent upon successful ramping of our design wins. In some cases there is little time between when a design win is achieved and when production level shipments begin. With many new design wins, customers may require us to provide enhanced features not on its immediate roadmap. In addition, customers may require significant time to port their own applications to our products. Adding features to our products to meet customer requests as well as porting of customer specific applications can take six to 12 months. After that, there is an additional time lag from the start of production ramp to peak revenue. Not all product designs ramp into production and, even if a product ramps into production, the volumes derived from such products and associated projects may be less than we had originally estimated. Customer projects related
to design wins are sometimes canceled or delayed, or can perform below original expectations, which can adversely impact anticipated revenues and profitability. In particular, the volumes and time to production ramp associated with new design wins depend on the adoption rate of new technologies in its customers’ end markets, especially in the communications networking sector. Program delays or cancellations could be more frequent during times of meaningful economic downturn.
Our business depends on conditions in the communications networks and commercial systems markets. Demand in these markets can be cyclical and volatile, and any inability to sell products to these markets or forecast customer demand due to unfavorable or volatile market conditions could have a material adverse effect on our revenues and gross margin.
We derive our revenues from a number of diverse end markets, some of which are subject to significant cyclical changes in demand. In 2011, we derived our revenues from both the enterprise and service provider markets, and we believe that our revenues will continue to be derived primarily from these two markets. In many instances, our products are building blocks for its customers’ products and as such, our customers are not the end-users of our products. If our customers experience adverse economic conditions in the end markets into which they sell our products, we would expect a significant reduction in spending by our customers. Some of these end markets are characterized by intense competition, rapid technological change and economic uncertainty. Our exposure to economic cyclicality and any related fluctuation in customer demand in these end markets could have a material adverse effect on its revenues and financial condition.
Increased political, economic and social instability in the Middle East may adversely affect our business and operating results.
The continued threat of terrorist activity and other acts of war or hostility, including the wars in Afghanistan and Iraq, the current violence and potential war in Syria, the ongoing uncertainty related to Iran’s nuclear ambitions and threats against Israel and the ongoing Israeli-Palestinian conflict, create uncertainty throughout the Middle East and significantly increase the political, economic, and social instability in Israel, where some of our products are manufactured and where some of our key and other employees are located. Acts of terrorism, either domestically or abroad and particularly in Israel, or a resumption of the confrontation along the northern border of Israel or any open conflict between Israel and Iran, would likely create further uncertainties and instability. To the extent terrorism, or the political, economic or social instability results in a disruption of our operations or delays in our manufacturing or shipment of our products, then our business, operating results and financial condition could be adversely affected.
Our Dialogic® I-Gate® 4000 media gateways and our DCME products are exclusively manufactured for us by Flextronics, with the DCME products being manufactured by Flextronics through our relationship with ECI. The Flextronics manufacturing facility is located in Migdal-Haemek, Israel, which is located in northern Israel. While Flextronics has other locations across the world at which our manufacturing requirements may be fulfilled, any disruption to its Israeli manufacturing capabilities in Migdal-Haemek would likely cause a material delay in our manufacturing process. If we are forced or if we decide to switch the manufacture of our products to a different Flextronics facility, the time and expense of such switch along with the increased costs, if any, of operating in another location, would adversely affect our operations. In addition, while we expect that Flextronics will have the capacity to manufacture our products at facilities outside of Israel, there can be no assurance that such capacity will be available when we require it or upon terms favorable or acceptable to us. To the extent terrorism or political, economic or social instability results in a disruption of Flextronics’ manufacturing facilities in Israel or ECI operations in Israel as they relate to our business, then our business, operating results and financial condition could be adversely affected.
In addition, any hostilities involving Israel or the interruption or curtailment of trade between Israel and its present trading partners, or a significant downturn in the economic or financial condition of Israel, could adversely affect our operations and product development, cause our revenues to decrease, and adversely affect the price of our shares. Furthermore, several countries, principally in the Middle East, still restrict doing business with Israel, Israeli companies or companies with operations in Israel. Should additional countries impose restrictions on doing business with Israel, our business, operating results and financial condition could be adversely affected.
Our operations may be disrupted by the obligations of our personnel to perform military service.
Many of our employees in Israel, including certain key employees, are obligated to perform up to one month (in some cases more) of annual military reserve duty until they reach age 45 and, in emergency circumstances, could be called to active duty. Recently, there have been call-ups of military reservists, including several of our employees, and it is possible that there will be additional call-ups in the future. Our operations could be disrupted by the absence of a significant number of our employees due to military service or the absence for extended periods of one or more of our key employees for military service. Such disruption could adversely affect our business and results of operations.
We have a material amount of intangible assets and goodwill which, if they become impaired, would result in an impairment loss.
Current accounting standards require that goodwill be evaluated for impairment at least annually and that long-lived assets such as intangible assets be evaluated periodically if there are any triggering events. We have $33.3 million of intangible assets, net and $31.2
million of goodwill as of December 31, 2011, that have originated from Dialogic Corporation’s acquisitions of Intel’s media and signaling business in 2006, EAS in 2007, and the NMS CP business acquired in 2008 and the transaction between us and Dialogic Corporation in 2010. While we have not had any impairment losses for our intangible assets and goodwill, any future impairment of our intangible assets or goodwill would have a negative impact on our operating results.
There are a number of trends and factors affecting our markets, including economic conditions in specific countries, regions and globally, which are outside our control. These trends and factors may result in increasing upward pressure on the costs of products and an overall reduction in demand.
There are trends and factors affecting our markets and our sources of supply that are beyond our control and may negatively affect our cost of sales. Such trends and factors include: adverse changes in the cost of raw commodities and increasing freight, energy, and labor costs in developing regions. Our business strategy has been to provide customers with faster time-to-market and greater value solutions to help them compete in an industry that generally faces downward pricing pressure. In addition, our competitors have in the past lowered, and may again in the future lower, prices to increase their market share, which would ultimately reduce the price we may realize from its customers. If we are unable to realize prices that allow us to continue to compete on this basis of performance, its profit margin, market share, and overall financial condition and operating results may be materially and adversely affected.
The deployment of advanced wireless networks may not proceed according to analyst projections and even if it does, the adoption of mobile video added services may not occur.
The successful deployment of advanced 3G and 4G wireless networks would significantly impact the deployment of video gateway infrastructure. Since our ability to increase revenue is partially dependent on video gateways and video media servers that attach to the advanced 3G and 4G wireless networks, delay in the deployment of 3G and 4G wireless networks would impact our ability to increase revenue. Additionally, even if the advanced wireless networks are deployed successfully, the use of mobile video value added services (including video ring tones, video with interactive voice response, video location based services and video chat) may not be widely adopted. If the deployment of advanced wireless networks does not proceed according to analyst projections or if mobile video added services are not widely adopted, the growth of our business could be negatively affected.
The success of our VoIP gateways is dependent upon the successful deployment of technology by other companies and any delay in the deployment of such technology would negatively impact the growth of our enterprise gateway business.
Our VoIP gateways are used to connect software-based IP private branch exchanges, or PBXs, such as Microsoft Office Communications Server, Microsoft Lync and IBM Sametime, which are currently in the process of being deployed, to existing legacy systems. Any delay in the deployment of the IP PBX could impact our revenues from products related to our VoIP gateways.
The conversion to certain new technology may result in some customers utilizing other products or developing their own technology.
We are in the process of converting certain of our media enabling components from a board based product to our Dialogic® PowerMedia™ Host Media Processing, or HMP, software product that can be deployed on the host central processing unit of the server. The cost of entry for an HMP based software product is significantly lower than that of a board based product. As a result, there is a risk that our board based customers may utilize alternative producers of media enabling components or develop their own software product. The loss of customers during this conversion would negatively impact our revenue and operating results.
As our product lines age, we may be required to redesign our products or make substantial purchases of end of life components.
We sell multiple product lines that have been in production for several years. In some instances the production of components that are used in the manufacturing of our products have been terminated or will be terminated. Such termination of production requires that we must either incur the additional costs of purchasing a significant amount of such components prior to their termination or we must invest in significant engineering efforts to redesign the product, either of which would adversely affect our operating results.
We anticipate that average selling prices for many of our products will decline in the future, which could adversely affect our operating results.
We expect that the price we can charge its customers for many of its products will decline as new technologies become available, as we transition to software based IP and as low cost regional providers take measures to achieve or maintain market share. If this occurs, our operating results will be adversely affected.
To respond to increasing competition and our anticipation that average-selling prices will decrease, we are attempting to reduce manufacturing costs of our new and existing products. If we do not reduce manufacturing costs and average selling prices decrease, our operating results will be adversely affected.
Two of our key U.S. patents expired in March 2011, which could lead to competitors entering the market.
The Dialogic® Brooktrout® fax boards, the Dialogic® Diva® media boards and the Dialogic® Brooktrout® SR140 software products make use of our patented technology to route a fax to a local area network using a direct inward dial number. The two patents covering this technology expired in March 2011. The expiration of a patent typically results in increased competition and a decline in revenue. If other companies start to manufacture and sell a similar product based on this technology in the United States it could adversely impact our revenues.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
Our worldwide corporate headquarters containing administration, engineering, sales and support personnel is located in a 34,481 square foot leased facility in Milpitas, California, pursuant to a lease that expires on January 31, 2019. Our annual base rent for the Milpitas facility is $0.5 million. Further, we lease 148,322 square feet at a facility located in Parsippany, NJ containing administration, engineering, sales and support personnel pursuant to a lease that expires at the end of 2015. Our annual base rent for the Parsippany facility is $2.4 million. Additional facilities which we lease and maintain with 2012 expected annual base rent exceeding $100,000, as of December 31, 2011, are listed below:
* Leases changes took effect as of midnight January 1, 2012 to revise the square footage and annual base rent to the amounts set out above.
We also lease facilities with annual base rental payments which are individually less than $0.1 million both internationally in: Nottingham, United Kingdom; Seoul, Korea; Fordingbridge, United Kingdom; Dublin, Ireland; Kuala Lumpur, Malaysia; St. Hubert, Quebec, Canada; Moscow, Russia; New Delhi and Pune, India; Shenzhen and Beijing, China; Sao Paulo, Brazil; and Paris, France as well as domestically in the United States in: Eatontown, New Jersey; Salem, New Hampshire; Herndon, Virginia; Plano, Texas; Ft. Lauderdale, Florida; and Schaumburg, Illinois. The aggregate annual base rental payments for these facilities are approximately $0.7 million.
We have short-term sales office leased space in Sydney, Australia; Hilvershim, Netherlands; Barcelona, Spain; Dubai, United Arab Emirates; Munich, Germany; Milan, Italy; and Lubjiana, Slovenia. The aggregate annual base rental payments (including management fees) for these sales offices are approximately $0.1 million.
We do not own any real estate and believe that these properties are sufficient to meet its current needs. As we expand our business into new markets, we expect to lease additional facilities.
Item 3.
Item 3. Legal Proceedings
Other than the SEC Informal Inquiry, we are not a party to any material legal proceeding. From time to time, we may be engaged in various legal proceedings incidental to our normal business activity.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market For Our Common Stock and Related Stockholder Matters
Our common stock is currently traded on The NASDAQ Global Market under the symbol “DLGC” and was, prior to consummation of the business arrangement with Dialogic Corporation, traded on The NASDAQ Global Market under the symbol “VRAZ.” The following table summarizes the high and low sales prices for our common stock as reported by The NASDAQ Global Market for the periods indicated, all of which have been adjusted to reflect the one for five reverse stock split approved by our stockholders on September 30, 2010 and effected on October 1, 2010.
As of February 28, 2012, we had approximately 111 stockholders of record. The number of stockholders of record does not include individuals whose stock is in nominee or “street name” accounts through brokers.
Dividend Policy
We have never declared or paid any cash dividends on our common stock. We currently intend to retain any earnings to finance future growth, and therefore do not expect to pay cash dividends on our common stock in the foreseeable future. Under the Revolving Credit Agreement, we cannot declare or pay any cash dividends without the consent of the Revolving Credit Lender.
Recent Sales of Unregistered Securities
There were no sales of unregistered securities by us that were not previously included in a quarterly report on a Form 10-Q or in a current report on Form 8-K.
Item 6.
Item 6. Selected Financial Data
Not applicable.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of our operation should be read in conjunction with the consolidated financial statements and the notes to those statements included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed in Part I, Item 1A “Risk Factors” and elsewhere in this report.
Overview
We are a leading provider of communications platforms and technology that enable developers and service providers to build and deploy innovative applications without concern for the complexities of the communication medium or network. We specialize in providing products and solutions that enhance the mobile communications experience. Our technology impacts over two billion mobile subscribers and our network solutions carry more than 15 billion minutes of traffic per month.
Wireless and wireline service providers use our products to transport, convert and manage data and voice traffic while enabling VoIP and other multimedia services. These service providers also utilize our underlying technology to provide innovative revenue-
generating value-added services such as messaging, SMS, voice mail and conferencing which are also increasingly becoming video-enabled. Enterprises rely on our innovative products to enable the integration of IP and wireless technologies and endpoints into existing communication networks, and to enable applications that serve businesses, including unified communication applications, contact center and IVR/ IVVR.
We sell our products to both enterprise and service provider customers and sell both directly and indirectly through distribution partners such as TEMs, VARs and other channel partners. Our customers build their enterprise communications solutions, their networks, or their value-added services on our products.
We were incorporated in Delaware on October 18, 2001 as Softswitch Enterprises, Inc., and subsequently changed our name to NexVerse Networks, Inc. in 2001, Veraz Networks, Inc. in 2002 and Dialogic Inc. in 2010. Companies we have acquired have been providing products and services for nearly 25 years.
Business Combination with Dialogic Corporation
On October 1, 2010, we completed our business combination, or the Acquisition, with Dialogic Corporation, a British Columbia Corporation, in accordance with the terms of an acquisition agreement dated May 12, 2010, or the Acquisition Agreement. We acquired all of Dialogic Corporation’s outstanding common and preferred shares in exchange for an aggregate of approximately 22.1 million shares of our common stock, after giving effect to the stock split described below and, accordingly Dialogic Corporation became our wholly-owned subsidiary. All outstanding options to purchase Dialogic Corporation common shares were cancelled and new options to purchase shares of our common stock were granted. Each option to purchase Dialogic Corporation common shares became an option to acquire that number of shares of our common stock equal to the product obtained by multiplying the number of shares in the capital of Dialogic Corporation subject to the option by 0.9, rounded down to the nearest whole share of our common stock. Each option to purchase shares of our common stock has a purchase price per share of our common stock equal to the exercise price per share (in U.S. dollars) for the Dialogic Corporation option immediately prior to October 1, 2010 divided by 0.9, rounded up to the nearest whole cent. After taking into account the issuance of stock options to purchase our common stock in exchange for Dialogic Corporation options, as October 1, 2010, the former Dialogic Corporation shareholders and option holders held approximately 70% and our existing stockholders held approximately 30% of our outstanding securities. As of October 1, 2010, there were approximately 31 million shares of our common stock issued and outstanding, after taking into account the effect of the one-for-five reverse stock split approved by the our stockholders on September 30, 2010 and effected on October 1, 2010. As of October 1, 2010, we changed our name from Veraz Networks, Inc. to Dialogic Inc. and on October 4, 2010, our common stock began trading on The NASDAQ Global Market under the symbol “DLGC.” Our business combination with Dialogic Corporation was accounted for as a reverse acquisition under the purchase method of accounting, whereby Dialogic Corporation was considered the accounting acquirer in accordance with U.S. generally accepted accounting principles, or U.S. GAAP.
All common stock share and per share data presented have been retroactively restated to give effect to the reverse stock split. Also, all common stock and per share data reflects the legal capital of the former Veraz Networks, Inc. retroactively adjusted for the exchange ratios in the Acquisition Agreement to reflect the number of shares received in the business combination.
Description of Existing Debt Obligations
We have related party long-term debt under a Term Loan Agreement and Stockholder Loans, and bank indebtedness with a Revolving Credit Agreement.
Term Loan Agreement
On March 22, 2012, Dialogic Corporation amended and restated its second amended and restated credit agreement dated as of October 1, 2010, or the Term Loan Agreement, with Obsidian, LLC, as agent, and Special Value Expansion Fund, LLC, Special Value Opportunities Fund, LLC and Tennenbaum Opportunities Partners V, LP, as lenders, or, together, the Term Lenders. Tennenbaum Capital Partners. LLC, or Tennenbaum, a private equity firm, manages the funds of the Term Lenders. Tennenbaum also owned approximately 6.6% of our common stock as of December 31, 2011, which interest it originally acquired in Dialogic Corporation in 2006. During the years ended December 31, 2011 and December 31, 2010, a Managing Partner for Tennenbaum also served, and continues to serve, as a member of our Board of Directors and during the year ended December 31, 2009, a Managing Partner for Tennenbaum also served as a member of Dialogic Corporation’s Board of Directors. In connection with entering into the Term Loan Agreement, on March 22, 2012, the Company issued to the Term Lenders warrants to purchase 18 million shares of common stock with an exercise price of $1.00 per share, subject to stockholder approval.
Principal Amount and Maturity. At December 31, 2011, term loans in the principal amount of $89.9 million, or the Term Loans, were outstanding under the Term Loan Agreement. The following describes certain provisions of the Term Loan Agreement as
amended and restated on March 22, 2012. In addition to these provisions and the Term Loan Agreement, the Term Lenders have at their discretion the ability to provide additional loans to Dialogic Corporation up to $10 million on the same terms of the Term Loans. As of April 5, 2012, we have received $1.0 million under this provision. As of March 22, 2012, $3.0 million of interest on the Term Loans accrued through March 22, 2012 was added to the principal thereof.
Maturity. The Term Loans are due on March 31, 2015.
Voluntary and Mandatory Prepayments. The Term Loans may be prepaid, in whole or in part, from time to time, subject to payment of (i) if prepaid on or prior to March 22, 2013, a premium of 5%, (ii) if prepaid after March 22, 2013 but on or prior to March 22, 2014, a premium of 2% and (iii) if prepaid after March 22, 2014, no premium is required.
Dialogic Corporation is required to offer to prepay the Term Loans out of the net proceeds of certain asset sales (including asset sales by the Company and its subsidiaries) at 100% of the principal amount of Term Loans prepaid, plus the prepayment premiums described above, subject to Dialogic Corporation’s right to retain proceeds of up to $1 million in the aggregate each fiscal year. Subject to the right to retain proceeds of up to $1.5 million in the aggregate in each fiscal year, Dialogic Corporation is also required to prepay the Term Loans out of 50% of the net proceeds from certain equity issuances by the Company and its subsidiaries, plus the prepayment premiums described above, except that no prepayment premium is required to be paid in respect to the first $35 million of net proceeds of an issuance of stock at a price of $1.25 per share or more.
Interest Rates. The Term Loans bear interest, payable quarterly in cash, at a fixed rate per annum of 10% except that, in 2012 and thereafter if certain minimum cash requirements are met, interest may be paid at the rate of 5% in cash with the remaining 5% added to principal and paid in kind (PIK). Upon the occurrence and continuance of an event of default, the Term Loans will bear interest at a default rate equal to the applicable interest rate plus 2%.
Guarantors. The terms loans are guaranteed by the Company, Dialogic US Inc., Dialogic Distribution Limited, Dialogic Manufacturing Limited, Dialogic Networks (Israel) Ltd., Dialogic do Brasil Comercio de Equipamentos Para Telecomunicacao Ltda. and certain of our U.S. subsidiaries, or, collectively, the Term Loan Guarantors.
Security. The Term Loans are secured by a pledge of all of the assets of Dialogic Corporation and of the Term Loan Guarantors, including all intellectual property, accounts receivable, inventory and capital stock in our direct and indirect subsidiaries. The security interest of the Term Lenders in inventory, accounts receivable and related property of Dialogic Corporation and the Term Loan Guarantors is subordinated to the security interest of the Revolving Credit Lender, as defined below, in those assets.
Financial Covenants. The following summarizes the financial covenants as defined in the third amended and restated Term Loan Agreement:
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Minimum Liquidity - Defined as either liquidity of not less than $15.0 million or Qualified Cash (as defined in the Term Loan Agreement) of not less than $10.0 million as of March 31, 2013 and thereafter.
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Minimum EBITDA - Defined as earnings plus interest expense, taxes, depreciation, amortization, foreign exchange gain or loss and subject to certain additional adjustments in accordance with U.S. GAAP of at least $15.0 million for the four quarters ending March 31, 2013; $16.9 million for the four quarters ending June 30, 2013; $17.1 million for the four quarters ending September 30, 2013 and December 31, 2013; $18.1 million for the four quarters ending March 31, 2014; $19.4 million for the four quarters ending June 30, 2014; $20.9 million for the four quarters ending September 30, 2014; $22.6 million for the four quarters ending December 31, 2014; and $24.7 million for the four quarters ending March 31, 2015.
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Minimum Interest Coverage Ratio - Defined as the ratio of (i) Consolidated EBITDA for such period minus Consolidated Capital Expenditures for such period to (ii) Consolidated Interest Expense for such period and is not permitted to be less than the correlative ratio of 1.50 to 1 for the four quarters ending March 31, 2013, June 30, 2013, September 30, 2013, December 31, 2013, March 31, 2014, June 30, 2014, September 30, 2014, December 31, 2014 and March 31, 2015.
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Maximum Consolidated Total Leverage Ratio - Defined as the ratio of (i) the total consolidated debt outstanding at the end of the quarter to (ii) the consolidated EBITDA for such period and is not permitted to be greater than a ratio of 4.40 to 1 for the four quarters ending March 31, 2013; ratio of 3.90 to 1 for the four quarters ending June 30, 2013; ratio of 3.80 to 1 for the four quarters ending September 30, 2013; ratio of 3.90 to 1 for the four quarters ended December 31, 2013; ratio of 3.60 to 1 for the four quarters ending March 31, 2014; ratio of 3.40 to 1 for the four quarters ending June 30, 2014; ratio of 3.20 to 1 for the four quarters ending September 30, 2014; ratio of 2.90 to 1 for the four quarters ending December 31, 2014; and ratio of 2.70 to 1 for the four quarters ending March 31, 2015.
Other Terms. We, Dialogic Corporation and our subsidiaries are subject to various affirmative and negative covenants under the Term Loan Agreement, including restrictions on incurring additional debt and contingent liabilities, granting liens, making
investments and acquisitions, paying dividends or making other distributions in respect of its capital stock, selling assets and entering into mergers, consolidations and similar transactions, entering into transactions with affiliates and entering into sale and lease-back transactions. The Term Loan Agreement contains customary events of default, including a change in control without the Term Lenders consent and an Event of Default (as defined in the Term Loan Agreement, and which constitutes an event of default under the Revolving Credit Agreement (as defined below)), which results in a cross-default under the Revolving Credit Agreement.
As of December 31, 2011, we were not in compliance with any of the financial covenants then in effect under the Term Loan Agreement. These defaults were waived by the Term Lenders pursuant to the third amended and restated Term Loan Agreement as described above.
On April 11, 2012, Dialogic Corporation, the Company and certain of our subsidiaries entered into a First Amendment to the Term Loan Agreement. Pursuant to the First Amendment, the Term Loan Agreement was amended to permit the conversion of $33.0 million of outstanding debt under the Term Loan Agreement in exchange for the Notes as described below and a share of our Series D-1 Preferred Stock, subject to payment of a prepayment premium of $1.5 million. The Term Loan Agreement was also amended to permit us to issue the remaining Notes sold in the Private Placement, as described in greater detail below.
Stockholder Loans
At each of December 31, 2011 and 2010, we had $4.8 million and $3.9 million, respectively, in long-term debt payable to certain of our stockholders, or, collectively, the Related Party Lenders including our Chief Executive Officer and members of our Board of Directors, bearing interest at an annual rate of 20% compounded monthly in form of a PIK, and repayable six months from the maturity date of the Term Loan Agreement, which, as of December 31, 2011 would have been March 2014, and under the third amended and restated Term Loan Agreement, would be in September 2015. During the years ended December 31, 2011 and 2010, we recorded interest expense of $0.9 million and $0.7 million, respectively, related to these stockholder loans. There are no covenants or cross default provisions associated with these stockholder loans.
In the event that we consummate an equity financing before the loans are repaid, the the Related Party Lenders, at their option, may convert all of the stockholder loan amount, including accrued PIK interest payable, into equity at the same rate and terms agreed to with other investors. The stockholder loan conversion option will apply solely to the first equity financing event consummated after the October 1, 2010 acquisition date.
Revolving Credit Agreement
Dialogic Corporation has a working capital facility pursuant to a credit agreement dated as of March 5, 2008, as amended, or the Revolving Credit Agreement, with Wells Fargo Foothill ULC, as administrative agent and as a lender, or the Revolving Credit Lender. On March 22, 2012, Dialogic Corporation entered into a Consent and Seventeenth Amendment, or the Seventeenth Amendment, relating to the Revolving Credit Agreement. Under the Seventeenth Amendment, the Revolving Credit Lender waived the events of default existing under the Revolving Credit Agreement as of March 22, 2012 and agreed to certain amendments to the Revolving Credit Agreement.
Pursuant to the Seventeenth Amendment, the Revolving Credit Agreement maturity date was amended and extended to the earlier of (i) March 31, 2015 and (ii) expiration of the Term Loan Agreement. Dialogic Corporation may borrow, repay and reborrow revolving credit loans from time to time provided that the aggregate principal amount of revolving credit loans outstanding at any time does not exceed the lesser of (i) $25.0 million, which is referred to as the “maximum revolver amount” or (ii) 85% of the aggregate amount of eligible accounts receivable, reduced by certain reserves and offsets and subject to certain caps in the case of accounts receivable owed to Dialogic Corporation and certain guarantors of the Revolving Credit Agreement, which is referred to as the “borrowing base.”
As of December 31, 2011, the borrowing base under the Revolving Credit Agreement amounted to $14.9 million, Dialogic Corporation had borrowed $12.5 million, and the unused line of credit totaled $12.5 million, of which $2.4 million was available for additional borrowings.
The following describes certain terms of the Revolving Credit Agreement, as amended by the Seventeenth Amendment:
Term. The commitment of the Revolving Credit Lender to make revolving credit loans terminates and all outstanding revolving credit loans are due on the maturity date described above. Dialogic Corporation may repay the facility at its own option with 30 days’ notice to the Revolving Credit Lender.
Mandatory Prepayments. Dialogic Corporation is required to prepay revolving credit loans in an amount equal to 100% of the net proceeds from the sale or other disposition of inventory other than in the ordinary course of business, subject to the right to apply the net proceeds to the acquisition of replacement property in lieu of prepayment.
Interest Rates and Fees. At Dialogic Corporation’s election, revolving credit loans may bear interest at a rate equal to the prime rate plus 1.5% or at a rate equal to reserve-adjusted one-, two- or three- month LIBOR plus 3%. Upon the occurrence and continuance of an event of default and at the election of the Revolving Credit Lender, the revolving credit loans will bear interest at a default rate equal to the then applicable interest rate or rates plus 2%. Dialogic Corporation pays the Revolving Credit Lender a monthly fee on the unused portion of the maximum revolver amount, as well as a monthly collateral management fee and an annual deferred closing fee.
The average interest rate for the years ended December 31, 2011 and 2010 was 5.75% and 6.1%, respectively.
Guarantors. The revolving credit loans are guaranteed by the Company, Dialogic (US) Inc., Cantata Technology, Inc., Dialogic Distribution Ltd., Dialogic Networks (Israel) Ltd. and Dialogic do Brasil Comercio de Equipamentos Para Telecomunicacao Ltda., or, collectively, the Revolving Credit Guarantors.
Security. The revolving credit loans are secured by a pledge of the assets of Dialogic Corporation and of the Revolving Credit Guarantors consisting of accounts receivable and inventory and related property. The security interest of the Revolving Credit Lender is prior to the security interest of the Term Lenders in these assets, subject to the terms and conditions of an intercreditor agreement.
Minimum EBITDA - Defined as earnings plus interest expense, taxes, depreciation, amortization, foreign exchange gain or loss and subject to certain additional adjustments in accordance with U.S. GAAP of at least $1.0 million for the three month period ending on June 30, 2012; $4.0 million for the six month period ending on September 30, 2012 and $7.5 million for the 9 month period ending December 31, 2012 to be tested only if the average amount of availability under the Revolving Credit Agreement plus unencumbered cash of Dialogic Corporation and the Revolving Credit Guarantors for the 30-day period preceding the applicable testing date is less than $2.5 million; and; $15.0 million for the 12 month period ending on March 31, 2013; $16.9 million for the 12 month period ending on June 30, 2013; $17.1 million for the 12 month period ending on September 30, 2013 and December 31, 2013; $18.1 million for the 12 month period ending on March 31, 2014; $19.4 million for the 12 month period ending on June 30, 2014; $20.9 million for the 12 month period ending on September 30, 2014; $22.6 million for the 12 month period ending on December 31, 2014; and $24.7 million for the 12 month period ending on March 31, 2015 and the last date of each 12-month period thereafter.
Other Terms. We, Dialogic Corporation, and our subsidiaries are subject to affirmative and negative covenants, including restrictions on incurring additional debt, granting liens, entering into mergers, consolidations and similar transactions, selling assets, prepaying indebtedness, paying dividends or making other distributions on its capital stock, entering into transactions with affiliates and making capital expenditures. The Revolving Credit Agreement contains customary events of default, including a change in control and an Event of Default (as defined in the Revolving Credit Agreement, and which constitutes an event of default under the Term Loan Agreement), which results in a cross-default under the Term Loan Agreement.
At December 31, 2011, Dialogic Corporation was in default under the Revolving Credit Agreement. Specifically, Dialogic Corporation had breached all of the financial covenants under the Term Loan Agreement as of December 31, 2011, which constitutes a breach under the terms of the Revolving Credit Agreement, and the Minimum EBITDA covenant under the Revolving Credit Agreement. The events of default existing under the Revolving Credit Agreement as of December 31, 2011 were waived by the Revolving Credit Lender pursuant to the Seventeenth Amendment. During the year ended December 31, 2011, we amortized an additional $0.4 million of deferred debt issuance costs related to the accelerated amortization as a result of the breach of the covenants under the Term Loan Agreement. We also recorded bank fees of $25,000 paid during 2011 in connection the defaults under the Revolving Credit Agreement.
On April 11, 2012, Dialogic Corporation, the Company and certain of our subsidiaries entered into an Eighteenth Amendment to Revolving Credit Agreement, or the Eighteenth Amendment, with the Revolving Credit Lender. Pursuant to the Eighteenth Amendment, the Revolving Credit Agreement was amended to permit us to issue the Notes in the Private Placement, as described in greater detail below.
Recent Financing Activity
On April 11, 2012, we entered into a securities purchase agreement, or the Purchase Agreement, with accredited investors, or the Investors, including certain related parties, pursuant to which we issued and sold $39.5 million aggregate principal amount of convertible promissory notes, or the Notes, and one share of our Series D-1 Preferred Stock, par value $0.001 per share, or the Series D-1 Preferred Share, to the Investors in a private placement, or the Private Placement.
The Investors in the Private Placement included the Term Lenders and Related Party Lenders. The Term Lenders purchased $34.5 million aggregate principal amount of Notes in exchange for the cancellation of (i) $33.0 million in outstanding principal under the Term Loan Agreement, $3.0 million of which represents accrued but unpaid interest that was capitalized under the Term Loan Agreement on March 22, 2012, or the Interest Amount, and (ii) a prepayment premium of $1.5 million triggered by the cancellation of the outstanding debt described above. The Related Party Lenders purchased the remaining $5.0 million aggregate principal amount of Notes in exchange for the cancellation of outstanding debt.
The Notes bear interest at the rate of 1% per annum, compounded annually, and are convertible into shares of our common stock. The conversion price of the Notes is generally $1.00 per share, provided that the Notes issued to the Term Lenders in exchange for the cancellation of the Interest Amount will have a conversion price of $0.87 per share, in each case as adjusted for any stock split, reverse stock split, stock dividend, recapitalization, reclassification, combination or other similar transaction. Under the terms of the Notes, the principal and all accrued but unpaid interest will automatically convert into shares of our common stock upon stockholder approval of the Private Placement.
Pursuant to the Purchase Agreement, we have agreed to call a meeting of the stockholders by June 30, 2012 to approve the Private Placement. If stockholder approval and the resulting conversion of the Notes do not occur by June 30, 2012, the outstanding principal amount and all accrued and unpaid interest under the Notes shall become due and payable on such date; however, amounts due under the Notes cannot be repaid before amounts under the Term Loan Agreement and Revolving Credit Agreement. The Notes are subordinated to our outstanding loans under the Term Loan Agreement and the Revolving Credit Agreement. We may not prepay such Notes prior to June 30, 2012 without the consent of the Term Lenders and Revolving Credit Lender.
Critical Accounting Policies and Estimates
Management’s discussion and analysis of our financial position and results of operations is based upon the consolidated financial statements, which have been prepared in accordance with U.S. GAAP pursuant to the rules and regulations of the Securities and Exchange Commission. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. We base our estimates on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. If actual results differ significantly from management’s estimates and projections, there could be a material effect on our financial statements. The accounting policies that we believe are the most critical to aid in fully understanding and evaluating our reported financial results, and which required the most subjective judgment by us, are the following:
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Revenue Recognition;
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Accounts Receivable and Allowance for Doubtful Accounts;
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Inventory Reserves;
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Impairment of Long-Lived Assets and Goodwill;
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Stock-Based Compensation;
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Accounting for Income Taxes; and
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Business Combinations
Revenue Recognition
Revenue derived from the sale of products and services is recognized when all of the following criteria are met:
(i) Persuasive evidence of an arrangement exists - Our customary practice is to have a written contract, which is signed by both us and the customer, or a purchase order or other written or electronic order documentation for those customers who have previously negotiated a standard arrangement with us.
(ii) Delivery has occurred - Delivery of hardware and software products generally occurs at the point of shipment when title and risk of loss have passed to the customer. However, some arrangements require evidence of customer acceptance of the hardware and software products that have been sold. In such cases, delivery of the software, hardware and services is not considered to have occurred until evidence of acceptance is received from the customer or we have completed our contractual requirements. Revenue from sales of standalone services, including training courses, is recognized when the services are completed. In certain arrangements involving subsequent sales of hardware and software products to expand a customers’ networks, the revenue recognition on these arrangements after the initial arrangement has been accepted, typically occurs at the point of shipment, since we have historically experienced successful implementations of these expansions and customer acceptance, although contractually required, does not represent a significant risk.
(iii) The fee is fixed or determinable - We sell our products through our direct sales force and channel partners. In certain cases where the sales price cannot be reliably determined due to frequent sales price reductions or returns cannot be estimated, the related fee is considered to be not fixed or determinable and revenue is deferred until such price reduction or return rights cease.
Arrangement fees are generally due within one year or less from date of acceptance, or the date of delivery if no acceptance. Some arrangements may have payment terms extending beyond these customary payment terms and therefore the arrangement fees may not be considered to be fixed or determinable. For multiple element arrangements with payment terms that are not considered to be fixed or determinable, revenue is recognized as payments become due, based on relative selling price, after delivery and acceptance of the software, hardware, and services, and assuming all other revenue recognition criteria are satisfied. For arrangements with contingent revenue provisions (a portion of the relative selling price of a delivered item is contingent upon the delivery of additional items or meeting other specified performance conditions), revenue recognized on delivered items is limited to the non-contingent amount. We defer the cost of inventory when products have been shipped, but have not yet been recognized as revenue, and expense those costs in full in the same period that the deferred revenue is recognized as revenue (generally upon customer acceptance or in the case of contingent revenue provisions, when amounts are no longer contingent). In arrangements for which revenue recognition is limited to amounts due because of extended payment terms, inventory costs are expensed upon acceptance. This will initially result in lower or negative product margins for those arrangements and cause higher margins in subsequent periods, as compared to similar arrangements with customary payment terms.
(iv) Collectability is probable - Collectability is assessed on a customer-by-customer basis. We evaluate the financial position, payment history, and ability to pay of new customers, and of existing customers that substantially expand their commitments. If it is determined prior to revenue recognition that collectability is not probable, recognition of the revenue is deferred and recognized upon receipt of cash, assuming all other revenue recognition criteria are satisfied. In arrangements for which revenue recognition is limited to amounts of cash received because of collectability concerns, all related inventory costs are expensed at the date of acceptance or delivery if no acceptance is required; this will initially result in lower or negative product margins and cause higher margins in subsequent periods, as compared to similar arrangements with customary payment terms.
Revenue received from maintenance contracts is presented as deferred revenue and is recognized into revenue on a straight-line basis over the term of the contract. License fee revenue is recognized upon delivery of the license or software and when all performance criteria are met. Revenue derived from the sale of products is generally recognized when title and risk of loss has been transferred to the customer. In addition, product, maintenance contract and license fee revenues are recognized when persuasive evidence of an arrangement exists, amounts are fixed or can be determined, and ability to collect is probable.
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Revenue Reserves and Adjustments
Sales incentives which are offered on some of our products are recorded as a reduction of revenue as there are no identifiable benefits received. We record a provision for estimated sales returns and allowances as a reduction from sales in the same period during which the related revenue is recorded. These estimates are based on historical sales returns and allowances, analysis of credit memo data and other known factors.
We have agreements with certain distributors which allow for stock rotation rights. The stock rotation rights permit the distributors to return a defined percentage of their purchases. Some distributors must exchange this stock for orders of an equal or greater amount. We recognize an allowance for stock rotation rights based on historical experience. The provision is recorded as a reduction in revenues in the period during which the related revenue is recognized.
We also have agreements with certain distributors that allow for price adjustments. We recognize an allowance for these price adjustments based on historical experience. The price adjustments are recorded as a reduction in revenue in the period during which the related revenue is recognized.
Revenues are primarily recognized net of sales taxes. Revenues include amounts billed to customers for shipping and handling. Shipping and handling fees represented less than 1% of revenues in each of the years ended December 31, 2011 and 2010. Shipping and handling costs are included in cost of revenues.
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Multiple Element Arrangements
In October 2009, the Financial Accounting Standards Board, or FASB, amended the accounting standards for revenue recognition to remove tangible products containing software components and non-software components that function together to deliver the
product’s essential functionality from the scope of industry specific software revenue recognition guidance. In October 2009, the FASB also amended the standards for multiple deliverable revenue arrangements to:
i. provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and how the arrangement consideration should be allocated among its elements;
ii. require an entity to allocate revenue where no vendor specific objective evidence exists, or VSOE, by using third party evidence of selling price, or TPE, or estimated selling prices, or ESP; and
iii. eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method.
This new accounting guidance became applicable to us beginning the first quarter of its fiscal year 2011. We adopted this guidance for transactions that were entered into or materially modified on or after January 1, 2011 using the prospective basis of adoption. Our products typically have both software and non-software components that function together to deliver the products’ essential functionality. Although our products are primarily marketed based on the software elements contained therein, the hardware sold generally cannot be used apart from the software. Therefore, we consider our principal hardware products to be subject to this new accounting guidance. Many of our sales involve multiple-element arrangements that include product, maintenance and various professional services. The adoption of the guidance discussed above affects our multiple-element arrangements when they contain tangible products (hardware) with software elements, which comprise the majority of our revenue transactions. We may enter into sales transactions that do not contain tangible hardware components, such as software-only add-on sales, which will continue to be subject to the previous software revenue recognition guidance in ASC 985-605.
The multiple-deliverable revenue guidance requires that we evaluate each deliverable in an arrangement to determine whether such deliverable would represent a separate unit of accounting.
The delivered item constitutes a separate unit of accounting when it has stand-alone value to the customer. If the arrangement includes a general refund or return right relative to the delivered item and the delivery and performance of the undelivered items are considered probable and substantially in our control, the delivered element constitutes a separate unit of accounting. In instances when the aforementioned criteria are not met, the deliverable is combined with the undelivered elements and revenue recognition is determined for the combination as a single unit of accounting. Most of our products and services qualify as separate units of accounting because they are sold separately or the customer could resell them on a standalone basis and, accordingly, revenue is recognized when the applicable revenue recognition criteria are met.
The total arrangement fees are allocated to all the deliverables based on their respective relative selling prices. The relative selling price is determined using VSOE, when available. We generally use VSOE to derive the selling price for its maintenance and professional services deliverables. VSOE for maintenance is based on contractual stated renewal rates while professional services are based on historical pricing for standalone professional service transactions. When VSOE cannot be established, we attempt to determine the TPE for the deliverables. TPE is determined based on competitor prices for similar deliverables when sold separately by the competitors. Generally our product offerings differ from those of our competitors and comparable pricing of its competitors is often not available. Therefore, we are typically not able to determine TPE. When we are unable to establish selling price using VSOE or TPE, we use ESP in our allocation of arrangement fees. The ESP for a deliverable is determined as the price at which we would transact if the products or services were sold on a standalone basis. The ESP for each deliverable is determined using average historical discounted selling prices based on several factors, including but not limited to, marketing strategy, customer considerations and pricing practices in a region. We use ESP to derive the relative selling price for our product deliverables.
The impact of applying the relative selling price method in the allocation of revenue, compared to previous revenue recognition methodologies, increased revenues for the year ended December 31, 2011 by approximately $0.7 million. In terms of the timing and pattern of revenue recognition, the new accounting guidance for revenue recognition is not expected to have a significant effect on revenues in periods after the initial adoption when applied to multiple element arrangements. However, as our marketing and product strategies evolve, we may modify our pricing practices in the future, which could result in changes in selling prices, including both VSOE and ESP which could impact future revenues.
For transactions entered into prior to the first quarter of fiscal year 2011, we recognized revenue based on the software revenue recognition guidance in place during the period in which the order was received. When an arrangement involved multiple elements, such as hardware and software products, maintenance and/or professional services, we allocated the entire sales price to each respective element based on VSOE of the fair value for each element. When arrangements contained multiple elements and VSOE of fair value existed for all undelivered elements but not for the delivered elements, we recognized revenue for the delivered elements using the residual method. We based our determination of VSOE of the fair value of the undelivered elements based on substantive renewal rates of maintenance and support agreements, and on independently sold and negotiated service arrangements. In limited circumstances when arrangements containing multiple elements where VSOE of fair value did not exist for an undelivered element,
we deferred revenue for the delivered and undelivered elements until VSOE of fair value existed for the undelivered elements or all elements had been delivered.
Accounts Receivable and Allowance for Doubtful Accounts
Generally, our receivables are recorded when billed and represent claims against third parties that will be settled in cash. The carrying value of the receivables, net of the allowance for doubtful accounts, represents their estimated net realizable value.
We maintain an allowance for doubtful accounts for estimated losses inherent in our accounts receivable portfolio. In establishing the required allowance, management considers historical losses, current receivable aging and evaluates individual customer receivables by considering our knowledge of a customer’s financial condition, credit history and current economic conditions. We write off trade receivables when they are deemed uncollectible. We review our allowance for doubtful accounts regularly. However, judgment is required to determine whether an increase or reversal of the allowance is warranted. We will record an increase of the allowance if there is a deterioration in past due balances, if economic conditions are less favorable than we had anticipated, or for customer-specific circumstances, such as bankruptcy. We will record a reversal of the allowance if there is significant improvement in collection rates. Historically, the allowance has been adequate to cover the actual losses from uncollectible accounts.
Inventory Reserves
Inventories are stated at the lower of cost or market, with cost being determined using the first-in, first-out method. In assessing the net realizable value of inventories, we are required to make judgments as to future demand requirements and compare these with the current or committed inventory levels. Once our inventory has been written down to its estimated net realizable value, our carrying value cannot be increased due to subsequent changes in demand forecasts. To the extent that a severe decline in forecasted demand occurs, or we experience a higher incidence of inventory obsolescence due to rapidly changing technology and customer requirements, we may incur significant charges for excess inventory.
Impairment of Long-lived Assets and Goodwill
Long-lived assets, such as property and equipment, and intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposal group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.
Intangible assets with indefinite useful lives are not amortized and are tested for impairment annually, or more frequently, if events or changes in circumstances indicate that the asset may be impaired. The impairment test compares the carrying amount of the intangible asset with its fair value, and an impairment loss is recognized for the excess, if any. The impairment testing is performed during the last quarter of the fiscal year.
Goodwill represents the excess of the purchase price over the fair value of the net assets acquired in a business acquisition. Goodwill is not subject to amortization and is tested for impairment annually or more frequently if events or circumstances indicate that the asset might be impaired. Impairment is identified by comparing the fair value of the reporting unit to which the goodwill relates to its carrying value. To the extent the carrying amount exceeds its fair value, we measure the amount of impairment by the excess of carrying value over the implied fair value of goodwill. The impairment is charged to income in the period in which it is determined. The impairment testing is performed during the last quarter of the fiscal year.
Considerable judgment is required to estimate discounted future operating cash flows. Judgment is also required in determining whether an event has occurred that may impair the value of intangible assets, long-lived assets and goodwill. Factors that could indicate an impairment may exist include significant underperformance relative to plan or long-term projections, strategic changes in business strategy, significant negative industry or economic trends and a significant change in circumstances relative to a large customer. We must make assumptions about future cash flows, future operating plans, discount rates and other factors in the models and valuation reports. To the extent these future projections and estimates change, the estimated amounts of impairment could differ from current estimates. Our annual testing for impairment of goodwill, intangible assets with indefinite useful lives and definite lived intangible assets for 2011 and 2010 indicated that no impairment of goodwill or the intangibles existed.
Stock-Based Compensation
We use generally accepted valuation option-pricing models to determine the fair value of stock options granted to our employees. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. Valuation models require the input of highly subjective assumptions, which represents our best estimate. The following are the key assumptions used to determine the stock-based compensation expense:
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Expected Stock Price Volatility - The computation of expected volatility is derived from a blend of our own historical volatility as well as the historical volatilities of comparable group of publicly listed companies within our industry over a period equal to the expected term of our options.
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Expected Term of Option - The expected term was determined using the simplified method.
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Expected Dividend Yield - The dividend yield assumption is based on our history and expectation of dividend payouts. We use a dividend yield of zero, as we have never paid cash dividends and do not expect to pay dividends in the future.
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Expected Risk Free Interest Rate - The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for the expected term of the option.
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Forfeiture Rate - The forfeiture rate is based on a review of historical forfeiture activity on a quarterly basis.
Accounting for Income Taxes
We account for income taxes using the asset and liability approach, which requires the recognition of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in our financial statements or tax returns. The measurement of current and deferred tax liabilities and assets are based on provisions of the enacted tax law. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be more likely than not realized. A judgment must then be made to determine the likelihood that any deferred tax asset will be utilized to offset taxable income. To the extent that we determine that it is more-likely-than-not that its deferred tax assets will not be utilized, a valuation allowance is established. A change in taxable income in future periods that is significantly different from that projected may cause adjustments to the valuation allowance that could materially increase or decrease future income tax expense.
We account for uncertainty in income taxes using a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely to be realized upon ultimate settlement. An uncertain tax position is considered effectively settled on completion of an examination by a taxing authority if certain other conditions are satisfied.
Business Combinations
Amounts paid for each acquisition are allocated to the assets acquired and liabilities assumed based on their relative fair values at the date of acquisition. Fair value was determined using the Income Approach (discounted cash flow approach) valuation methodology. Such valuations require management to make significant estimates and assumptions, especially with respect to the identifiable intangible assets. Management makes estimates of fair value based upon assumptions believed to be reasonable and that of a market participant. These estimates are based on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. The separately identifiable intangible assets generally include technology and customer relationships. We estimate the fair value of deferred revenue related to product support assumed in connection with acquisitions. The estimated fair value of deferred revenue is determined by estimating the costs related to fulfilling the obligations plus a normal profit margin. The estimated costs to fulfill the support contracts are based on the historical direct costs related to providing the support. We then allocate the purchase price in excess of net tangible assets acquired to identifiable intangible assets based on detailed valuations that use information and assumptions provided by management. We allocate any excess purchase price over the fair value of the net tangible and intangible assets acquired and liabilities assumed to goodwill.
Key Financial Highlights
Revenues increased by 11%, or $19.3 million in 2011 as compared to 2010, including incremental revenues of $48.6 million due to the acquisition of the former Veraz Networks, Inc. business on October 1, 2010. The $48.6 million of incremental revenue increase is comprised of $28.9 million in product revenue, or 15% of total revenues, and $19.7 million in services revenues, or 10% of total revenues. Our IP product revenues were $79.1 million in 2011, or 40% of total revenues, as compared to $51.2 million in 2010, or 29% of total revenues, an increase of 54% or $27.9 million. Our TDM products revenues were $78.0 million in 2011, or 39% of total
revenues, as compared to $111.3 million in 2010, or 62% of total revenues, a decrease of 30% or $33.3 million due primarily to the expected decline in the TDM markets. Our services revenues were $41.0 million in 2011, or 21% of total revenues, as compared to $16.3 million in 2010, or 9% of total revenues, an increase of 151% or $24.7 million.
Revenues, excluding the incremental impact from the Acquisition, declined by 16%, or $29.3 million in 2011 as compared to 2010. The revenue decline is primarily attributable to a continued decline in our TDM revenues which was not offset by a corresponding increase in our IP product or Service revenue.
Gross profit of 58% was consistent in 2011 as compared to 59% in 2010.
Operating expenses increased by 13%, or $17.1 million in 2011 as compared to 2010 mainly due to incremental expenses of $35.3 million due to the acquisition of the Veraz Networks, Inc. business. The $35.3 million of incremental expense is comprised of $13.9 million in research and development expenses, $11.3 million in sales and marketing expenses and $10.1 million in general and administrative expenses.
Operating expenses, excluding the incremental impact from the Acquisition, decreased 14%, or $18.2 million in 2011 as compared to 2010. The operating expense decrease is primarily due to a decrease in stock-based compensation expense of $4.3 million. In 2010 we recognized $6.6 million in acquisition costs in 2010, while no acquisition costs were recognized in 2011. Other decreases of $11.2 million in salaries and benefits were achieved from our cost reduction initiatives implemented in 2011 and 2010. In addition, depreciation and amortization expense decreased by $3.3 million in 2011, primarily related to the decreasing carrying values of purchased assets. Other cost increases totaled $2.0 million. Restructuring charges increased by $5.2 million in 2011 compared to 2010 as our post-merger integration plans were implemented.
At December 31, 2011, we had cash and cash equivalents of $10.4 million and an additional $2.3 million in available borrowing under a Revolving Credit Agreement previously described. At December 31, 2010, we had cash and cash equivalents of $24.6 million and an additional $3.5 million in available borrowing under the Revolving Credit Agreement. At December 31, 2011 and 2010, we had bank indebtedness of $12.5 million and $12.8 million, respectively. At December 31, 2011 and 2010, we had short-term and long-term debt payable to related parties of $94.7 million and $93.8 million, respectively.
Net cash used in operations was $10.5 million in 2011 as compared to $5.9 million in 2010. The 2010 cash used in operating activities included $6.5 million in amounts paid for acquisition costs.
Results of Operations (amounts in 000’s)
Comparison of Years Ended December 31, 2011 and 2010
Revenues
Total revenues were $198.1 million for the year ended December 31, 2011 and increased by 11% or $19.3 million from $178.8 million in the year ended December 31, 2010. Included in the total revenue increase is $48.6 million due to the Acquisition for the year ended December 31, 2011. The $48.6 million revenue increase is attributable to sales of $21.4 million in the Americas region; $23.5 million in the Europe, Middle East and Africa region; and $3.7 million in the Asia Pacific region. Our IP product revenues were 40% of total revenues at $79.1 million in 2011 as compared to $51.2 million in 2010, an increase of 54% or $27.8 million. Our TDM products revenues were 39% of total revenues at $78.0 million in 2011 as compared to $111.3 million in 2010, a decrease of 30% or $33.3 million. Our services revenues were 21% of total revenues at $41.0 million in 2011 as compared to $16.3 million in 2010, an increase of 151% or $24.7 million. The $48.6 million revenue increase attributable to the acquisition is comprised of $28.5 million in IP product revenue, or 14% of total revenues, $0.4 million in TDM product revenue, or 0.2% of total revenue, and $19.7 million in services revenues, or 10% of total revenues.
Revenues, excluding the incremental impact from the Acquisition, were $149.5 million, for the year ended December 31, 2011, which represented a decrease of 16%, or $29.3 million, from $178.8 million in the year ended December 31, 2010. The decrease in revenue is primarily attributable to the decline in revenues for our TDM technology products (our Legacy products) of $33.7 million, primarily attributable to the decreasing revenue of TDM traditional blades which decreased by $14.8 million, and NMS Boards which decreased by $9.2 million. The decrease in TDM revenue is part of the expected decline in this older product. This decrease was partially offset by incremental revenues of $5.0 million from services revenue. We expect IP product revenues to increase as we grow our sales of existing IP products (our NextGen products) and introduce new IP products to the marketplace.
The $29.3 million decrease in revenue, excluding the incremental impact from the Acquisition, from December 31, 2011 to December 31, 2010, resulted from a decrease in sales in the three regions. Americas declined by $17.2 million, Europe, Middle East and Africa revenues decreased by $9.3 million and Asia Pacific decreased by $2.8 million. The decrease in revenues in the three regions is due to continued challenging global economic conditions, and continued decline in demand for our TDM products.
In Americas, our IP product revenues, excluding the incremental impact from the Acquisition, increased by 15% or $3.0 million to $23.9 million in 2011, as compared to $20.8 million in 2010. Our TDM product revenues decreased by 39%, or $22.9 million to $35.8 million in 2011, as compared to $58.7 million in 2010. Our services revenues increased by 31% or $2.6 million to $11.2 million in 2011, as compared to $8.6 million in 2010.
In Europe, Middle East and Africa, our IP product revenues, excluding the incremental impact from the Acquisition, decreased by 25% or $5.1 million to $15.5 million in 2011 as compared to $20.6 million in 2010. Our TDM product revenues decreased by 22%, or $6.0 million to $21.8 million in 2011 as compared to $27.8 million in 2010. Services revenues increased by $1.8 million in 2011 to $7.7 million as compared to $5.8 million in 2010.
In Asia Pacific, our IP product revenues, excluding the incremental impact from the Acquisition, increased by 15% or $1.5 million to $11.2 million in 2011, as compared to $9.7 million in 2010. Our TDM product revenues decreased by 19% or $4.8 million to $20.0 million in 2011, as compared to $24.8 million in 2010. Services revenues increased by $0.5 million in 2011 to $2.5 million, as compared to $1.9 million in 2010.
Product Revenue
Product revenues of $157.1 million for the year ended December 31, 2011 decreased by 3% or $5.4 million from $162.4 million in the year ended December 31, 2010. Included in product revenues is an increase of $28.9 million due to the Acquisition for the year ended December 31, 2011.
Product revenues, excluding the incremental impact from the Acquisition, of $128.1 million for the year ended December 31, 2011 decreased by 21%, or $34.3 million, from $162.4 million in the year ended December 31, 2010. The decline resulted from lower customer demand for our TDM products and the challenge that global economic conditions had on investment in new IP product deployment. The TDM products revenues are expected to decline as there is a gradual conversion of the telecommunication networks to the IP technology.
Service Revenue
Service revenues of $41.0 million for the year ended December 31, 2011 increased by 151% or $24.7 million from $16.3 million in the year ended December 31, 2010. Included in service revenues for the year ended December 31, 2010 is an increase of $19.7 million due to the Acquisition.
Service revenues of $21.3 million, excluding the incremental impact from the Acquisition, for the year ended December 31, 2011 increased by 31%, or $5.0 million, from $16.3 million in the year ended December 31, 2010. The increase in service revenue was the result of being able to maintain our installed base of product customers and a related increase in IP maintenance revenue.
Cost of Revenue and Gross Profit
Cost of Revenue
Cost of revenues was $82.4 million for the year ended December 31, 2011, which increased by 13% or $9.3 million from $73.1 million in the year ended December 31, 2010. Included in cost of revenues is an increase of $20.0 million due to the Acquisition for the year ended December 31, 2011 and $1.5 million representing a legal settlement.
Cost of product revenues of $61.0 million for the year ended December 31, 2011 decreased by 1% or $0.7 million from $61.7 million in the year ended December 31, 2010. Included in cost of product revenues is an increase of $11.6 million due to the Acquisition for the year ended December 31, 2011 and $1.5 million representing a legal settlement.
Cost of product revenues, excluding the incremental impact from the Acquisition and the legal settlement, decreased by $13.8 million in 2011 as compared to 2010. The decrease is attributable to $10.1 million in lower outsourced product manufacturing costs due to a decline in product quantities ordered. Amortization expense decreased by $1.1 million in 2011 to $8.2 million as compared to $9.3 million in 2010, due to the amortization policy of the economic consumption method where the expense decreases over the asset life of our acquired intangibles. In addition, salaries and related benefits decreased by $2.1 million in 2011 as compared to 2010, occupancy costs decreased by $0.3 million and other costs decreased by $1.2 million. Partly offsetting these expense decreases is an increase in outside services of $0.3 million in 2011 which totaled $0.5 million in 2011 as compared to $0.2 million in 2010.
Cost of services revenues of $21.4 million for the year ended December 31, 2011 increased by 88% or $10.0 million from $11.4 million in the year ended December 31, 2010. Included in the cost of services revenues is an increase of $8.4 million due to the Acquisition for the year ended December 31, 2011.
Cost of services includes the direct costs of customer support and consists primarily of payroll, related benefits and travel for our support personnel. Cost of services, excluding the incremental impact from the Acquisition, was $13.0 million for the year ended December 31, 2011 compared to $11.4 million for the year ended December 31, 2010. The cost increase in 2011 as compared to 2010 primarily results from increased average headcount and an increase in outside services associated with third party vendors supplying maintenance services.
Gross Profit
Gross profit of $115.7 million for the year ended December 31, 2011 increased by 10% or $10.0 million from $105.6 million in the year ended December 31, 2010. Included within the gross profit increase is $28.3 million due to the Acquisition for the year ended December 31, 2011 and $1.5 million representing a legal settlement. As a percentage of sales, product gross profit was 61% in 2011 and 62% in 2010. The gross margin did not materially change since the products had similar gross margins. As a percentage of sales, services gross profit was 48% in 2011 as compared to 30% in 2010 due to an increased mix of service revenue attributable to the Acquisition.
For the year ended December 31, 2011, gross profit, excluding the incremental impact from the Acquisition and the legal settlement, decreased by 16%, or $16.7 million, from $105.6 million for the year ended December 31, 2010 to $88.9 million for the year ended December 31, 2011. The decrease is primarily a result of a decline in TDM product revenues.
Operating Expenses
Research and Development Expenses
Research and development expenses of $54.6 million for the year ended December 31, 2011 increased by 18% or $8.4 million from $46.2 million in the year ended December 31, 2010. Included in the total research and development expenses are $13.9 million in additional expenses from the Acquisition for the year ended December 31, 2011. The incremental research and development costs are comprised of salaries and related costs of $10.2 million, occupancy costs of $2.5 million, equipment depreciation of $0.6 million, consultants of $0.4 million, and other costs of $1.5 million partially offset by research grants from the Israeli government of $1.3 million.
Research and development expenses, excluding the incremental impact from the Acquisition, decreased by 12%, or $5.5 million in 2011 to $40.6 million as compared to $46.2 million in 2010. The decrease is primarily attributable to a decrease in headcount of 27 employees in 2011 as compared to 2010, which lowered the salaries and related employee benefits by $3.7 million. Depreciation expense decreased by $0.3 million, occupancy costs decreased by $0.7 million and all other expenses decreased by $0.8 million in 2011 as compared to 2010.
Research and development expenses increased to 28% of total revenues in 2011 from 26% of total revenues in 2010. We expect that research and development expenses will decrease in 2012 both in absolute dollars and as a percentage of total revenue as we continue to integrate our research and development operations during the year.
Sales and Marketing
Sales and marketing expenses were $54.3 million for the year ended December 31, 2011, which increased by 5% or $2.8 million from $51.5 million in the year ended December 31, 2010. Included within the sales and marketing expenses are $11.4 million in additional expenses due to the Acquisition for the year ended December 31, 2011. The incremental sales and marketing costs related to the Acquisition are salaries and related costs of $5.8 million, sales commissions of $2.2 million, sales agents and consultant expenses of $0.5 million, occupancy costs of $1.3 million, travel of $0.7 million and other costs of $0.9 million.
Sales and marketing expenses, excluding the incremental impact from the Acquisition, decreased by 17%, or $8.6 million in 2011 to $42.9 million as compared to $51.5 million in 2010. The decrease is primarily attributable to a decrease in salaries and related employee benefit expenses of $4.7 million resulting from a decrease of 23 employees, and a decrease in depreciation and amortization expense of $2.4 million. Occupancy expense decreased by $0.5 million, outside services expense decreased by $0.8 million and other expenses decreased by $0.2 million.
Sales and marketing expenses decreased to 27% of total revenues in 2011 from 29% of total revenues in 2010. We expect that sales and marketing will decrease in 2012 both in absolute dollars and as a percentage of total revenue as we continue to integrate our sales and marketing operations during the year.
General and Administrative
General and administrative expenses were $35.9 million for the year ended December 31, 2011, which increased by 26% or $7.4 million from $28.5 million in the year ended December 31, 2010. Included in general and administrative expenses is $10.1 million
due to the Acquisition for the year ended December 31, 2011. The incremental general and administrative expenses from the Acquisition are salaries and related costs of $3.9 million, legal and accounting fees of $1.7 million, consulting fees of $3.4 million, and other costs of $1.1 million.
General and administrative expenses, excluding the incremental impact from the Acquisition, decreased by 9%, or $2.6 million in 2011 to $25.9 million as compared to $28.5 million in 2010. The decrease is primarily attributable to decreases in salaries and related employee benefits of $1.4 million, which includes an increase in stock-based compensation expense of $0.4 million, depreciation and amortization expense of $0.6 million, legal, accounting and consulting fees of $0.3 million and other expenses of $0.3 million. Included in general and administrative expenses for the year ended December 31, 2011 are $3.7 million in costs related to the SEC informal inquiry.
General and administrative expenses increased to 18% of total revenues in 2011 from 16% of total revenues in 2010. We expect that general and administrative expenses will decrease in 2012 both in absolute dollars and as a percentage of total revenue as we continue to integrate our general and administrative operations during the year.
Acquisition Costs
For the year ended December 31, 2010, we recorded acquisition costs of $6.6 million mainly related to $4.0 million in investment bankers fees, and $2.6 million in legal and accounting fees.
We did not recognize any acquisition costs in 2011.
Restructuring Charges
In a continued effort to consolidate certain operations across all organizations, we incurred employee termination costs for severance and benefits aggregating to $3.7 million and $2.0 million during the years ended December 31, 2011 and 2010, respectively, resulting from the termination of approximately 60 and 59 individuals during the years ended December 31, 2011 and 2010, respectively. During the second quarter of 2011, we vacated our Salem, New Hampshire facility and accrued $0.1 million in non-cancellable lease obligations. In addition, we vacated a portion of our New Jersey facilities during 2011 and expensed $3.4 million for the non-cancellable lease obligations and related costs associated with the vacated space.
We expect to realize approximately $3.5 million in annualized salary and benefits savings and an additional $0.9 million in facilities costs from our restructuring efforts
Interest and Other Income (expense), net
Interest and other income, net was $0.1 million in 2011 as compared to interest and other income, net of $0.5 million in 2010. This decrease relates primarily to the receipt of $0.5 million related to a legal settlement in 2010.
Interest Expense
Interest expense increased by $0.2 million or 1%, from $17.8 million in 2010 to $18.0 million in 2011. The increase over 2010 is primarily attributable to higher interest expense on the Term Loan Agreement and the Revolving Credit Agreement which were partially offset by a decrease in amortization of debt issuance costs. Interest expense on the Stockholder Loans increased by $0.1 million in 2011. The average interest rate was 14.5% on the Term Loan Agreement and 5.75% on the Revolving Credit Agreement in 2011 compared to 13.5% on the Term Loan Agreement and 6.0% on the Revolving Credit Agreement in 2010. Interest expense for 2011 consisted of $0.9 million relating to the Revolving Credit Agreement, $14.1 million relating to the Term Loan Agreement and amortization of debt issuance costs of $3.0 million.
Interest expense for 2010 consisted of $11.7 million and $1.4 million in PIK interest to be paid at the Term Loan maturity date under the Term Loan Agreement, and $3.3 million of amortization charges for deferred debt issuance costs related to the Term Loan and Revolving Credit Lender. We also recorded $0.8 million of interest expense under the Revolving Credit Agreement and $0.7 million of PIK interest expense related to the Stockholder Loans in 2010.
Foreign Exchange Losses, net
The $0.3 million foreign exchange losses in 2011 and 2010 were due to unfavorable foreign exchange rates to monetary assets and liabilities denominated in currencies other than the U.S. dollar.
Income Tax Provision (Benefit)
For the year ended December 31, 2011, we recorded an income tax provision of $0.3 million which was primarily due to current income taxes in our foreign jurisdictions offset by a current period release of reserves related to uncertain tax positions due to expiring statues of limitations. In addition, we released a valuation allowance against our deferred tax assets in France. The income tax benefit for the year ended December 31, 2010 of $0.2 million primarily related to carrying back net operating losses and changes in uncertain tax positions.
Redemption Value of Preferred Shares
Preferred shares are recorded at full redemption value at each balance sheet date as redemption of those securities are not solely within our control. For the year ended December 31, 2010, due to the Acquisition, we recorded a $3.0 million charge to additional paid-in capital related to a change in redemption value of the preferred shares as of the Acquisition date of October 1, 2010 when we acquired all of the outstanding preferred shares of Dialogic Corporation in consideration of the issuance of shares of our common stock.
Financial Position
Liquidity and Capital Resources
As of December 31, 2011, we had cash and cash equivalents of $10.4 million (of which approximately $8.7 million was held by our subsidiaries outside of the U.S. and could be subject to tax implications if repatriated to the U.S.) Our primary anticipated sources of liquidity are funds generated from operations, and as required, funds borrowed under the Revolving Credit Agreement. As of December 31, 2011, we had borrowed $12.5 million under our Revolving Credit Agreement. Under the Revolving Credit Agreement, the unused line of credit totaled $12.5 million, of which $2.4 million was available to us. At December 31, 2011, we had long-term debt of $94.7 million under the Term Loan Agreement and Stockholder Loans. Following the restructuring of our debt in March 2012 and the Private Placement, $60 million of our long-term debt matures in March 2015, and $39.5 million of Notes will convert into shares of our common stock upon stockholder approval of the Private Placement, if it occurs, and $100 was cancelled in exchange for a share of our Series D-1 Preferred Stock. The following summarizes the activity under the Term Loan and Stockholder Loans, including interest, in 2011 and 2010:
During 2011, we decreased borrowings by $0.3 million under the Revolving Credit Agreement and used net cash in operating activities of $10.5 million. As of December 31, 2011, total liquidity including cash and availability under the Revolving Credit Agreement was $12.7 million as compared to $28.1 million on December 31, 2010.
We budget capital expenditures on an annual basis. For each of the 2011 and 2010 fiscal years budgeted capital expenditures for property and equipment totaled $3.0 million. Total capital expenditures in 2011 amounted to $2.6 million. Management expects to remain within our capital expenditures budget of approximately $3.5 million for fiscal year 2012.
In 2012, the cash requirement to service the mandatory interest payments on the Term Loan and Revolving Credit Agreements is estimated to be $6.5 million.
We monitor and manage liquidity by preparing and updating annual budgets as well as monitor compliance with terms of our financing agreements.
For the year ended December 31, 2011, we incurred a net loss of $54.8 million and used cash in operating activities of $10.5 million. As of December 31, 2011, our cash and cash equivalent balance was $10.4 million, our current bank indebtedness was $12.5 million and our long-term debt with related parties was $94.7 million. As discussed in Note 9 to the consolidated financial statements, on March 22, 2012, the Term Lenders agreed to restructure $89.9 million of our current debt into a new three-year long-term note with a maturity date of March 31, 2015 and, as discussed in Note 20, $33.0 million of outstanding debt under the Term Loan Agreement and $5.0 million in outstanding debt owed to the Related Party Lenders was cancelled in exchange for Notes.
As of December 31, 2011, we were not in compliance with any of the financial covenants then in effect under the Term Loan Agreement and were also in default under the Revolving Credit Agreement. Although existing defaults were waived in connection with the third amended and restated Term Loan Agreement and the Seventeenth Amendment, if we fail to comply with the covenants under such agreements, the maturity date of our outstanding indebtedness may be accelerated. In addition, under the terms of the Notes, if stockholder approval and the resulting conversion of the Notes do not occur by June 30, 2012, the outstanding principal amount and all accrued and unpaid interest under the Notes shall become due and payable on such date; provided, that amounts due under the Notes cannot be repaid before amounts outstanding under the Term Loan Agreement and Revolving Credit Agreement.
While we believe that our current cash resources, together with anticipated product and services revenues, will be sufficient to fund our operations, including interest payments, in 2012, they may not be sufficient to fund both our operations and repayment of principal on our outstanding indebtedness in 2013 or beyond. Further, we do not anticipate having sufficient cash and cash equivalents to repay the debt should the Revolving Credit Lender or the Term Lenders accelerate the maturity date of outstanding debt or if the Notes become due and payable, and we would be forced to seek alternative sources of financing. In light of these circumstances, we are currently seeking additional capital through public or private debt or equity financings or development financings.
However, there are no assurances that those efforts will be successful or that additional capital will be available on terms that do not adversely affect our existing stockholders or restrict our operations, if it is available at all. If we raise additional funds through the issuance of debt securities, these securities could have rights that are senior to holders of our common stock and could include different financial covenants, restrictions and financial ratios other than what we currently operate under. The conversion of the Notes, if it occurs, will result in substantial dilution to our stockholders and any additional equity financing would also likely be substantially dilutive to our stockholders, particularly in light of the prices at which our common stock has been recently trading. In addition, if we raise additional funds through the sale of equity securities, new investors could have rights senior to our existing stockholders. The terms of any future financings may restrict our ability to raise additional capital, which could delay or prevent the further development or marketing of our products and services. Our need to raise capital before the repayment of our debt becomes due may require us to accept terms that may harm our business or be disadvantageous to our current stockholders, particularly in light of the current illiquidity and instability in the global financial markets.
In the event of an acceleration of our obligations under the Term Loan Agreement or Revolving Credit Agreement and our failure to pay the amounts that would then become due, the Revolving Credit Lender or Term Lenders could seek to foreclose on our assets. As a result of this, or if our stockholders do not approve the Private Placement and the Notes become due and payable, we would likely need to seek protection under the provisions of the U.S. Bankruptcy Code and/or our affiliates might be required to seek protection under the provisions of applicable bankruptcy codes. In that event, we could seek to reorganize our business, or we or a trustee appointed by the court could be required to liquidate our assets. In either of these events, whether the stockholders receive any value for their shares is highly uncertain. If we needed to liquidate our assets, we might realize significantly less from them than the value that could be obtained in a transaction outside of a bankruptcy proceeding. The funds resulting from the liquidation of our assets would be used first to pay off the debt owed to secured creditors, including the Term Lenders, Revolving Credit Lender, followed by any unsecured creditors such as the holders of the Notes, before any funds would be available to pay our stockholders. If we are required to liquidate under the federal bankruptcy laws, it is unlikely that stockholders would receive any value for their shares.
Operating Activities
Net cash used in operating activities of $10.5 million in 2011 was primarily attributable to our net loss of $54.8 million, offset by adjustments for non-cash items aggregating to $25.1 million for items such as depreciation, amortization, stock-based compensation, PIK interest on long-term debt, allowance for doubtful accounts, deferred income taxes and other non-cash charges, which amounts to $29.7 million before net changes in operating assets and liabilities. Our operating assets decreased by $21.0 million and our operating liabilities decreased by $1.8 million. The decrease in operating assets, relates to accounts receivable of $7.4 million, inventories of
$6.9 million, and prepaid expenses and other assets of $6.7 million. The decrease in our operating liabilities is primarily attributable to a decrease of $2.1 million in deferred revenue, an increase of $0.5 million in interest payable, a decrease in income taxes payable of $0.3 million, and an increase of $0.2 million in accounts payable and accrued liabilities.
Net cash used in operating activities of $5.9 million in 2010 was primarily attributable to our net loss of $46.7 million, offset by adjustments for non-cash items aggregating to $33.6 million for items such as depreciation, amortization, stock-based compensation, interest payable-in-kind on long-term debt, allowance for doubtful accounts, deferred income taxes and other non-cash charges, which amounts to $13.1 million before net changes in operating assets and liabilities, net of the effect of the Acquisition. Our operating assets and liabilities increased by $5.4 million and $12.6 million, net of the effect of the Acquisition. The increase in operating assets, relates to accounts receivable of $2.8 million, and prepaid expenses and other assets of $2.8 million. The increase in our operating liabilities is primarily attributable to an increase of $8.3 million in deferred revenue, an increase of $2.6 million in interest payable, and an increase of $2.4 million in accounts payable and accrued liabilities.
Investing Activities
Net cash used in investing activities of $3.7 million in 2011 consisted primarily of $2.6 million in purchases of property and equipment and an increase in restricted cash of $0.8 million.
Net cash provided by investing activities of $26.4 million in 2010 consisted primarily of cash assumed from the Acquisition of $29.4 million offset by $2.6 million in purchases of property and equipment.
Financing Activities
Net cash used in financing activities of $15 thousand in 2011 included a net $0.3 million repayment of our Revolving Credit Agreement facility to fund our operations which was partly offset by $0.3 million in proceeds from the exercise of stock options and issuance of shares pursuant to our Employee Stock Purchase Plan.
Net cash provided by financing activities of $0.1 million in 2010 included a $2.6 million payment of debt issuance costs related to the Acquisition for the closing of the Term Loan and Revolving Credit Agreements, offset by $2.5 million in proceeds from our Revolving Credit Agreement facility to fund our operations and $0.2 million in proceeds from the exercise of stock options.
Off-Balance Sheet Arrangements
At December 31, 2011, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, special purpose or variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. We do not have any off-balance sheet arrangements that are currently material or reasonably likely to be material to our consolidated financial position or results of operations.
Recent Accounting Pronouncements
See Note 2(w) of the Consolidated Financial Statements for a full description of the recent accounting pronouncements including the expected date of adoption and effect on results of operations and financial condition.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Not applicable.
Item 8.
Item 8. Financial Statements and Supplementary Data
Index to Consolidated Financial Statements
Page
Report of Independent Registered Public Accounting Firm
Consolidated Financial Statements:
Consolidated Balance Sheets
Consolidated Statements of Operations and Comprehensive Loss
Consolidated Statements of Stockholders’ Equity (Deficit) and Redeemable Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of
Dialogic Inc.:
We have audited the accompanying consolidated balance sheets of Dialogic Inc. (the Company) and subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of operations and comprehensive loss, stockholders’ equity (deficit) and redeemable equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Dialogic Inc. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
/s/ KPMG LLP
Short Hills, New Jersey
April 16, 2012
DIALOGIC INC.
Consolidated Balance Sheets
(in thousands)
See accompanying notes to consolidated financial statements.
DIALOGIC INC.
Consolidated Statements of Operations and Comprehensive Loss
(in thousands, except per share data)
See accompanying notes to consolidated financial statements.
DIALOGIC INC.
Consolidated Statements of Stockholders’ Equity (Deficit) and Redeemable Equity
(in thousands, except share data)
See accompanying notes to consolidated financial statements
DIALOGIC INC.
Consolidated Statements of Cash Flows
(in thousands)
See accompanying notes to consolidated financial statements.
DIALOGIC INC.
Notes to Consolidated Financial Statements
Note 1 - The Company
Dialogic Inc. (the “Company”) is a leading provider of communications platforms and technology that enable developers and service providers to build and deploy innovative applications without concern for the complexities of the communication medium or network. The Company specializes in providing products and solutions that enhance the mobile communications experience. The Company’s technology impacts over two billion mobile subscribers and its network solutions carry more than 15 billion minutes of traffic per month.
Wireless and wireline service providers use the Company’s products to transport, convert and manage data and voice traffic while enabling VoIP and other multimedia services. These service providers also utilize the Company’s underlying technology to provide innovative revenue-generating value-added services such as messaging, SMS, voice mail and conferencing. These services are also increasingly becoming video-enabled. Enterprises rely on the Company’s innovative products to enable the integration of IP and wireless technologies and endpoints into existing communication networks, and to enable applications that serve businesses, including unified communication applications, contact center and IVR/ IVVR.
The Company sells its products to both enterprise and service provider customers and sell both directly and indirectly through distribution partners such as TEMs, VARs and other channel partners. The Company’s customers build their enterprise communications solutions, their networks, or their value-added services on its products.
The Company was incorporated in Delaware on October 18, 2001 as Softswitch Enterprises, Inc., and subsequently changed its name to NexVerse Networks, Inc. in 2001, Veraz Networks, Inc. in 2002 and Dialogic Inc. in 2010. Companies the Company has acquired have been providing products and services for nearly 25 years.
Acquisition
On October 1, 2010, the transaction contemplated by the Acquisition Agreement, dated May 12, 2010, (the “Acquisition Agreement”) was consummated, by and between the Company (formerly Veraz Networks, Inc.) and Dialogic Corporation, pursuant to which Dialogic Corporation became a wholly owned subsidiary of the Company (the “Arrangement”). On October 1, 2010, the Company also effected: (1) an amendment to its amended and restated certificate of incorporation to change the name from “Veraz Networks, Inc.” to “Dialogic Inc.” (the “Name Change Amendment”); and (2) an amendment to its amended and restated certificate of incorporation to effect a reverse stock split of the issued and outstanding shares of the Company’s common stock, pursuant to which each five shares of common stock outstanding became one share of common stock, (the “Reverse Stock Split Amendment”).
The Arrangement was accounted for as a reverse acquisition under the purchase method of accounting whereby Dialogic Corporation was considered the accounting acquirer in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) for accounting and financial reporting purposes. As such, on the acquisition date of October 1, 2010, the assets and liabilities of the former Veraz Networks, Inc. were assessed at fair value and the assets and liabilities of Dialogic Corporation were carried over at the historical cost. Refer to Note 3 for details on the allocation of the consideration transferred. For the year ended December 31, 2010, the statement of operations and statement of cash flows include the historical results of Dialogic Corporation. For all reporting periods following the consummation of the Arrangement, the statements of operations and statements of cash flows include the results of the former Veraz Networks, Inc. since the date of acquisition of October 1, 2010.
All common stock share and per share data presented in the accompanying consolidated financial statements have been retroactively restated to give effect to the reverse stock split. Also, all common stock share and per share data presented in the accompanying consolidated financial statements reflects the legal capital of the former Veraz Networks, Inc. and the common stock share and per share amounts reflect the shares outstanding of the former Dialogic Corporation retroactively adjusted for the exchange ratios in the Acquisition Agreement to reflect the number of shares received in the business combination.
The Reverse Stock Split Amendment and the Name Change Amendment became effective after the close of markets on October 1, 2010 and the common stock of Dialogic Inc. began trading on The NASDAQ Global Market on a post-reverse-split basis on October 4, 2010 under the new symbol “DLGC”.
DIALOGIC INC.
Notes to Consolidated Financial Statements
Note 2 - Summary of Significant Accounting Policies
The significant accounting policies of the Company are as follows:
(a) Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated upon consolidation.
(b) Use of Estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates and assumptions include the useful lives of long-lived assets, the allowance for doubtful accounts, the reserves for sales returns and allowances, inventory obsolescence and warranty obligation, the valuation of deferred tax assets, stock-based compensation, income tax uncertainties, impairment testing of goodwill and intangible assets and estimating the fair value of assets acquired and liabilities assumed at date of acquisition for businesses acquired. The financial statements include estimates based on currently available information and management’s judgment as to the outcome of future conditions and circumstances. Changes in the status of certain facts or circumstances could result in material changes in the estimates used in the preparation of the consolidated financial statements, and actual results could differ from the estimates and assumptions. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. The Company adjusts such estimates and assumptions when facts and circumstances dictate. Illiquid credit markets, volatile equity, foreign currency, emerging markets, and declines in consumer spending have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in those estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.
(c) Basis of Presentation
For the year ended December 31, 2010, the Company changed the presentation of its consolidated statements of stockholders’ equity (deficit). Dialogic Corporation was the acquiree for legal purposes in the Arrangement, but for accounting purposes, Dialogic Corporation was the acquirer of the Company. The consolidated financial statements prepared following the closing of the Arrangement are issued in the name of the Company, but are a continuation of the financial statements of Dialogic Corporation, with one adjustment: the legal capital is retroactively adjusted to reflect the legal capital of the Company. As the consolidated financial statements represent the continuation of the financial statements of Dialogic Corporation, except for the capital structure, consolidated financial statements after the close of the Arrangement reflect:
•
The assets and liabilities of Dialogic Corporation recognized and measured at their pre-combination carrying amounts;
•
The assets and liabilities of the former Veraz Networks, Inc. recognized and assessed at fair value at the closing date in accordance with Accounting Standards Codification (“ASC”) 805; and
•
The results of operations of Dialogic Corporation plus the results of operations of the former Veraz Networks, Inc. commencing on the date of the Arrangement and the related purchase accounting adjustments to measure the former Veraz Networks, Inc.’s assets and liabilities at fair value.
Certain prior year presentations were adjusted to conform to the current year presentation.
(d) Risks and Uncertainties
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. For the years ended December 31, 2011 and 2010, the Company incurred a net loss of $54.8 million and $46.7 million, respectively, and used cash in operating activities of $10.5 million and $5.9 million, respectively. As of December 31, 2011, the Company’s cash and cash equivalent balance was $10.4 million, of which approximately $8.7 million was held by the Company’s subsidiaries outside the U.S. and could be subject to tax implications if repatriated to the U.S. Its current bank indebtedness was $12.5 million and its short-term and long-term debt, including accrued interest, with related parties was $98.1 million. Events of default existing under the second amended and restated credit agreement dated October 1, 2010 (the “Term Loan Agreement”) with Obsidian,
DIALOGIC INC.
Notes to Consolidated Financial Statements
LLC, as agent, and Special Value Expansion Fund, LLC and Tennenbaum Opportunities Partners V, LP, as lenders (collectively the “Term Lenders”) and the credit agreement dated as of March 5, 2008, as amended (the Revolving Credit Agreement”), with Wells Fargo Foothill Canada ULC, as administrative agent and lender (the “Revolving Credit Lender”), as of December 31, 2011 have been waived by the Term Lenders and Revolving Credit Lender pursuant to the third amendment and restatement of the Term Loan Agreement and the Seventeenth Amendment to the Revolving Credit Agreement (the “Seventeenth Amendment”), respectively, each entered into on March 22, 2012. In addition, $33.0 million of outstanding debt under the Term Loan Agreement was cancelled in exchange for convertible promissory notes on April 11, 2012, as discussed further in Note 20 below. However, if future defaults occur under the Term Loan Agreement or Revolving Credit Agreement, or the convertible promissory notes become due and payable, then the Company does not anticipate having sufficient cash and cash equivalents to repay the debt under these agreements should it be accelerated and would be forced to seek alternative sources of financing. There can be no assurances that alternative financing will be available on acceptable terms or at all. In the event of an acceleration of the Company’s obligations under the Revolving Credit Agreement or Term Loan Agreement and the Company’s failure to pay the amounts that would then become due, the Revolving Credit Lender and Term Loan Lenders could seek to foreclose on the Company’s assets, as a result of which the Company would likely need to seek protection under the provisions of the U.S. Bankruptcy Code and/or its affiliates might be required to seek protection under the provisions of applicable bankruptcy codes. In that event, the Company could seek to reorganize its business, or the Company or a trustee appointed by the court could be required to liquidate its assets. In either of these events, whether the stockholders receive any value for their shares is highly uncertain. If the Company needed to liquidate its assets, the Company might realize significantly less from them than the value that could be obtained in a transaction outside of a bankruptcy proceeding. The funds resulting from the liquidation of its assets would be used first to pay off the debt owed to secured creditors, including the Term Lenders, Revolving Credit Lender followed by any unsecured creditors such as the convertible promissory notes, before any funds would be available to pay its stockholders. If the Company is required to liquidate under the federal bankruptcy laws, it is unlikely that stockholders would receive any value for their shares.
In order for the Company to meet the debt repayment requirements under the Term Loan Agreement and Revolving Credit Agreement, the Company will need to raise additional capital by refinancing its debt, raising equity capital or selling assets. Uncertainty in future credit markets may negatively impact the Company’s ability to access debt financing or to refinance existing indebtedness in the future on favorable terms, or at all. If additional capital is raised through the issuance of debt securities or other debt financing, the terms of such debt may include different financial covenants, restrictions and financial ratios other than what the Company currently operates under. Any equity financing transaction could result in additional dilution to the Company’s existing stockholders.
Based on the Company’s current plans and business conditions, it believes that its existing cash and cash equivalents, expected cash generated from operations and available credit facilities will be sufficient to satisfy its anticipated cash requirements during fiscal 2012.
(e) Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with an original or remaining maturity of three months or less at the date of purchase to be cash equivalents. Cash and cash equivalents are maintained with several high credit quality financial institutions.
(f) Restricted Cash
Restricted cash represents collateral securing guarantee arrangements with banks. The amounts expire upon achievement of certain agreed objectives, typically customer acceptance of the product, completion of installation and commissioning services, or expiration of the term of the product warranty or maintenance period.
(g) Inventories
Inventories are stated at the lower of cost or market, with cost being determined using the first-in, first-out method. In assessing the net realizable value of inventories, the Company is required to make judgments as to future demand requirements and compare these with the current or committed inventory levels. Once inventory has been written down to its estimated net realizable value, its carrying value cannot be increased due to subsequent changes in demand forecasts. To the extent that a severe decline in forecasted demand occurs, or the Company experiences a higher incidence of inventory obsolescence due to rapidly changing technology and customer requirements, the Company may incur significant charges for excess inventory.
Title and risk of loss of inventory generally transfer to the customer when the product is shipped. However, when certain revenue arrangements require evidence of customer acceptance where the services have been identified as critical to the functionality, the Company classifies the delivered product as inventory in the accompanying consolidated financial statements. The revenue associated
DIALOGIC INC.
Notes to Consolidated Financial Statements
with such delivered product is deferred as a result of not meeting the revenue recognition criteria (see Note 2(i)). During the period between product shipment and acceptance, the Company recognizes all labor-related expenses as incurred but defers the cost of the related equipment and classifies the deferred costs as “Work in process” within the inventories line item (see Note 5). These deferred costs are then expensed in the same period that the deferred revenue is recognized as revenue (generally upon customer acceptance or in the case of contingent revenue provisions, when amounts are no longer contingent). In arrangements for which revenue recognition is limited to amounts due and payable because of extended payment terms, all related inventory costs are expensed at the date of customer acceptance.
(h) Concentrations and Credit risk
Cash and cash equivalents are maintained with several financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and therefore bear minimal risk.
Credit risk results from the possibility that a loss may occur from the failure of another party to perform according to the terms of the contract. The Company’s financial assets that are exposed to credit risk consist primarily of cash and accounts receivable. Cash is placed with major financial institutions. Concentration of credit risk with respect to accounts receivable is mitigated by the Company’s credit evaluation process, credit insurance on certain receivables and the dispersion of the Company’s customers among different geographical locations around the world. The carrying amount of these financial assets, as disclosed in the consolidated balance sheet, represents the Company’s credit exposure at the reporting date.
No customers accounted for over 10% of the Company’s revenues in 2011 and one customer accounted for 10% of the Company’s revenues in 2010. One customer accounted for 12% of the Company’s accounts receivable as of December 31, 2011. As of December 31, 2010, a different customer accounted for 10% of the Company’s accounts receivable.
No supplier accounted for 10% or more of the Company’s purchases in 2011. Two suppliers accounted for 10% or more of the Company’s purchases in 2010.
(i) Revenue Recognition
•
Revenue Recognition Criteria
Revenue derived from the sale of products and services is recognized when all of the following criteria are met:
(i) Persuasive evidence of an arrangement exists - The Company’s customary practice is to have a written contract, which is signed by both the customer and the Company, or a purchase order or other written or electronic order documentation for those customers who have previously negotiated a standard arrangement with the Company.
(ii) Delivery has occurred - Delivery of hardware and software products generally occurs at the point of shipment when title and risk of loss have passed to the customer. However, some arrangements require evidence of customer acceptance of the hardware and software products that have been sold. In such cases, delivery of the software, hardware and services is not considered to have occurred until evidence of acceptance is received from the customer or the Company has completed its contractual requirements. Revenue from sales of standalone services, including training courses, is recognized when the services are completed. In certain arrangements involving subsequent sales of hardware and software products to expand a customers’ networks, the revenue recognition on these arrangements after the initial arrangement has been accepted, typically occurs at the point of shipment, since the Company has historically experienced successful implementations of these expansions and customer acceptance, although contractually required, does not represent a significant risk.
(iii) The fee is fixed or determinable - The Company sells its products through its direct sales force and channel partners. In certain cases where the sales price cannot be reliably determined due to frequent sales price reductions or returns cannot be estimated, the related fee is considered to be not fixed or determinable and revenue is deferred until such price reduction or return rights cease.
Arrangement fees are generally due within one year or less from date of acceptance, or the date of delivery if no acceptance. Some arrangements may have payment terms extending beyond these customary payment terms and therefore the arrangement fees may not be considered to be fixed or determinable. For multiple element arrangements with payment terms that are not considered to be fixed or determinable, revenue is recognized as payments become due, based on relative selling price, after delivery and acceptance of the software, hardware, and services, and assuming all other revenue recognition criteria are
DIALOGIC INC.
Notes to Consolidated Financial Statements
satisfied. For arrangements with contingent revenue provisions (a portion of the relative selling price of a delivered item is contingent upon the delivery of additional items or meeting other specified performance conditions), revenue recognized on delivered items is limited to the non-contingent amount. The Company defers the cost of inventory when products have been shipped, but have not yet been recognized as revenue, and expenses those costs in full in the same period that the deferred revenue is recognized as revenue (generally upon customer acceptance or in the case of contingent revenue provisions, when amounts are no longer contingent). In arrangements for which revenue recognition is limited to amounts due because of extended payment terms, inventory costs are expensed upon acceptance. This will initially result in lower or negative product margins for those arrangements and cause higher margins in subsequent periods, as compared to similar arrangements with customary payment terms.
(iv) Collectability is probable - Collectability is assessed on a customer-by-customer basis. The Company evaluates the financial position, payment history, and ability to pay of new customers, and of existing customers that substantially expand their commitments. If it is determined prior to revenue recognition that collectability is not probable, recognition of the revenue is deferred and recognized upon receipt of cash, assuming all other revenue recognition criteria are satisfied. In arrangements for which revenue recognition is limited to amounts of cash received because of collectability concerns, all related inventory costs are expensed at the date of acceptance or delivery if no acceptance is required; this will initially result in lower or negative product margins and cause higher margins in subsequent periods, as compared to similar arrangements with customary payment terms.
Revenue received from maintenance contracts is presented as deferred revenue and is recognized into revenue on a straight-line basis over the term of the contract. License fee revenue is recognized upon delivery of the license or software and when all performance criteria are met. Revenue derived from the sale of products is generally recognized when title and risk of loss has been transferred to the customer. In addition, product, maintenance contract and license fee revenues are recognized when persuasive evidence of an arrangement exists, amounts are fixed or can be determined, and ability to collect is probable.
•
Revenue Reserves and Adjustments
Sales incentives which are offered on some of the Company’s products are recorded as a reduction of revenue as there are no identifiable benefits received. The Company records a provision for estimated sales returns and allowances as a reduction from sales in the same period during which the related revenue is recorded. These estimates are based on historical sales returns and allowances, analysis of credit memo data and other known factors.
The Company has agreements with certain distributors which allow for stock rotation rights. The stock rotation rights permit the distributors to return a defined percentage of their purchases. Most distributors must exchange this stock for orders of an equal or greater amount. The Company recognizes an allowance for stock rotation rights based on historical experience. The provision is recorded as a reduction in revenues in the period during which the related revenue is recognized.
The Company also has agreements with certain distributors that allow for price adjustments. The Company recognizes an allowance for these price adjustments based on historical experience. The price adjustments are recorded as a reduction in revenue in the period during which the related revenue is recognized.
Revenues are primarily recognized net of sales taxes. Revenues include amounts billed to customers for shipping and handling. Shipping and handling fees represented less than 1% of revenues in each of the years ended December 31, 2011 and 2010. Shipping and handling costs are included in cost of revenues.
•
Multiple Element Arrangements
In October 2009, the Financial Accounting Standards Board (“FASB”) amended the accounting standards for revenue recognition to remove tangible products containing software components and non-software components that function together to deliver the product’s essential functionality from the scope of industry specific software revenue recognition guidance. In October 2009, the FASB also amended the standards for multiple deliverable revenue arrangements to:
i. provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and how the arrangement consideration should be allocated among its elements;
ii. require an entity to allocate revenue where no vendor specific objective evidence exists (“VSOE”) by using third party evidence of selling price (“TPE”) or estimated selling prices (“ESP”); and
iii. eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method.
DIALOGIC INC.
Notes to Consolidated Financial Statements
This new accounting guidance became applicable to the Company beginning the first quarter of its fiscal year 2011. The Company adopted this guidance for transactions that were entered into or materially modified on or after January 1, 2011 using the prospective basis of adoption. The Company’s products typically have both software and non-software components that function together to deliver the products’ essential functionality. Although the Company’s products are primarily marketed based on the software elements contained therein, the hardware sold generally cannot be used apart from the software. Therefore, the Company considers its principal hardware products to be subject to this new accounting guidance. Many of the Company’s sales involve multiple-element arrangements that include product, maintenance and various professional services. The adoption of the guidance discussed above affects the Company’s multiple-element arrangements when they contain tangible products (hardware) with software elements, which comprise the majority of the Company’s revenue transactions. The Company may enter into sales transactions that do not contain tangible hardware components, such as software-only add-on sales, which will continue to be subject to the previous software revenue recognition guidance in ASC 985-605.
The multiple-deliverable revenue guidance requires that the Company evaluate each deliverable in an arrangement to determine whether such deliverable represents a separate unit of accounting.
The delivered item constitutes a separate unit of accounting when it has stand-alone value to the customer. If the arrangement includes a general refund or return right relative to the delivered item and the delivery and performance of the undelivered items are considered probable and substantially in the Company’s control, the delivered element constitutes a separate unit of accounting. In instances when the aforementioned criteria are not met, the deliverable is combined with the undelivered elements and revenue recognition is determined for the combination as a single unit of accounting. Most of the Company’s products and services qualify as separate units of accounting because they are sold separately or the customer could resell them on a standalone basis and, accordingly, revenue is recognized when the applicable revenue recognition criteria are met.
The total arrangement fees are allocated to all the deliverables based on their respective relative selling prices. The relative selling price is determined using VSOE, when available. The Company generally uses VSOE to derive the selling price for its maintenance and professional services deliverables. VSOE for maintenance is based on contractual stated renewal rates while professional services are based on historical pricing for standalone professional service transactions. When VSOE cannot be established, the Company attempts to determine the TPE for the deliverables. TPE is determined based on competitor prices for similar deliverables when sold separately by the competitors. Generally the Company’s product offerings differ from those of its competitors and comparable pricing of its competitors is often not available. Therefore, the Company is typically not able to determine TPE. When the Company is unable to establish selling price using VSOE or TPE, the Company uses ESP in its allocation of arrangement fees. The ESP for a deliverable is determined as the price at which the Company would transact if the products or services were sold on a standalone basis. The ESP for each deliverable is determined using average historical discounted selling prices based on several factors, including but not limited to, marketing strategy, customer considerations and pricing practices in a region. The Company uses ESP to derive the relative selling price for its product deliverables.
The impact of applying the relative selling price method in the allocation of revenue, compared to previous revenue recognition methodologies, increased revenues for the year ended December 31, 2011 by approximately $0.7 million. In terms of the timing and pattern of revenue recognition, the new accounting guidance for revenue recognition is not expected to have a significant effect on revenues in periods after the initial adoption when applied to multiple element arrangements. However, as the Company’s marketing and product strategies evolve, the Company may modify its pricing practices in the future, which could result in changes in selling prices, including both VSOE and ESP which could impact future revenues.
For transactions entered into prior to the first quarter of fiscal year 2011, the Company recognized revenue based on the software revenue recognition guidance in place during the period in which the order was received. When an arrangement involved multiple elements, such as hardware and software products, maintenance and/or professional services, the Company allocated the entire sales price to each respective element based on VSOE of the fair value for each element. When arrangements contained multiple elements and VSOE of fair value existed for all undelivered elements but not for the delivered elements, the Company recognized revenue for the delivered elements using the residual method. The Company based its determination of VSOE of the fair value of the undelivered elements based on substantive renewal rates of maintenance and support agreements, and on independently sold and negotiated service arrangements. In limited circumstances when arrangements containing multiple elements where VSOE of fair value did not exist for an undelivered element, the Company deferred revenue for the delivered and undelivered elements until VSOE of fair value existed for the undelivered elements or all elements had been delivered.
DIALOGIC INC.
Notes to Consolidated Financial Statements
(j) Deferred Revenue
Deferred revenue represents fixed or determinable amounts billed to or collected from customers for which the related revenue has not been recognized because one or more of the revenue recognition criteria have not been met. Advances paid by customers prior to the delivery of product and services, due to existing legal arrangements for futures sales as of the balance sheet date, are classified as deferred revenue. Revenue from maintenance contracts is presented as deferred revenue and is recognized into revenue on a straight-line basis over the term of the contract. The current portion of deferred revenues represents deferred revenue that is expected to be recognized as revenue within 12 months from the balance sheet date. The long-term portion of deferred revenues represents deferred revenue that is expected to be recognized as revenue beyond 12 months from the balance sheet date.
(k) Product Warranties
The Company’s products are generally subject to warranties, and liabilities are established for the estimated future costs of repair or replacement through charges to cost of revenues at the time the related sale is recognized. Factors considered in determining appropriate accruals for product warranty obligations include the size of the installed base of products subject to warranty protection, historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. The Company assesses the adequacy of its preexisting warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in future estimates.
(l) Property and Equipment and Intangible Assets
Property and equipment are stated at cost less accumulated depreciation. Upon retirement or disposal, the cost of the asset disposed of and the related accumulated amortization are removed from the accounts, and any gain or loss is reflected in income. Expenditures for repairs and maintenance are expensed as incurred.
Depreciation and amortization
Depreciation and amortization are based on estimated useful lives using the following methods, rates and periods:
Property and equipment:
Method
Rate/period
Computer software, other than operating system and ERP
Straight-line
3 years
Computer operating system
Straight-line
3 years
ERP systems
Straight-line
10 years
Computer equipment
Straight-line
3 years
Furniture and fixtures
Straight-line
3 years
Machinery and equipment
Straight-line
5 years
Leasehold improvements
Straight-line
Lesser of lease term and economic life, to a maximum of 10 years
Intangible assets:
Software licenses
Straight-line
3 years
Technology
Economic consumption
2 to 10 years
Customer relationships
Economic consumption
6 to 14 years
The Company has operating leases related to its leased office space, equipment and cars.
(m) Impairment of Long-Lived Assets
Long-lived assets, such as property and equipment, and definite-lived intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposal group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. Definite-lived intangible assets were tested for impairment during the last quarter of fiscal 2011 and no impairment was identified.
DIALOGIC INC.
Notes to Consolidated Financial Statements
Intangible assets with indefinite useful lives are not amortized and are tested for impairment annually, or more frequently, if events or changes in circumstances indicate that the asset may be impaired. The impairment test compares the carrying amount of the intangible asset with its fair value, and an impairment loss is recognized for the excess, if any. The impairment testing for indefinite- lived intangibles is performed during the last quarter of the fiscal year. This impairment test performed during the last quarter of fiscal 2011 did not reveal any impairment.
(n) Goodwill
Goodwill represents the excess of the purchase price over the fair value of the net assets acquired in a business acquisition. Goodwill is not subject to amortization and is tested for impairment annually or more frequently if events or circumstances indicate that the asset might be impaired. Impairment is identified by comparing the fair value of the reporting unit to which the goodwill relates to its carrying value. To the extent the carrying amount exceeds its fair value, the Company measures the amount of impairment by the excess of carrying value over the implied fair value of goodwill. The impairment is charged to income in the period in which it is determined. The impairment testing is performed during the last quarter of the fiscal year.
During the quarters ended December 31, 2011 and 2010, the Company performed its annual impairment review of goodwill and concluded that there was no impairment in either year.
(o) Advertising Costs
The Company expenses all advertising costs as incurred. The Company incurred $66 thousand and $0.9 million in advertising costs in 2011 and 2010, respectively.
(p) Research and Development
Research and development expenses are charged to expense as incurred. These costs include payroll, employee benefits, equipment depreciation, materials, and other personnel-related costs associated with product development. Costs incurred with respect to internally developed technology and engineering services included in research and development are expensed as incurred.
(q) Government-Sponsored Research and Development
The Company records grants received from the Office of the Chief Scientist of the Israeli Ministry of Industry, Trade, and Labor, (the “OCS”), as a reduction of research and development expenses on a monthly basis, based on the estimated reimbursable cost incurred. Royalties payable to the OCS are classified as cost of revenues.
(r) Foreign Currency Translation
Functional and reporting currency:
The Company’s revenues, expenses, assets and liabilities are primarily denominated in U.S. dollars, and as a result, the Company adopted the U.S. dollar as its functional and reporting currency. The Company has identified certain foreign subsidiaries where the functional currency is their local reporting currency. Translation gains or losses are recorded in foreign exchange gains (losses), net in the accompanying consolidated statements of operations.
Foreign currency translation:
For foreign subsidiaries using the U.S. dollar as their functional currency, transactions and monetary balances denominated in non-dollar currencies are remeasured into dollars using current exchange rates. Monetary assets and liabilities are revalued into the functional currency at each balance sheet date using the exchange rate in effect at that date, with any resulting exchange gains or losses being credited or charged to the foreign exchange gains (losses), net in the accompanying consolidated statements of operations. Non-monetary assets and liabilities are measured and recorded in the functional currency using the exchange rate in effect at the date of the transaction and are not revalued for subsequent changes in exchange rates.
For foreign subsidiaries using the local currency as their functional currency, assets and liabilities are translated at exchange rates in effect at the balance sheet date and income and expenses are translated at average exchange rates. The effect of these translation adjustments are reported as a separate component of stockholders’ equity.
DIALOGIC INC.
Notes to Consolidated Financial Statements
(s) Accounts Receivable and Allowance for Doubtful Accounts
Generally, the Company’s receivables are recorded when billed and represent claims against third parties that will be settled in cash. The carrying value of the receivables, net of the allowance for doubtful accounts, represents their estimated net realizable value.
The Company maintains an allowance for doubtful accounts for estimated losses inherent in its accounts receivable portfolio. In establishing the required allowance, management considers historical losses, current receivable aging and evaluates individual customer receivables by considering its knowledge of a customer’s financial condition, credit history and current economic conditions. The Company writes off trade receivables when they are deemed uncollectible. The Company reviews its allowance for doubtful accounts regularly. However, judgment is required to determine whether an increase or reversal of the allowance is warranted. The Company will record an increase of the allowance if there is a deterioration in past due balances, if economic conditions are less favorable than the Company had anticipated, or for customer-specific circumstances, such as bankruptcy. The Company will record a reversal of the allowance if there is significant improvement in collection rates. Historically, the allowance has been adequate to cover the actual losses from uncollectible accounts.
(t) Income Taxes
The Company accounts for income taxes using the asset and liability approach, which requires the recognition of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. The measurement of current and deferred tax liabilities and assets are based on provisions of the enacted tax law. A valuation allowance is provided if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
The Company classifies interest and penalties related to uncertain tax contingencies as a component of income tax expense in the consolidated statement of operations. Income taxes payable are recorded whenever there is a difference between amounts reported by the Company in its tax returns and the amounts the Company believes it would likely pay in the event of an examination by the taxing authorities. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in the recognition or measurement are reflected in the period in which the change occurs.
(u) Comprehensive Income (Loss)
Comprehensive income (loss) consists of two components, net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) refers to revenue, expenses, gains and losses that are recorded as an element of stockholders’ equity but are excluded from net income (loss). The Company’s other comprehensive income (loss) consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency. There is no significant difference between the Company’s net loss and its total comprehensive loss for the years ended December 31, 2011 and 2010.
(v) Stock-Based Compensation
Stock-based compensation cost is estimated at the grant date based on the award’s fair-value as calculated by the Black-Scholes option-pricing model and is recognized as expense on a straight-line basis over the requisite service period. This model requires various judgment-based assumptions including expected volatility, interest rates and expected option life. Significant changes in any of these assumptions could materially affect the fair value of stock-based awards granted in the future; specifically, any changes in assumptions for expected volatility and expected life significantly affect the grant date fair value. Changes in the expected dividend rate and expected risk-free rate of return do not significantly impact the calculation of fair value, and determining these inputs is not highly subjective. The expected term represents the period that stock-based awards are expected to be outstanding, giving consideration to the contractual terms of the stock-based awards, vesting schedules, and expectations of future employee behavior as influenced by changes to the terms of the stock-based awards. The Company determined the expected term in accordance with the “simplified method” for a plain vanilla employee stock option for which the value was estimated using a Black-Scholes formula. Under this approach, the expected term would be presumed to be the mid-point between the vesting date and the end of the contractual term. The use of this approach was permitted as the Company did not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term due to the limited period of time its equity shares have been publicly traded. The computation of expected volatility is based on the historical and implied volatility of comparable companies from a representative peer group based on industry and market capitalization data.
DIALOGIC INC.
Notes to Consolidated Financial Statements
(w) Recent Accounting Pronouncements
In May, 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. The amendments in this ASU generally represent clarification of Topic 820, but also include instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with GAAP and International Financial Reporting Standards (“IFRS”). The amendments are effective for interim and annual periods beginning after December 15, 2011 and are to be applied prospectively. Early application is not permitted. The Company will adopt ASU 2011- 04 effective January 1, 2012 and this adoption is not expected to have a material impact on the Company’s condensed consolidated financial statements.
In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. The amendments in this ASU allow an entity to present components of net income and other comprehensive income in one continuous statement or in two separate, but consecutive statements. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in stockholders’ equity. While the new guidance changes the presentation of comprehensive income, there are no changes to the components that are recognized in net income or other comprehensive income under current accounting guidance. The amendments are effective for interim and annual periods beginning after December 15, 2011. The Company will adopt ASU 2011-05 effective January 1, 2012 and this adoption will not impact the Company’s consolidated financial position, results of operations or cash flows.
In September 2011, the FASB issued ASU No. 2011-08, Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment. This new guidance allows entities testing goodwill for impairment to perform a qualitative assessment before having to calculate the fair value of a reporting unit. If an entity determines, based on qualitative factors, that the fair value of the reporting unit is more-likely-than-not less than the carrying amount of that reporting unit, the existing quantitative impairment test is required. Otherwise, no further impairment testing is required. The guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 31, 2011 with early adoption permitted. The Company will adopt ASU 2011-08 for its annual or interim goodwill impairment testing performed after January 1, 2012. The adoption of this ASU is not expected to impact the Company’s consolidated financial position, results of operations or cash flows.
Note 3 - Acquisition
Completion of Dialogic Corporation Acquisition
Background
On October 1, 2010, the Company, completed its business combination with Dialogic Corporation in accordance with the terms of the Acquisition Agreement, pursuant to which the Dialogic Corporation became a wholly owned subsidiary of the Company. In accordance with the Acquisition Agreement, the Company acquired all of Dialogic Corporation’s outstanding common and preferred shares in exchange for an aggregate of 22,116,155 shares of Company’s common stock. Acquisition costs related to the business combination were $6.6 million and expensed during 2010 as disclosed in the accompanying consolidated statement of operations.
All outstanding options to purchase Dialogic Corporation’s common shares were cancelled and new options to purchase shares of the Company’s common stock were granted. Each such option became an option to acquire that number of shares of the Company’s common stock equal to the product obtained by multiplying the number of shares in the capital of Dialogic Corporation subject to such option by 0.9, rounded down to the nearest whole share of the Company’s common stock. Each such option has a purchase price per share of the Company’s common stock equal to the exercise price per share (in U.S. dollars) for such Dialogic Corporation option immediately prior to the consummation of the Arrangement divided by 0.9, rounded up to the nearest whole cent.
After taking into account the issuance of common stock in exchange for Dialogic Corporation’s preferred and common stock, as of immediately following the effective time of the Arrangement, the former Dialogic Corporation’s shareholders held approximately 70% of the total outstanding shares of common stock of the Company, and the former Veraz Networks, Inc. stockholders held approximately 30% of the Company’s outstanding common stock. As of October 1, 2010, immediately following the consummation of the Arrangement, there were approximately 31.0 million shares of the Company’s common stock issued and outstanding, after taking into account the one for five reverse stock split. As of December 31, 2010, there were approximately 31.2 million shares of the Company’s common stock issued and outstanding.
DIALOGIC INC.
Notes to Consolidated Financial Statements
The Arrangement was accounted for as a reverse acquisition under the purchase method of accounting whereby Dialogic Corporation was considered the accounting acquirer in accordance with U.S. GAAP for accounting and financial reporting purposes. As such, on the acquisition date of October 1, 2010, the assets and liabilities of the former Veraz Networks, Inc. were remeasured at fair value and the assets and liabilities of Dialogic Corporation were carried over at their historical cost. For the year ended December 31, 2010, the accompanying consolidated statements of operations and cash flows include the historical results of Dialogic Corporation. For all reporting periods following the consummation of the Arrangement, the accompanying consolidated statements of operations and statements of cash flows of the former Veraz Networks, Inc. are included from the date of acquisition of October 1, 2010.
The consideration transferred was based upon the fair value of the Company’s common stock outstanding of 8,919,158 shares as of October 1, 2010, multiplied by the stock closing price at October 1, 2010 of $6.65. The consideration transferred is based on the market price of the Company since management has determined that this was the most reliable measure of fair value. The total consideration transferred for the acquisition as of October 1, 2010 is as follows (in thousands):
Fair Value of Stock Awards
The fair value of the Company’s vested stock options and earned portion of the unvested restricted stock units were considered in the determination of the purchase price. At October 1, 2010, the number of vested options and the earned portion of the unvested restricted stock units of Dialogic used in computing the purchase price were 1,137,000 and 49,000, respectively.
The total fair value of the Company’s vested stock options and restricted stock units assumed as of October 1, 2010 was $4.1 million using the Black-Scholes option valuation model. The unearned compensation related to the Company’s stock options as of October 1, 2010 was determined to be $0.3 million, net of estimated forfeitures, and will be expensed on a straight line basis over the remaining service period.
The fair values of the Company’s stock options as of October 1, 2010 were estimated using the following assumptions:
The total purchase price was allocated based on the estimated fair value of net tangible and intangible assets acquired and assumed liabilities, and the excess of the purchase price over the fair value of the assets acquired and liabilities assumed has been recorded as goodwill. Goodwill recorded includes the value of establishing a global business enterprise in the telecommunications market. Intangible assets consist of product technology and customer relationships.
DIALOGIC INC.
Notes to Consolidated Financial Statements
The following table presents the fair value of the net assets assumed at date of acquisition (in thousands):
The intangible assets subject to amortization are being amortized on the economic consumption method during the useful lives below:
Supplementary pro forma information (Unaudited)
The following pro forma financial information reflects the consolidated results of operations as if the acquisition of Dialogic Corporation had taken place on January 1, 2009. The pro forma financial information is not necessarily indicative of the results of operations as it would have been, had the transactions been reflected on the assumed date. No effect has been given for synergies that may have been realized through the acquisition. The pro forma financial information also includes the business combination accounting effects resulting from the acquisition, including amortization charges from acquired intangible assets, stock-based compensation charges for unvested stock options and restricted stock-based awards assumed, adjustments to interest expense for borrowings and the elimination of merger costs incurred in 2010. Amounts are shown in thousands except per share amounts.
DIALOGIC INC.
Notes to Consolidated Financial Statements
Note 4 - Cash and Cash Equivalents
(a) Fair value
Assets are measured and recorded at fair value on a recurring basis for cash and cash equivalents as presented on the Company’s consolidated balance sheets as of December 31, 2011 and 2010. A summary of cash and cash equivalents, including restricted cash, were as follows (in thousands):
Cash equivalents consist of instruments with the remaining maturities of three months or less at the date of purchase.
If applicable, for other-than-temporary impairments, the Company discloses the gross unrealized losses and fair value for those investments that were in an unrealized loss position and have been in a continuous loss position. As of December 31, 2011 and 2010, the gross unrealized losses were zero.
Fair Value of Financial Instruments
The fair value guidance clarifies the definition of fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The guidance classifies the inputs used to measure fair value into the following hierarchy:
Level 1:
Unadjusted quoted prices in active markets for identical assets or liabilities
Level 2:
Unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the assets or liability
Level 3:
Unobservable inputs for the asset or liability
The Company measures its available-for-sale securities assets at fair value on a recurring basis and has determined that these financial assets were level 1 in the fair value hierarchy. The following table sets forth the Company’s financial assets that were measured at fair value on a recurring basis as of December 31, 2011 and 2010 (in thousands):
DIALOGIC INC.
Notes to Consolidated Financial Statements
Fair Value
The carrying amounts of cash, cash equivalents, accounts receivable, bank indebtedness, accounts payable and accrued liabilities and interest payable on long-term debt approximate fair value because of their generally short maturities. For cash equivalents the estimated fair values are based on market prices. In addition, the fair value of the long-term debt approximates the carrying amount since interest is based on fixed interest rates which approximate market-based interest rates for the same type of debt instrument. The fair value of the Company’s long-term debt is estimated by discounting the future cash flows for such instruments at rates currently offered to the Company for similar debt instruments of comparable maturities.
(b) Interest rate risk
The Company’s current monetary assets are not exposed to significant rate risk due to their relatively short-term nature. Excess cash was invested with major financial institutions and generally bears interest at fixed rates. Changes in interest rates on cash balances held with those financial institutions would not have a significant effect on the Company’s consolidated results. Bank indebtedness and the majority of long-term debt bear interest at floating rates, generally tied to LIBOR. Accordingly, the Company was exposed to interest rate risk to the extent that its long-term debt was at a variable rate of interest.
(c) Currency risk
A significant portion of the Company’s cash flows and financial assets and liabilities are denominated in U.S. dollars, which was the Company’s functional and reporting currency. Foreign currency risk was limited to the portion of the Company’s business transactions denominated in currencies other than U.S. dollars, primarily for expenses in the Company’s Canadian and European operations. For the Company’s foreign currency transactions, fluctuations in the respective exchange rates relative to the U.S. dollar will create volatility in the Company’s cash flows and the reported amounts for revenues and expenses in its consolidated statements of operations on a period-to-period basis. Additional earnings variability arises from the translation of foreign denominated monetary assets and liabilities for those foreign subsidiaries whose functional currency is the U.S. dollar, the impact of which was reported as foreign exchange gains and losses in the accompanying consolidated statements of operations.
Note 5 - Balance Sheet Components
The following tables provide details of selected balance sheet items as of December 31, 2011 and 2010 (in thousands):
DIALOGIC INC.
Notes to Consolidated Financial Statements
Depreciation expense was $4.8 million and $5.1 million for the years ended December 31, 2011 and 2010, respectively.
Accounts receivable
As of December 31, 2011 and 2010, accounts receivable aggregating approximately $10.9 million and $11.9 million were insured for credit risk, which are amounts that represent total insured accounts receivable less an average co-insurance amount of 10%, subject to the terms of the insurance agreement. Under the terms of the insurance agreement, the Company is required to pay a premium equal to 0.20% of consolidated revenues.
Other current assets
At December 31, 2011 and 2010, other current assets include $0.3 and $0.1 million in amounts due from stockholders for expenses that the Company has paid on their behalf.
Note 6 - Goodwill and Intangible Assets
The following was a summary of changes in goodwill for the fiscal years ended December 31, 2011 and 2010 (in thousands):
During 2011, the Company decreased goodwill by $0.4 million as a result of fair value adjustments to certain liabilities assumed in the business combination with Dialogic Corporation. The Company applies a fair value based impairment test to the carrying value of goodwill and indefinite-lived intangible assets on an annual basis in the fourth quarter of each fiscal year or earlier if indicators of impairment exist.
During 2010, the increase to goodwill relates to the business combination with Dialogic Corporation (see Note 3).
DIALOGIC INC.
Notes to Consolidated Financial Statements
Goodwill at December 31, 2011 and 2010 did not include any accumulated impairment losses.
The Company’s other intangible assets are comprised of the following:
Technology
Technology consists of patents, patent applications, design formulas, technical data, source code, drawings, and specifications and databases related to the developed technology.
Customer relationships
The acquired contractual customer relationships represent established relationships with customers of an acquired enterprise such that it can generate ongoing cash flows as well as the expectation of future business opportunities to be leveraged from the existing relationships with each client.
Trade names
Trade names consist of the Company’s and its subsidiaries’ registered trademarks including, but not limited to “Dialogic” , the dialogic.com domain name, and other registered and unregistered trademarks, trade names, service marks and registration applications. Trade names are considered to have an indefinite life because they are expected to contribute to cash flows for an indefinite period of time.
Software licenses
Software licenses represent the right to use software for a specified period of time.
DIALOGIC INC.
Notes to Consolidated Financial Statements
The following was a summary of other intangible assets as at December 31, 2011 and 2010 (in thousands):
Amortization expense was $13.8 million and $16.1 million for the years ended December 31, 2011 and 2010, respectively.
Estimated aggregate amortization expense based on existing intangibles for each of the five succeeding fiscal years and thereafter is approximately as follows (in thousands):
DIALOGIC INC.
Notes to Consolidated Financial Statements
Note 7 - Deferred Debt Issuance Costs
The following is a summary of changes in deferred debt issuance costs (in thousands):
Debt issuance costs are being amortized over the term of the related debt using the effective interest method and such amortization is classified as interest expense in the accompanying consolidated statements of operations.
As more fully described in Notes 8 and 9, certain events of default existing under the Revolving Credit Agreement and Term Loan Agreement were waived by the Revolving Credit Lender and Term Loan Lenders, respectively, on March 22, 2012.
As more fully described in Notes 8 and 9, during the year ended December 31, 2011, the Company accelerated the amortization of deferred debt issuance costs to reflect the potential acceleration of the maturity dates of the principal amounts and accrued interest under the Revolving Credit Agreement and Term Loan Agreement.
Note 8 - Bank Indebtedness
Dialogic Corporation has a working capital facility, the Revolving Credit Agreement with the Revolving Credit Lender. On March 22, 2012, Dialogic Corporation entered into a Consent and Seventeenth Amendment (“Seventeenth Amendment”) to the Revolving Credit Agreement. Under the Seventeenth Amendment, the Revolving Credit Lender waived the events of default existing under the Revolving Credit Agreement as of March 22, 2012 and agreed to certain amendments to the Revolving Credit Agreement. Specifically, pursuant to the Seventeenth Amendment, the Revolving Credit Agreement maturity date was amended and extended to the earlier of (i) March 31, 2015 and (ii) expiration of the Term Loan Agreement. Dialogic Corporation may borrow, repay and reborrow revolving credit loans from time to time provided that the aggregate principal amount of revolving credit loans outstanding at any time does not exceed the lesser of (i) $25.0 million, which is referred to as the “maximum revolver amount” or (ii) 85% of the aggregate amount of eligible accounts receivable, reduced by certain reserves and offsets and subject to certain caps in the case of accounts receivable owed to Dialogic Corporation and certain guarantors of the Revolving Credit Agreement, which is referred to as the “borrowing base.”
As of December 31, 2011, the borrowing base under the Revolving Credit Agreement amounted to $14.9 million, Dialogic Corporation had borrowed $12.5 million, and the unused line of credit totaled $12.5 million, of which $2.4 million was available for additional borrowings.
The following describes certain terms of the Revolving Credit Agreement, as amended by the Seventeenth Amendment:
Term. The commitment of the Revolving Credit Lender to make revolving credit loans terminates and all outstanding revolving credit loans are due on the maturity date described above. Dialogic Corporation may repay the facility at its own option with 30 days’ notice to the Revolving Credit Lender.
Mandatory Prepayments. Dialogic Corporation is required to prepay revolving credit loans in an amount equal to 100% of the net proceeds from the sale or other disposition of inventory other than in the ordinary course of business, subject to the right to apply the net proceeds to the acquisition of replacement property in lieu of prepayment.
Interest Rates and Fees. At Dialogic Corporation’s election, revolving credit loans may bear interest at a rate equal to the prime rate plus 1.5% or at a rate equal to reserve-adjusted one-, two- or three-month LIBOR plus 3%. Upon the occurrence and continuance of an event of default and at the election of the Revolving Credit Lender, the revolving credit loans will bear interest at a default rate equal to
DIALOGIC INC.
Notes to Consolidated Financial Statements
the then applicable interest rate or rates plus 2%. Dialogic Corporation pays the Revolving Credit Lender a monthly fee on the unused portion of the maximum revolver amount, as well as a monthly collateral management fee and an annual deferred closing fee.
The average interest rate for the years ended December 31, 2011 and 2010 was 5.75% and 6.1%, respectively.
Guarantors. The revolving credit loans are guaranteed by the Company, Dialogic (US) Inc., Cantata Technology, Inc., Dialogic Distribution Ltd., Dialogic Networks (Israel) Ltd. and Dialogic do Brasil Comercio de Equipamentos Para Telecomunicacao Ltda. (collectively the “Revolving Credit Guarantors”).
Security. The revolving credit loans are secured by a pledge of the assets of Dialogic Corporation and of the Revolving Credit Guarantors consisting of accounts receivable and inventory and related property. The security interest of the Revolving Credit Lender is prior to the security interest of the Term Lenders, as defined below, in these assets, subject to the terms and conditions of an intercreditor agreement.
Minimum EBITDA - Defined as earnings plus interest expense, taxes, depreciation, amortization, foreign exchange gain or loss and subject to certain additional adjustments in accordance with U.S. GAAP of at least $1.0 million for the three month period ending on June 30, 2012; $4.0 million for the six month period ending on September 30, 2012 and $7.5 million for the 9 month period ending December 31, 2012 to be tested only if the average amount of availability under the Revolving Credit Agreement plus unencumbered cash of Dialogic Corporation and the Revolving Credit Guarantors for the 30-day period preceding the applicable testing date is less than $2.5 million; and; $15.0 million for the 12 month period ending on March 31, 2013; $16.9 million for the 12 month period ending on June 30, 2013; $17.1 million for the 12 month period ending on September 30, 2013 and December 31, 2013; $18.1 million for the 12 month period ending on March 31, 2014; $19.4 million for the 12 month period ending on June 30, 2014; $20.9 million for the 12 month period ending on September 30, 2014; $22.6 million for the 12 month period ending on December 31, 2014; and $24.7 million for the 12 month period ending on March 31, 2015 and the last date of each 12-month period thereafter.
Other Terms. Dialogic Corporation, the Company and their subsidiaries are subject to affirmative and negative covenants, including restrictions on incurring additional debt, granting liens, entering into mergers, consolidations and similar transactions, selling assets, prepaying indebtedness, paying dividends or making other distributions on its capital stock, entering into transactions with affiliates and making capital expenditures. The Revolving Credit Agreement contains customary events of default, including a change in control of the Company and an Event of Default (as defined in the Revolving Credit Agreement, and which constitutes an event of default under the Term Loan Agreement), which results in a cross-default under the Term Loan Agreement.
At December 31, 2011, Dialogic Corporation was in default under the Revolving Credit Agreement. Specifically, Dialogic Corporation had breached all of the financial covenants under the Term Loan Agreement as of December 31, 2011, which constitutes a breach under the terms of the Revolving Credit Agreement, and the Minimum EBITDA covenant under the Revolving Credit Agreement. The events of default existing under the Revolving Credit Agreement as of December 31, 2011 were waived by the Revolving Credit Lender pursuant to the Seventeenth Amendment. During the year ended December 31, 2011, the Company amortized an additional $0.4 million of deferred debt issuance costs related to the accelerated amortization as a result of the breach of the covenants under the Term Loan Agreement. The Company also recorded bank fees of $25,000 paid during 2011 in connection the defaults under the Revolving Credit Agreement.
On April 11, 2012, Dialogic Corporation, the Company and certain of its subsidiaries entered into an Eighteenth Amendment to Revolving Credit Agreement (the “Eighteenth Amendment”), with the Revolving Credit Lender. Pursuant to the Eighteenth Amendment, the Revolving Credit Agreement was amended to permit the issuance of convertible notes in the Private Placement, as described in greater detail in Note 20, Subsequent Events.
Note 9 - Long-Term Debt and Related Party Transactions
Term Loan Agreement
On March 22, 2012, Dialogic Corporation entered into a third amended and restated Term Loan Agreement with the Term Lenders. Tennenbaum Capital Partners. LLC (“Tennenbaum”), a private equity firm, manages the funds of the Term Lenders. Tennenbaum also owns approximately 6.5% of the Company’s common stock as of December 31, 2011, which interest it originally acquired in Dialogic Corporation in 2006. During the years ended December 31, 2011 and December 31, 2010, a Managing Partner for
DIALOGIC INC.
Notes to Consolidated Financial Statements
Tennenbaum also served and continues to serve as a member of the Company’s Board of Directors and during the year ended December 31, 2009, a Managing Partner for Tennenbaum also served as a member of Dialogic Corporation’s Board of Directors. The Company incurred costs of $2.6 million paid to the Term Lenders in connection with the Term Loan Agreement, which was capitalized as debt issuance costs as of October 1, 2010. In connection with entering into the third amended and restated Term Loan Agreement, on March 22, 2012, the Company issued to the Term Lenders warrants to purchase 18 million shares of common stock with an exercise price of $1.00 per share, subject to stockholder approval.
As of December 31, 2011 and 2010, Dialogic Corporation owed long-term debt to the Term Lenders in the amounts of $89.9 million, and interest payable of $3.6 million and $3.0 million, respectively. As of March 22, 2012, interest accrued since December 31, 2011 in the amount of $3.0 million was added to the outstanding principal amount of the Term Loans. For the years ended December 31, 2011 and 2010, Dialogic Corporation recorded interest expense of $15.7 million and $16.1 million, respectively, related to the Term Loan Agreement of which zero and $1.4 million, respectively, related to accrued Payment-In-Kind (“PIK”) interest; and $2.4 million and $3.1 million, respectively, of amortization charges for deferred debt issuance costs. For the years ended December 31, 2011 and 2010, Dialogic Corporation paid cash of $12.7 million and $9.1 million related to the interest expense to the Term Lenders. In addition, during the years ended December 31, 2011 and 2010, the Term Lenders were paid $0 and $2.6 million, respectively, related to debt issuance costs.
The following table summarizes the short-term and long-term debt with related parties at December 31, 2011 and 2010 (in thousands):
Principal Amount and Maturity. At December 31, 2011, Term Loans in the principal amount of $89.9 million were outstanding under the Term Loan Agreement. The following describes certain provisions of the Term Loan Agreement as amended and restated on March 22, 2012. In addition to these provisions, under the Term Loan Agreement, the Term Lenders have at their discretion the ability to provide additional loans to Dialogic Corporation up to $10 million on the same terms as the Term Loans. As of April 5, 2012, the Company has received $1 million under this provision. As of March 22, 2012, $3.0 million of interest on the Term Loans accrued through March 22, 2012 was added to the principal thereof.
Maturity. The Term Loans are due on March 31, 2015.
Voluntary and Mandatory Prepayments. The Term Loans may be prepaid, in whole or in part, from time to time, subject to payment of (i) if prepaid prior to the first anniversary of the closing date, a premium of 5%, (ii) if prepaid after the first but prior to the second anniversary of the closing date, a premium of 2% and (iii) if prepaid after the second anniversary of the closing date, no premium is required.
Dialogic Corporation is required to offer to prepay the Term Loans out of the net proceeds of certain asset sales (including asset sales by the Company and its subsidiaries) at 100% of the principal amount of Term Loans prepaid, plus the prepayment premiums described above, subject to Dialogic Corporation’s right to retain proceeds of up to $1 million in the aggregate each fiscal year. Subject to the right to retain proceeds of up to $1.5 million in the aggregate in each fiscal year, Dialogic Corporation is also required to prepay the Term Loans out of 50% of the net proceeds from certain equity issuances by the Company and its subsidiaries, plus the prepayment premiums described above, except that no prepayment premium is required to be paid in respect of the first $35 million of net proceeds of an issuance by the Company of stock at a price of $1.25 per share or more.
Interest Rates. The Term Loans bear interest, payable quarterly in cash, at a rate per annum of 10% except that, in 2012 and thereafter if certain minimum cash requirements are not met, interest may be paid at the rate of 5% in cash with the remaining 5% added to principal and paid in kind (“PIK”). Upon the occurrence and continuance of an event of default, the Term Loans will bear interest at a default rate equal to the applicable interest rate plus 2%.
DIALOGIC INC.
Notes to Consolidated Financial Statements
Guarantors. The terms loans are guaranteed by the Company, Dialogic US Inc., Dialogic Distribution Limited, Dialogic Manufacturing Limited, Dialogic Networks (Israel) Ltd., Dialogic do Brasil Comercio de Equipamentos Para Telecomunicacao Ltda. and certain U.S. subsidiaries of the Company (collectively, the “Term Loan Guarantors”).
Security. The Term Loans are secured by a pledge of all of the assets of Dialogic Corporation and of the Term Loan Guarantors, including all intellectual property, accounts receivable, inventory and capital stock in the Company’s direct and indirect subsidiaries. The security interest of the Term Lenders in inventory, accounts receivable and related property of Dialogic Corporation and the Term Loan Guarantors is subordinated to the security interest of the Revolving Credit Lender in those assets.
Financial Covenants. The following summarizes the financial covenants as defined in the third amended and restated Term Loan Agreement:
•
Minimum Liquidity - Defined as either liquidity of not less than $15.0 million or Qualified Cash (as defined in the Term Loan Agreement) of not less than $10.0 million, as of March 31, 2013 and thereafter.
•
Minimum EBITDA - Defined as earnings plus interest expense, taxes, depreciation, amortization, foreign exchange gain or loss and subject to certain additional adjustments in accordance with U.S. GAAP of at least $15.0 million for the four quarters ending March 31, 2013; $16.9 million for the four quarters ending June 30, 2013; $17.1 million for the four quarters ending September 30, 2013 and December 31, 2013; $18.1 million for the four quarters ending March 31, 2014; $19.4 million for the four quarters ending June 30, 2014; $20.9 million for the four quarters ending September 30, 2014; $22.6 million for the four quarters ending December 31, 2014; and $24.7 million for the four quarters ending March 31, 2015.
•
Minimum Interest Coverage Ratio - Defined as the ratio of (i) Consolidated EBITDA for such period minus Consolidated Capital Expenditures for such period to (ii) Consolidated Interest Expense for such period and is not permitted to be less than the correlative ratio of 1.50 to 1 for the four quarters ending March 31, 2013, June 30, 2013, September 30, 2013, December 31, 2013, March 31, 2014, June 30, 2014, September 30, 2014, December 31, 2014 and March 31, 2015.
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Maximum Consolidated Total Leverage Ratio - Defined as the ratio of (i) the total consolidated debt outstanding at the end of the quarter to (ii) the consolidated EBITDA for such period and is not permitted to be greater than a ratio of 4.40 to 1 for the four quarters ending March 31, 2013; ratio of 3.90 to 1 for the four quarters ending June 30, 2013; ratio of 3.80 to 1 for the four quarters ending September 30, 2013; ratio of 3.90 to 1 for the four quarters ending December 31, 2013; ratio of 3.60 to 1 for the four quarters ending March 31, 2014; ratio of 3.40 to 1 for the four quarters ending June 30, 2014; ratio of 3.20 to 1 for the four quarters ending September 30, 2014; ratio of 2.90 to 1 for the four quarters ending December 31, 2014; and ratio of 2.7 to 1 for the four quarters ending March 31, 2015.
Other Terms. The Company, Dialogic Corporation and their subsidiaries are subject to various affirmative and negative covenants under the Term Loan Agreement, including restrictions on incurring additional debt and contingent liabilities, granting liens, making investments and acquisitions, paying dividends or making other distributions in respect of its capital stock, selling assets and entering into mergers, consolidations and similar transactions, entering into transactions with affiliates and entering into sale and lease-back transactions. The Term Loan Agreement contains customary events of default, including a change in control of the Company without the Term Lenders consent and an Event of Default (as defined in the Term Loan Agreement, and which constitutes an event of default under the Revolving Credit Agreement), which results in a cross-default under the Revolving Credit Agreement.
As of December 31, 2011, the Company was not in compliance with any of the financial covenants then in effect under the Term Loan Agreement. These defaults were waived by the Term Lenders pursuant to the third amended and restated Term Loan Agreement referred to above.
On April 11, 2012, Dialogic Corporation, the Company and certain of its subsidiaries entered into a First Amendment to the Term Loan Agreement (the “First Amendment”). Pursuant to the First Amendment, the Term Loan Agreement was amended to permit the conversion of $33.0 million of outstanding debt under the Term Loan Agreement in exchange for convertible notes as described in Note 20, and a share of the Company’s Series D-1 Preferred Stock, subject to payment of a prepayment premium of $1.5 million. The Term Loan Agreement was also amended to permit the Company to issue the remaining convertible notes sold in the Private Placement, as described in greater detail in Note 20, Subsequent Events.
Stockholder Loans
At December 31, 2011 and 2010, the Company had $4.8 million and $3.9 million, respectively, in long-term debt payable to certain stockholders of the Company (the “Related Party Lenders”), including the Company’s Chief Executive Officer and members of the Company’s Board of Directors, bearing interest at an annual rate of 20% compounded monthly in form of a PIK and repayable six months from the maturity date of the Term Loan Agreement, which, as of December 31, 2011 would have been March 2014, and
DIALOGIC INC.
Notes to Consolidated Financial Statements
under the third amended and restated Term Loan Agreement would be in September 2015. During the years ended December 31, 2011 and 2010, the Company recorded interest expense of $0.9 million and $0.7 million, respectively, related to these stockholder loans. There are no covenants or cross default provisions associated with these stockholder loans.
In the event that the Company consummates an equity financing before the loans are repaid, the Related Party Lenders, at their option, may convert the entire stockholder loan amount, including accrued PIK interest payable, into equity at the same rate and terms agreed to with other investors. The stockholder loan convertible option will apply solely to the first equity financing event consummated after October 1, 2010.
The stockholder loans were exchanged for convertible notes on April 11, 2012. See Note 20.
Note 10 - Restructuring Charges
In a continued effort to consolidate certain operations across all organizations, the Company incurred employee termination costs for severance and benefits aggregating to $3.7 million and $2.0 million during the years ended December 31, 2011 and 2010, respectively, resulting from the termination of approximately 60 and 59 individuals during the years ended December 31, 2011 and 2010, respectively. During the second quarter of 2011, the Company vacated its Salem, New Hampshire facility and expensed $0.1 million in non-cancellable lease obligations. In addition, the Company vacated a portion of its New Jersey facilities during the first quarter of 2011 and expensed $3.4 million for the non-cancellable lease obligations and related costs associated with the vacated space.
Restructuring activity for the years ended December 31, 2011 and 2010 was as follows (in thousands):
As of December 31, 2011, approximately $1.8 million of accrued restructuring expenses was included as a component of current accrued liabilities and $2.5 million was classified as long-term liabilities in the accompanying consolidated balance sheets. As of December 31, 2010, $1.7 million of accrued restructuring expenses was included in the Company’s current accrued liabilities. The Company expects to pay $1.4 million in employee related costs through December 31, 2012. The Company expects to pay $0.4 million in facilities costs through December 31, 2012 and the remaining $2.5 million over the lease periods ending in 2015.
Note 11 - Stockholders’ Equity
(a) Redeemable equity
Pursuant to the terms of the Acquisition Agreement, the Company acquired all of the outstanding common and preferred shares of Dialogic Corporation in consideration of the issuance of shares of the Company’s common stock. The Dialogic Corporation shareholders received an aggregate of 22.1 million shares of the Company’s common stock, of which 14.5 million shares were received by the Class A, B and C preferred shareholders. The Arrangement was carried out pursuant to a plan of arrangement pursuant to the British Columbia Business Corporation Act as set forth in the Acquisition Agreement. The holders of Class A, B and C preferred shares had the right to demand redemption of their shares from Dialogic Corporation at specified dates. The redemption price was determined to be the higher of the original subscription price or fair value as determined by the Dialogic Corporation Board of Directors. According to the Acquisition Agreement, on October 1, 2010 Dialogic Corporation’s Class A, B and C preferred shares were redeemed and converted into 7.2 million, 4.2 million and 3.1 million shares of the Company’s common stock, respectively, at the applicable conversion factors in the Acquisition Agreement.
DIALOGIC INC.
Notes to Consolidated Financial Statements
The Company follows the applicable U.S. GAAP and Securities and Exchange Commission (“SEC”) authoritative guidance for redeemable stock, which requires the Company to record the Class A, B and C shares at full redemption value at each balance sheet date as redemption of those securities is not solely within the control of the Company. In the absence of retained earnings or additional paid-in capital, increases to the redemption value of the securities are charged to paid-in capital (common stock). Decreases to the redemption value of the securities are credited to additional paid-in capital. During 2010, the Company recorded increases in the redemption values of the redeemable equity, which aggregated $3.0 million. These shares were exchanged for the Company’s common stock at the time of the acquisition.
(b) Reverse Stock Split
In accordance with the Reverse Stock Split Amendment, on October 1, 2010, the Company effected a reverse split of its common stock pursuant to which each five shares of common stock outstanding became one share of common stock. All references to shares in the consolidated financial statements and the accompany notes, including but not limited to the number of shares and per share amounts, unless otherwise noted, have been retroactively adjusted to reflect the reverse stock split for all periods presented. As a result, previously awarded options to purchase shares of the Company’s common stock by Dialogic Corporation have been also retroactively adjusted to reflect the reverse stock split.
Note 12 - Stock-Based Compensation
Employee Benefit Plans
For the year ended December 31, 2009 and for the period ended September 30, 2010, the Dialogic Corporation Employee Stock Option Plan (“ESOP”) was effective. For each period following October 1, 2010, the Company’s 2006 Equity Incentive Plan (“2006 Plan”) became effective due to the reverse acquisition of Dialogic Corporation and the Company’s adoption of the 2006 Plan on a go forward basis.
(i) Dialogic Corporation - ESOP for the period from January 1, 2009 through September 30, 2010
The ESOP was adopted on October 24, 2003 for the purchase of common shares and was for the benefit of the executives of Dialogic Corporation. The granting of options under the ESOP was limited to a 10% dilution factor and was based upon the approval of the Board. The options vested equally over three years and expire ten years from date of grant. Approximately 0.3 million initial options were granted under the original plan. The ESOP was subsequently amended to limit the dilution factor to 5%, to include all employees to increase the number of shares reserved for issuance under the ESOP and to amend the vesting conditions (“Amended Plan”), with the last amendment occurring in 2008.
The Amended Plan provides that the options will vest as follows: (i) 25% on the first anniversary of the grant date, and commencing one month after the first anniversary of the grant date and ending on the fourth anniversary of the grant date, 1/36 of the remaining 75% of the options shall vest each month; or (ii) at such other time or times as may be determined by the Board on the grant date, and shall expire ten years from the grant date. Options granted under the Amended Plan become exercisable once both the service and performance conditions (occurrence of a liquidation event such as an initial public offering or acquisition as defined in the Amended Plan) are probable of being achieved. Dialogic Corporation would only commence recognizing compensation expense once the performance conditions have been achieved in accordance with the vesting provisions.
As of December 31, 2009, the maximum number of common shares that could be issued under the ESOP was 1.6 million, of which 1.3 million (net of actual forfeitures) had been granted and 0.3 million were vested. Unless otherwise determined by the Board, on the date of grant of the option, the price at which common shares were to be purchased under the plan was the estimated fair market value of the common shares as at the date of issue, as determined by the Board.
For the options already granted under the ESOP, the provisions of the ESOP applied to the 0.3 million options issued thereunder, except that the holders could have exercised the options once vested without the occurrence of a liquidation event. In addition, the option holders retained the right to participate in dividends of the Dialogic Corporation in proportion to their shareholdings or options. However, until the options were exercised, any proportionate dividend was paid in the form of a cash bonus, at fair market value, concurrent with the payment of a dividend. The holders had the right to demand that the Dialogic Corporation repurchase their common shares upon termination of employment for their book value at that date. Reciprocally, Dialogic Corporation also had the right to repurchase any shares for their book value issued under the ESOP and Amended Plan upon an employee’s termination. These
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Notes to Consolidated Financial Statements
options were accounted for as liability classified awards, and the cumulative stock-based compensation expense recognized for these awards was zero through September 30, 2010.
For the remaining 1.0 million options granted under the Amended Plan, if and when the service and performance conditions are met, Dialogic Corporation would record in that period the cumulative expense that would have otherwise been recognized had the outcome of the performance conditions been known as at the grant date and the cumulative stock-based compensation expense recognized for these awards was zero through September 30, 2010.
On June 12, 2009, Dialogic Corporation’s Board of Directors approved a modification to the exercise price of all stock options issued under its amended stock option plan and reduced the exercise price of 0.9 million options granted subsequent to January 1, 2007 at exercise prices of $9.22 and $11.50 per share, to $6.17 per share.
(ii) The Company - 2006 Plan for the period from October 1, 2010 through December 31, 2011
The 2006 Plan is a stockholder approved plan of the Company, and is intended as the successor to and continuation of the Company’s 2001 Equity Incentive Plan (“2001 Plan”). The 2006 Plan provides for broad based grants to employees, directors and consultants. The 2006 Plan provides for the grant of the following stock awards: incentive stock options (“ISO”) nonstatutory stock options (“NSO”) restricted stock awards, restricted stock unit awards, stock appreciation rights, performance stock awards and other stock awards. Since April 2007, no additional stock awards were granted under the 2001 Plan and the shares that remained available for issuance pursuant to the exercise of options or settlement of stock awards under the 2001 Plan became available for issuance pursuant to stock awards granted under the 2006 Plan. Any shares subject to outstanding stock awards granted under the 2001 Plan that expire or terminate for any reason prior to exercise or settlement become available for issuance pursuant to stock awards granted under the 2006 Plan. All outstanding stock awards granted under the 2001 Plan are deemed to be stock awards granted pursuant to the 2006 Plan, but remain subject to the terms of the 2001 Plan with respect to which they were originally granted. All stock awards granted since April 2007 are subject to the terms on the 2006 Plan.
Through December 31, 2011, the Company had reserved 5.9 million shares of common stock for issuance under the 2006 Plan. The shares reserved under the 2006 Plan automatically increases on each January 1, beginning in 2006 and continuing through January 1, 2016, by the lesser of 3% of the total number of shares of common stock outstanding as of December 31 of the preceding calendar year, or a number of shares determined by the Board of Directors, but not in excess of 3 million shares. Options may be granted for periods of up to ten years and at prices equal to the estimated fair value of the shares on the date of grant, as determined by the Board of Directors based upon the stock price as posted on the NASDAQ Stock Market, provided, however, that the exercise price of an ISO or NSO granted under the Plans shall not be less than 100% or 85% of the estimated fair value of the shares on the date of grant, respectively. Options granted generally become exercisable over a period of four years, based on continued employment, with 25% of the shares underlying such options vesting one year after the vesting commencement date and with the remaining 75% of the shares underlying such options vesting in equal monthly installments during the following three years. Options generally terminate three months following the end of a grantee’s continuous service to the Company. In addition to the automatic plan increase on January 1, 2010, the Company increased its shares available for grant by 1.4 million shares on October 1, 2010 due to the acquisition.
DIALOGIC INC.
Notes to Consolidated Financial Statements
Stock Award Activity
A summary of the Company’s stock award activity and related information for the years ended December 31, 2011 and 2010 is set forth in the following table (in thousands except for exercise price amounts):
The total intrinsic value of options exercised was $0.3 million during both of the years ended December 31, 2011 and 2010.
As of December 31, 2011, the balance of $3.0 million of total unrecognized compensation costs related unvested stock options granted to employees and directors is expected to be recognized over a weighted average period of 2.9 years. As of December 31, 2011, the balance of $2.3 million of total unrecognized compensation costs related to unvested restricted stock units granted to employees and directors is expected to be recognized over a weighted average period of 1.3 years.
Stock-Based Compensation
The following table summarizes the effects of stock-based compensation (in thousands):
On October 1, 2010, due to the acquisition of Dialogic Corporation, the service and performance conditions were met, and the Company recorded the cumulative expense of $4.1 million during the year ended December 31, 2010 relating to both the equity and liability classified awards. The ESOP options were then cancelled, and replacement awards were granted under the Dialogic option plan in accordance with the Agreement. The 1.5 million replacement awards issued by the Company were considered modified and an incremental expense for vested options of $1.4 million was recorded during the year ended December 31, 2010.
DIALOGIC INC.
Notes to Consolidated Financial Statements
Stock Options
The Company uses the Black-Scholes option-pricing model to determine the fair value of options which is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period.
The expected term represents the period that stock-based awards are expected to be outstanding, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee exercise behavior. The expected term was determined using the “simplified method”. Under this approach, the expected term would be presumed to be the weighted average mid-point between the vesting date and the end of the contractual term. The use of this approach, with appropriate disclosure, is permitted for a plain vanilla employee stock option for which the value is estimated using a Black-Scholes formula. Accordingly, the Company will continue to use the simplified method until it has enough historical experience to provide a reasonable estimate of expected term.
The risk-free interest rate for periods within the contractual life of the award was based on the U.S. Treasury yield curve in effect at the time of grant. The computation of expected volatility is derived from a blend of our own historical volatility as well as the historical volatilities of a comparable group of publicly listed companies within our industry over a period equal to the expected term of our options. Management makes an estimate of expected forfeitures and recognizes compensation costs only for those equity awards expected to vest. The Company has not declared dividends to date.
The following weighted average assumptions were used to value options granted during the years ended December 31, 2011 and 2010, respectively:
Restricted Stock Awards
Due to the acquisition on October 1, 2010, the Company assumed the former Veraz Networks, Inc. restricted stock award plan which resulted in 296,000 RSUs being assumed. During the years ended December 31, 2011 and 2010, the Company granted 570,130 and zero restricted stock units (“RSUs”), respectively.
RSU activity for the period from December 31, 2011 through December 31, 2010 was as follows:
Generally, RSUs vest over four years in equal installments on each of the first through fourth anniversaries of the vesting commencement date. Upon vesting, the RSUs will convert into an equivalent number of shares of common stock. The amount of the expense related to RSUs is based on the closing market price of the Company’s common stock on the date of grant and is amortized on a straight-line basis over the requisite service period.
DIALOGIC INC.
Notes to Consolidated Financial Statements
Stock Purchase Plan
On June 29, 2006 the former Veraz Networks, Inc. stockholders approved the 2006 Employee Stock Purchase Plan (“2006 ESPP”) and reserved 480,281 shares of common stock for issuance thereunder. In May, 2011, the 2006 ESPP was amended by the Company’s stockholders to increase the shares available for issuance thereunder by 500,000 shares. As of December 31, 2011, 74,489 shares have been issued under this plan and 905,792 shares remained available for issuance under the 2006 ESPP.
Subject to certain limitations, employees may elect to have 1% to 15% of their compensation withheld through payroll deductions to purchase shares of common shares under the 2006 ESPP. Employees purchase shares of common stock at a price per share equal to 85% of lesser of the fair market value on the first day of the purchase period or the fair market value on the purchase date at the end of each six-month purchase period. The first purchase period under the 2006 ESPP commenced on June 1, 2011. The total ESPP expense for the year ended December 31, 2011 was $0.1 million.
Note 13 - Net Loss Allocable to Common Stockholders per Share
On October 1, 2010, the Company effected a one-for-five reverse stock split of its common stock. All references to shares in the accompanying consolidated financial statements and notes, including but not limited to the number of shares and per share amounts, unless otherwise noted, have been adjusted to reflect the reverse stock split retroactively. Previously awarded options and warrants to purchase shares of the Company’s common stock have also been retroactively adjusted to reflect the reverse stock split. All share and per share amounts in the accompanying consolidated financial statements and related notes have been retroactively adjusted to reflect the stock split for all periods presented.
Net loss allocable to common stockholders per share is computed by dividing the net loss allocable to common stockholders by the weighted average number of shares of common stock outstanding. The Company has outstanding stock options and restricted stock units, which have not been included in the calculation of diluted net loss allocable to common stockholders per share because to do so would be anti-dilutive. As such, the numerator and the denominator used in computing both basic and diluted net loss allocable to common stockholders per share for each period are the same.
Basic and diluted net loss per share were calculated as follows (in thousands, except per share data):
For the years ended December 31, 2011 and 2010, 2,358,000 and 1,731,000 stock options and 654,176 and 0 restricted stock units,, respectively, were anti-dilutive.
DIALOGIC INC.
Notes to Consolidated Financial Statements
Note 14 - Commitments and Contingencies
(a) Leases
The Company has several non-cancelable operating leases for premises. The leases for rental premises generally contain renewal options ranging from one to three years and require the Company to pay all executory costs such as maintenance and insurance. The minimum rental payments, exclusive of other occupancy charges, under the leases for the Company’s premises and future lease payments required under other operating leases is as follows (in thousands):
Rent expense for operating leases during both of the years ended December 31, 2011 and 2010 was $8.1 million.
(b) Office of the Chief Scientist Grants
The Company’s research and development efforts in Israel have been partially financed through grants from the OCS. In return for the OCS’s participation, the Israeli subsidiary is committed to pay royalties to the Israeli Government at the rate of approximately 3.5% of sales of products in which the Israeli Government has participated in financing the research and development, up to the amounts granted plus interest. The grants received bear annual interest at LIBOR as of the date of approval. The grants are presented in the accompanying consolidated statements of operations as an offset to related research and development expenses. Repayment of the grants is not required in the event that there are no sales of products developed within the framework of such funded programs. However, under certain limited circumstances, the OCS may withdraw its approval of a research program or amend the terms of its approval. Upon withdrawal of approval, the grant recipient may be required to refund the grant, in whole or in part, with or without interest, as the OCS determines. Total amounts received relating to these grants totaled $1.7 million and $0.5 million during the years ended December 31, 2011 and 2010, respectively. Royalties payable to the OCS are recorded as sales are recognized and the associated royalty becomes due and are classified as cost of revenues. Royalty expenses relating to OCS grants included in cost of product revenues was $0.9 million and $0.4 million for the years ended December 31, 2011 and 2010, respectively. As of December 31, 2011 and 2010, the royalty payable amounted to $0.4 million and $0.8 million, respectively. The maximum amount of the contingent liability under these grants potentially due to the Israeli Government (excluding interest) was approximately $17.6 million and $17.3 million as of December 31, 2011 and 2010, respectively.
(c) Indemnification Obligations
Agreements between the Company and its customers under which its customers purchase or license products generally have indemnification provisions under which the Company selling or licensing the products is obliged to defend third party claims against the customer arising as a result of the Company’s products infringing or misappropriating third party intellectual property rights. Depending on the customer and the nature of the agreement, these claims may or may not have a monetary limitation and generally the Company would not cover indirect, special or punitive damages. These clauses are always contingent on the Company selling or licensing the products being allowed to have full authority to defend or settle the claim with the customer’s assistance and subject to industry standard carve-outs such as the Company not being responsible for infringement arising as a result of the Company’s products being combined with third party technology or arising as a result of the Company or a third parties modification of the Company product concerned. In some agreements, the Company selling or licensing the product to the customer has accepted indemnification obligations related to damages caused by the Company’s product or employees which result in death or personal injury or damages as to property. Generally when these provisions are included they are reciprocal and subject to various limitations and carve-outs. The Company has received no indemnification claims in any of the years included in these accompanying consolidated financial statements, and the Company has no current expectation of significant claims related to existing contractual indemnification obligations.
DIALOGIC INC.
Notes to Consolidated Financial Statements
The Company enters into agreements in the ordinary course of business with, among others, customers, systems integrators, resellers, service providers, lessors, sub-contractor, sales representatives, and parties to other transactions with the Company, with respect to certain matters. Most of these agreements require the Company to indemnify the other party against third party claims alleging that its product infringes a patent or copyright. Certain of these agreements require the Company to indemnify the other party against losses arising from: a breach of representations or covenants, claims relating to property damage, personal injury or acts or omissions of the Company, its employees, agents, or representatives. In addition, from time to time the Company has made certain guarantees regarding the performance of its products to its customers.
The duration and scope of these indemnities, commitments, and guarantees varies, and in certain cases, is indefinite.
(d) Guarantees
From time to time, customers require the Company to issue bank guarantees for stated monetary amounts that expire upon achievement of certain agreed objectives, typically customer acceptance of the product, completion of installation and commissioning services, or expiration of the term of the product warranty or maintenance period. Restricted cash represents the collateral securing these guarantee arrangements with banks. At December 31, 2011 and 2010, the maximum potential amount of future payments the Company could be required to make under the guarantees, amounted to $1.5 million and $1.6 million, respectively. The guarantee term generally varies from three months to thirty years. The guarantees are usually provided for approximately 10% of the contract value.
(e) Purchase Commitments
The Company purchases raw material and components for its I-Gate 4000 line of media gateways, under binding purchase orders for each product covered by a product forecast. In addition to the inventory purchased, as of December 31, 2011 and 2010, the Company had open purchase commitments totaling $1.5 million and $1.3 million, respectively.
(f) Litigation
From time to time, the Company is engaged in various legal proceedings incidental to its normal business activity. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations, or cash flows. Legal costs will be expensed as incurred.
(g) Loss Contingency
The Company is subject to various claims that have arisen in the ordinary course of business. At December 31, 2011 and 2010, the Company had a reserve of $1.8 million and $0.3 million, respectively, related to asserted third party claims. The asserted third party claims for which the reserve was taken were settled on March 23, 2012. The monetary settlement was for a total of $1.8 million and accordingly, the Company recorded an additional charge of $1.5 million during the fourth quarter of 2011. This amount is recorded in cost of product revenue in the 2011 consolidated statement of operations. The monetary settlement will be paid in installments over a 12-month period beginning in April 2012.
DIALOGIC INC.
Notes to Consolidated Financial Statements
Note 15 - Segment and Geographic Information
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company is required to disclose certain information regarding operating segments, products and services, geographic areas of operation and major customers. The Company’s chief operating decision maker is the Company’s Chief Executive Officer. The Chief Executive Officer reviews financial information presented on a consolidated basis, accompanied by information about revenue by geographic region for purposes of allocating resources and evaluating financial performance. The Company has one business activity and there are no segment managers who are held accountable for operations, operating results and plans for levels or components below the consolidated unit level. Accordingly, the Company is considered to be in a single reporting segment and operating unit structure. Revenue by geography is based on the billing address of the customer. The following tables set forth revenues by major product group and geographic areas, and long-lived assets and goodwill by geographic area (in thousands):
(a) Revenues by major product group
(b) Legacy vs. NextGen revenue
(c) Revenues were derived from customers located in the following geographic areas:
It is not practical for the Company to report revenues from external customers attributed to an individual foreign country.
DIALOGIC INC.
Notes to Consolidated Financial Statements
(d) Long-lived assets and goodwill by geographic areas:
Note 16 - Income Taxes
The components of the Company’s loss before income taxes for the years ended December 31, 2011 and 2010 were as follows (in thousands):
The Company’s provision (benefit) for income taxes for the years ended December 31, 2011 and 2010 were as follows (in thousands):
DIALOGIC INC.
Notes to Consolidated Financial Statements
The Company’s provision (benefit) for income taxes included in the consolidated statement of operations is comprised of the following (in thousands):
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial statement purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets are as follows (in thousands):
Certain amounts for 2010 have been reclassified to reflect comparability with 2011 amounts.
A valuation allowance is provided to the extent recoverability of the deferred tax asset, or the timing of such recovery, is not “more likely than not” of being realized. The need for a valuation allowance is continually reviewed by management. The utilization of tax
DIALOGIC INC.
Notes to Consolidated Financial Statements
attributes by the Company is dependent on the generation of taxable income by the Company in the principal jurisdictions in which it operates and/or tax planning strategies. As required the Company has evaluated and weighted the positive and negative evidence present at each period. In arriving at its conclusion the Company has given significant weight to the history of pretax losses. If circumstances change and management believes a larger or smaller deferred tax asset is justified, the reduction (increase) of the valuation allowance will result in an income tax benefit (expense). During 2011, the Company released a valuation allowance against its French deferred tax assets. The Company has established a history of positive earnings in France and projects positive earnings in France in future years. Accordingly, the Company believes that these deferred assets are more likely than not to be utilized going forward.
At December 31, 2011, the Company had U.S. federal, state and foreign net operating loss carry forwards of approximately $82.5 million, $75.4 million and $262.2 million, respectively. These U.S. federal, state and foreign net operating loss carryforwards expire in varying amounts from 2021 to 2031, 2012 to 2031 and 2012 to indefinite, respectively. Foreign losses are primarily related to operations in Canada, Ireland and Israel.
At December 31, 2011, the Company had U.S. federal, state and foreign tax credits of approximately $2.3 million, $9.7 million and $5.9 million, respectively. The tax credits primarily relate to research tax credits and investment tax credits. The U.S. federal, state and foreign tax credits expire in varying amounts from 2022 to 2026, 2018 to 2027, and 2018 to indefinite, respectively. The Company has recorded a net deferred tax asset of $14.6 million related to these tax credits before consideration of a valuation allowance. As at December 31, 2011, the Company had approximately $42.2 million of Canadian and $20.2 million of provincial reported unclaimed research and development expenditures available to reduce income for Canadian tax purposes in 2011, or thereafter. The Company has recorded a net deferred tax asset of $8.7 million related to these expenditures before consideration of a valuation allowance.
Utilization of the Company’s net operating loss carryforwards and tax credits may be subject to substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code (Section 382) and similar foreign provisions. Such an annual limitation could result in the expiration of the net operating loss before utilization. The Company has not yet determined the full extent of such limitations or if an ownership change has occurred. The Company expects to complete a Section 382 analysis.
Unrecognized tax benefits represent uncertain tax positions for which reserve have been established. As of December 31, 2011 and 2010, the total liability for unrecognized tax benefits was $2.5 million and $3.2 million respectively, of which all would impact the annual effective rate, if realized, consistent with the principles of ASC No. 805. Each year the statute of limitations for income tax return filed in various jurisdictions closes, sometimes without adjustments. During the year ended December 31, 2011, the unrecognized tax benefits were reduced by $1.3 million as a result of expiration of statute of limitations in several jurisdictions. This was offset in part by the establishment of reserves of $0.6 million for various matters in different jurisdictions.
The aggregate change in the gross consolidated liability for uncertain tax positions, inclusive of interest and penalties, is as follows (in thousands):
The Company recognizes interest and penalties related to unrecognized tax benefits as a component of income tax expense. For both December 31, 2011 and 2010, the reserve for uncertain tax positions included interest and penalties of $0.6 million. Interest and penalty expense (benefit) included above was $0.02 million and $0.06 million for 2011 and 2010, respectively. The Company classified the entire $2.5 million and $3.2 million liability at December 31, 2011 and 2010, respectively as long term as cash settlement in the next year has not been established. The Company anticipates that during the next twelve months the total liability for unrecognized tax benefits may change by $1.8 million due to the expiration of different tax statutes or tax settlements. Any reduction due to expiring statutes would impact the Company’s effective tax rate.
DIALOGIC INC.
Notes to Consolidated Financial Statements
The Company files U.S. federal income tax returns as well as income tax returns in various states and foreign jurisdictions. The Company is currently under examination by the Internal Revenue Service (“IRS”) for calendar years 2008 and 2009. The Company does not expect an adverse outcome. Additionally, any net operating losses and credits that were generated in prior years may also be subject to examination by the IRS, in the tax year the net operating loss and credits are utilized. In addition, the Company may be subject to examination in foreign jurisdictions for the years from 2004 through 2011.
Taxes on income earned by the Company’s subsidiaries in various countries have been accrued and are being paid in accordance with the laws of each country. Deferred income taxes are not provided on undistributed earnings of $44.7 million from certain foreign subsidiaries as of December 31, 2011, such unremitted earnings are to be indefinitely reinvested outside the United States. At this time, the Company has deemed it impracticable to determine the amount of any tax payable if these amounts were repatriated. Determination of the liability is largely dependent on circumstances under which the remittance occurs.
Note 17 - Settlement Agreement
In August 2008, the Company’s subsidiary Cantata Technology, Inc. (“Cantata”) filed a complaint against InterMetro Communications, Inc. (“InterMetro”) before the District Court for the District of Massachusetts USDC Civil Action No. 08-11371(PBS). InterMetro filed a counterclaim against Cantata and instituted a third party claim against the Company. A settlement agreement (“Settlement Agreement”) was reached in the matter and signed on January 29, 2010, the terms of which are confidential. In January 2010, the Company recorded the gain on the settlement, $0.5 million as other income in the accompanying consolidated statements of operations. However under the Settlement Agreement, all counterclaims against Cantata and third party claims against Dialogic were dropped. The Settlement Agreement was entered by the District Court under seal and the case was officially closed on February 19, 2010.
Note 18 - Employee Benefit Plans
The Company has a 401(k) plan covering all eligible employees. The Company is not required to contribute to the plan and has made no contributions during 2011 or 2010.
Note 19 - Valuation and Qualifying Accounts
(1) Year ended December 31, 2010 includes acquired bad debt reserves of $3.3 million from the Acquisition.
DIALOGIC INC.
Notes to Consolidated Financial Statements
Note 20 - Subsequent Events
a) Receipt of Deficiency Letters from the NASDAQ Stock Market
On February 28, 2012, the Company received a deficiency letter from the Listing Qualifications Department of The NASDAQ Stock Market (the “Staff”), notifying it that, for the last 30 consecutive business days, the bid price for the Company’s common stock had closed below the minimum $1.00 per share requirement for continued listing on the NASDAQ Global Market pursuant to NASDAQ Listing Rule 5450(a)(1)(the “Bid Price Rule).
In accordance with Listing Rule 5810(c)(3)(A), the Company has been given 180 calendar days, or until August 27, 2012, to regain compliance with the Bid Price Rule. If at any time before August 27, 2012 the bid price for the Company’s common stock closes at $1.00 or more for a minimum of 10 consecutive business days as required under Listing Rule 5810(c)(3)(A), the Staff will provide written notification to the Company that it complies with the Bid Price Rule. If the Company does not regain compliance with the Bid Price Rule by August 27, 2012, but applies for listing on the NASDAQ Capital Market by such date, provided it meets the initial inclusion and continued listing requirements of that market as set forth in Listing Rule 5505 other than the $1.00 per share bid price requirement, and provides the Staff with written notice of its intention to cure the deficiency, the Company will be granted an additional 180 calendar day compliance period.
If the Company does not regain compliance with the Bid Price Rule by August 27, 2012 and is not eligible for an additional compliance period at that time, the Staff will provide written notification to the Company that its common stock is subject to delisting. At that time, the Company may appeal the Staff’s delisting determination to a Hearings Panel, or the Panel. The Company would remain listed pending the Panel’s decision. There can be no assurance that, if the Company does appeal the delisting determination by the Staff to the Panel, that such appeal would be successful.
On February 28, 2012, the Company also received a deficiency letter from the Staff notifying it that, for the last 30 consecutive business days, the market value of the Company’s publicly held shares has been below the minimum $15.0 million requirement for continued listing on the NASDAQ Global Market pursuant to Listing Rule 5450(b)(3)(C) (the “Market Value Rule”).
In accordance with Listing Rule 5810(c)(3)(D), the Company has been given 180 calendar days, or until August 27, 2012, to regain compliance with the Market Value Rule. If at any time before August 27, 2012 the market value of the Company’s publicly held shares closes at $15.0 million or more for a minimum of 10 consecutive business days as required under the Listing Rule 5810(c)(3)(D), the Staff will provide written notification to the Company that it complies with the Market Value Rule.
If the Company does not regain compliance with the Market Value Rule by August 27, 2012, the Staff will provide written notification to the Company that its common stock is subject to delisting. At that time, the Company may either apply for listing on the NASDAQ Capital Market, provided the Company meets the initial inclusion and continued listing requirements of that market as set forth in Listing Rule 5505, or appeal the Staff’s delisting determination to the Panel. The Company would remain listed pending the Panel’s decision. There can be no assurance that, if the Company does appeal the delisting determination by the Staff to the Panel, that such appeal would be successful.
b) Debt Restructuring
On March 22, 2012, Dialogic Corporation entered into the third amended and restated Term Loan Agreement with the Term Lenders pursuant to which, among other things, interest of $3.0 million accrued through March 22, 2012 was added to the principal amount of the term loans outstanding and the maturity date of the term loans was extended to March 31, 2015. As restructured, the term loans bear interest at the rate of 10% per annum payable in cash, except that, in 2012 and thereafter if certain minimum cash requirements are not met, interest may be paid at the rate of 5% in cash with the remaining 5% added to principal and PIK. The Term Loan Agreement contains other terms and covenants more fully described in Note 9. Associated with the debt restructuring, the Company also issued warrants to purchase 18 million shares of common stock with an exercise price of $1.00 per share to the Term Lenders, subject to stockholder approval.
On March 22, 2012, Dialogic Corporation entered into the Seventeenth Amendment with Wells Fargo Foothill Canada ULC and the Revolving Credit Lender. Under the Seventeenth Amendment, the Revolving Credit Lender waived the events of default existing under the Revolving Credit Agreement as of March 22, 2012 and agreed to certain amendments to the Revolving Credit Agreement, as more fully described in Note 8.
DIALOGIC INC.
Notes to Consolidated Financial Statements
c) Private Placement
On April 11, 2012, the Company entered into a securities purchase agreement (the “Purchase Agreement”) with accredited investors (the “Investors”), including certain related parties, pursuant to which the Company issued and sold $39.5 million aggregate principal amount of convertible promissory notes (the “Notes”) and one share of the Company’s Series D-1 Preferred Stock, par value $0.001 per share (the “Series D-1 Preferred Share”), to the Investors in a private placement (the “Private Placement”).
The Notes
The Investors in the Private Placement include the Term Lenders and the Related Party Lenders. The Term Lenders purchased $34.5 million aggregate principal amount of Notes in exchange for the cancellation of (i) $33.0 million in outstanding principal under the Term Loan Agreement, $3.0 million of which represents accrued but unpaid interest that was capitalized under the Term Loan Agreement on March 22, 2012 (the “Interest Amount”), and (ii) a prepayment premium of $1.5 million triggered by the cancellation of the outstanding debt described above. The remaining $5.0 million aggregate principal amount of Notes was purchased by the holders of the Related Party Lenders in exchange for the cancellation of outstanding debt.
The Notes bear interest at the rate of 1% per annum, compounded annually, and are convertible into shares of the Company’s common stock, par value $0.001 per share (the “Common Stock”). The conversion price of the Notes is generally $1.00 per share, provided that the Notes issued to the Term Lenders in exchange for the cancellation of the Interest Amount will have a conversion price of $0.87 per share, in each case as adjusted for any stock split, reverse stock split, stock dividend, recapitalization, reclassification, combination or other similar transaction. Under the terms of the Notes, the principal and all accrued but unpaid interest will automatically convert into shares of Common Stock upon stockholder approval of the Private Placement.
Pursuant to the Purchase Agreement, the Company has agreed to call a meeting of the stockholders by June 30, 2012 to approve the Private Placement. If stockholder approval and the resulting conversion of the Notes do not occur by June 30, 2012, the outstanding principal amount and all accrued and unpaid interest under the Notes shall become due and payable on such date; however, amounts due under the Notes cannot be repaid before amounts outstanding under the Term Loan Agreement and Revolving Credit Agreement. The Notes are subordinated to the Company’s outstanding loans under the Term Loan Agreement and Revolving Credit Agreement, and the Company may not prepay such Notes prior to June 30, 2012 without the consent of the Term Lenders and Revolving Credit Lender.
The Purchase Agreement contains customary representations, warranties, covenants and closing conditions by, among and for the benefit of the parties thereto. The Purchase Agreement also provides for indemnification of the Investors in the event that any Investor incurs losses, liabilities, costs and expenses related to a breach of the representations and warranties by the Company under the Purchase Agreement or the other transaction documents or any action instituted against an Investor or its affiliates due to the transactions contemplated by the Purchase Agreement or other transaction documents, subject to certain limitations.
Series D-1 Preferred Stock
On April 11, 2012, the Company filed a certificate of designation (the “Certificate”) for the Company’s Series D-1 Preferred Stock (the “Series D-1 Preferred”) with the Secretary of State of the State of Delaware. The Series D-1 Preferred Share was issued and sold to Tennenbaum in exchange for cancellation of $100 in outstanding principal under the Term Loan Agreement.
The Certificate authorizes one share of Series D-1 Preferred Stock, which is non-voting and is not convertible into other shares of the Company’s capital stock. However, following stockholder approval of the Private Placement, if it occurs, the holder of the Series D-1 Preferred Share (the “Holder”) has the right to designate certain members of the Board as follows:
•
four directors to the Board (each director to the Board designated and elected pursuant by the Holder, a “Series D-1 Director”, and all such directors, the “Series D-1 Directors”) at any time while the Holder (together with its affiliates) beneficially owns in the aggregate at least 45% of the then issued and outstanding shares of Common Stock (assuming (x) the exercise in full of all warrants then exercisable by the Holder and any affiliates thereof and (z) conversion or exercise, as applicable, of any other securities of the Company that by their terms are convertible or exercisable into shares of Common Stock that are held by the Holder, collectively, the “Fully Diluted Common Stock”);
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three Series D-1 Directors at any time while the Holder (together with its affiliates) beneficially owns in the aggregate at least 30% and less than 45% of the Fully Diluted Common Stock;
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two Series D-1 Directors at any time while the Holder (together with its affiliates) beneficially owns in the aggregate at least 10% and less than 30% of the Fully Diluted Common Stock; or
•
one Series D-1 Director at any time while the Holder (together with its affiliates) beneficially owns in the aggregate at least three percent and less than 10% of the Fully Diluted Common Stock.
At any time when the Holder has the right to designate two or more directors, one such director will be the chairman of the Board.
The Certificate further provides that the Company must obtain the Holder’s consent to, among other things, (i) take any action that alters or changes the rights, preferences or privileges of the Series D-1 Preferred; (ii) convert the Company into any other organizational form; (iii) change the size of the Board; (iii) appoint or remove the chairman of the Board; or (iv) establish, remove or change the authority of any committee of the Board or appoint or remove members thereof.
The Holder is not entitled to any dividends from the Company. However, upon any liquidation, dissolution or winding up of the Company, excluding the sale of all or substantially all of the assets or capital stock of the Company and the merger or consolidation of the Company into or with any other entity or the merger or consolidation of any other entity into or with the Company (a “Liquidation Event”), the Holder is entitled to a liquidation preference, prior to any distribution of the Company’s assets to the holders of Common Stock, in an amount equal to $100 payable in cash. After payment to the Holder of the full preferential amount, the Holder will have no further right or claim to the Company’s remaining assets.
The Series D-1 Preferred Share is redeemable for $100 (i) at the written election of the Holder, or (ii) at the election of the Company at any time after the earlier to occur of the following: (x) the Holder (together with its affiliates) beneficially owns in the aggregate less than three percent of the Fully Diluted Common Stock at any time following the stockholder approval of the Private Placement, if it occurs, or (y) a Liquidation Event.
Amendment of Existing Debt Arrangements
In connection with the Private Placement, Dialogic Corporation, the Company and certain of its subsidiaries entered into the First Amendment with the Term Loan Lenders and the Eighteenth Amendment with the Revolving Credit Lender. These amendments were entered into concurrently with the closing of the Private Placement.
Pursuant to the First Amendment, the Term Loan Agreement was amended to permit the conversion of $33.0 million of outstanding debt under the Term Loan Agreement in exchange for the Notes and Series D-1 Preferred Share as described above, subject to payment of a prepayment premium of $1.5 million, which the Company also paid through the issuance of Notes. The Term Loan Agreement was also amended to permit the Company to issue the remaining Notes sold in the Private Placement.
Pursuant to the Eighteenth Amendment, the Revolving Credit Agreement was also amended to permit the Company to issue the Notes.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable
Item 9A.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) that are designed to provide reasonable assurance that the information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Our management evaluated (with the participation of our Chief Executive Officer and Chief Financial Officer) our disclosure controls and procedures, and concluded that, because we have identified a material weakness with respect to our internal controls over financial reporting as detailed below, our disclosure controls and procedures were not effective as of December 31, 2011, to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Exchange Act, is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined under Rule 13a-15(f) and Rule 15d-15(f) of the Exchange Act. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s principal executive officer and principal financial officer to provide reasonable assurance regarding the (i) effectiveness and efficiency of operations, (ii) reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with U.S. GAAP, and (iii) compliance with applicable laws and regulations. Public Company Accounting Oversight Board Auditing Standard No. 5, or AS-5, defines a material weakness as a deficiency or a combination of deficiencies in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.
Management, with the participation of our principal executive officer and principal financial officer, has conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework set forth in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission as of December 31, 2011. Based on this evaluation, management concluded that the material weakness identified in connection with its evaluation of our internal controls as of December 31, 2010 had not yet been remediated. The material weakness identified as of December 31, 2010 related to a lack of sufficient accounting and finance personnel with technical accounting expertise to apply accounting requirements to non-routine and complex transactions and to perform in-depth analysis and review of accounting matters within the timeframes set by management for finalizing financial statements. While management did hire several new accounting and finance personnel during 2011 and did establish certain new processes and controls as more fully described below, as a result of the timing of when these controls were put in place in the fourth quarter of 2011, management determined that these controls were not in place for a sufficient period of time to conclude that they were operating effectively. Accordingly, management has concluded that we did not maintain effective internal control over financial reporting as of December 31, 2011 based on criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework.
Management has taken measures to remediate the material weakness previously identified. These measures are broadly grouped into the following categories: (a) improving finance staff, (b) implementing appropriate internal control processes and procedures, and (c) training.
•
Improving finance staff: During 2011, the finance department was enhanced by the hiring of a new Chief Financial Officer (October 2011) with significant industry and U.S. public company experience; a new Director of Financial Reporting with specific responsibility for improving internal controls and overseeing SEC reporting; and a new Corporate Tax Director with significant experience in federal, state and international tax. In addition, we promoted a divisional controller with significant industry and revenue recognition experience to Corporate Controller. We continue to evaluate our personnel needs and hire talented and qualified employees as appropriate and as needed.
•
Implementing appropriate internal control processes and procedures: We have steadily made improvements in our internal control processes during 2011, with more significant actions taken in the fourth quarter of 2011. Such process improvements have included, but are not limited to, the establishment of a centralized electronic database of key contracts, accounting records and related documentation, increased uniformity and consistency with respect to customer contracts, accounting records and related documentation, and increased level of management review of key processes, particularly the revenue cycle and sales process. In addition, we have implemented more detailed management reviews of period-end account reconciliations and analyses in the areas of accruals, inventory, revenue and related reserves, accounts receivable and stock-based compensation. During the fourth quarter, we also established a more timely and efficient financial close schedule and integrated two instances of our Oracle ERP system into one, which we expect will enhance our reporting capabilities in 2012.
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Training: In 2011, we held a controllers’ conference that provided opportunities for professional development and technical accounting education in areas such as revenue recognition, impairments, restructuring and debt. Our finance team members participate in other relevant and available courses to enhance their technical skills. We have also instituted regular weekly finance team calls to discuss accounting and finance matters and to align our goals and objectives. Further, we provide cross-training amongst members of our finance team to ensure critical processes and controls can be performed by more than one individual.
Further, management has engaged an outside consultant to further review the design effectiveness of our internal controls and perform sufficient testing to determine the operating effectiveness of internal control over financial reporting for the year ended December 31, 2012.
Changes in Internal Controls
During our most recent fiscal quarter, the Company has made the following changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting other than as otherwise set forth above: the Company instituted enhanced procedures related to compliance with the Foreign Corrupt Practices Act of 1977, as amended, and analogous foreign legislation. This included a revised contract review and diligence procedure, updates to Company policies and certifications, modified provisions in the Company’s standard contracts and enhanced training and documentation. The Company intends to continue to enhance its compliance program in 2012.
Limitations of Disclosure Controls and Procedures and Internal Control Over Financial Reporting
Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by this Item 10 will be set forth under the captions “Executive Officers of the Company,” “Proposal No. 1 - Election of Directors” “Information Regarding the Board of Directors an Corporate Governance” and “Section 16(a) Beneficial Ownership Reporting Compliance”, in our Proxy Statement for our 2012 Annual Meeting of Stockholders, or the Proxy Statement, which we expect to file on or before April 30, 2012, and is incorporated herein by this reference.
We have adopted a code of business conduct and ethics applicable to our directors, officers (including our principal executive officer, principal financial officer, and principal accounting officer), and employees. The Code of Business Conduct and Ethics is available on our website at www.dialogic.com under the section titled Corporate Governance. In addition, we intend to promptly disclose (1) the nature of any amendment to our code of business conduct and ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions and (2) the nature of any waiver, including an implicit waiver, from a provision of our code of business conduct and ethics that is granted to one of these specified officers, the name of such person who is granted the waiver and the date of the waiver on our website in the future.
Item 11.
Item 11. Executive Compensation
The information required by this Item 11 will be set forth under the caption “Proposal No. 1 - Election of Directors”, and “Compensation of Executive Officers” in our Proxy Statement and is incorporated herein by this reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this Item 12 will be set forth under the caption “Equity Compensation Plan Information” and “Security Ownership of Certain Beneficial Owners and Management” in our Proxy Statement and is incorporated herein by this reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this Item 13 will be set forth under the caption “Certain Relationships and Related Transactions” and “Information Regarding the Board of Directors and Corporate Governance” in our Proxy Statement and is incorporated herein by reference.
Item 14.
Item 14. Principal Accountant Fees and Services
The information required by this Item 14 will be set forth under the caption “Principal Accountant Fees and Services” in our Proxy Statement and is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules.
(a)(1) Financial Statements
Index to Consolidated Financial Statements
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations and Comprehensive Loss
Consolidated Statements of Stockholders’ Equity (Deficit) and Redeemable Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(a)(2) Financial Statement Schedules
All financial statement schedules have been omitted, since the required information is not applicable or because the information is included in the consolidated financial statements and notes thereto.
(a)(3) Exhibits
The information required by this item is set forth on the exhibit index that follows the signature page of this report.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Nick Jensen and John Hanson, as his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place, and stead, in any and all capacities, to sign any and all amendments to this Report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming that said attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
* Management contract, compensatory plan or arrangement.
# The certifications attached as Exhibit 32.1 accompany this Annual Report on Form 10-K, are not deemed filed with the Securities and Exchange Commission and are not to be incorporated by reference into any filing of Dialogic Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Annual Report on Form 10-K, irrespective of any general incorporation language contained in such filing.
 Pursuant to applicable securities laws and regulations, the Registrant is deemed to have complied with the reporting obligation related to the submission of interactive data files in such exhibits and is not subject to liability under any anti-fraud provisions of the federal securities laws as long as the Registrant has made a good faith attempt to comply with the submission requirements and promptly amends the interactive data files after becoming aware that the interactive data files fails to comply with the submission requirements. These interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act, are deemed not filed for the purposes of section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.