CAVIUM, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the Consolidated Condensed Financial Statements and the related notes that appear elsewhere in this document.

The information in this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended ("Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended ("Exchange Act"), which are subject to the "safe harbor" created by those sections. Forward-looking statements are based on our management's beliefs and assumptions and on information currently available to our management. In some cases, you can identify forward-looking statements by terms such as "may," "will," "should," "could," "would," "estimate," "project," "predict," "potential," "continue," "strategy," "believe," "anticipate," "plan," "expect," "intend" and similar expression intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this Quarterly Report on Form 10-Q in greater detail under the heading "Risk Factors." Given these risks, uncertainties and other factors, you should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this filing. You should read this Quarterly Report on Form 10-Q completely and with the understanding that our actual future results may be materially different from what we expect. We hereby qualify our forward-looking statements by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

OCTEON®, OCTEON®Plus™, OCTEON II®, NITROX®, NEURON™, Celestial™ , ECONA® and PureVu® are trademarks or registered trademarks of Cavium, Inc.

Overview We are a provider of highly integrated semiconductor processors that enable intelligent processing for networking, communications, storage, wireless, security, video and connected home and office applications. Our products allow our customers to develop networking, wireless, storage and electronic equipment that is application-aware and content-aware and securely processes voice, video and data traffic at high speeds. Our products are systems on a chip, or SoCs, which incorporate single or multiple processor cores, a highly integrated architecture and customizable software that is based on a broad range of standard operating systems. We focus our resources on the design, sales and marketing of our products, and outsource the manufacturing of our products.

From our incorporation in 2000 through 2003, we were primarily engaged in the design and development of our first processor family, NITROX, which we began shipping commercially in 2003. In 2004, we introduced and commenced commercial shipments of NITROX Soho. In 2006, we commenced our first commercial shipments of our OCTEON family of multi-core MIPS64® processors. We introduced a number of new products within all three of these product families in 2006. In 2007 we introduced our new line of OCTEON based storage services processors designed to address the specific needs in the storage market, as well as other new products in the OCTEON and NITROX families. In 2008, we expanded our OCTEON and NITROX product families with new products including wireless services processors to address the needs for wireless infrastructure equipment. In 2009, we announced the OCTEON II Internet Application Processor ("IAP") family multi-core MIPS64® processors, with one to 32 cores to address next generation networking applications support converged voice, video, data mobile traffic and services.

In 2010, we announced the next generation NITROX III, a processor family with 16 to 64-cores that delivers security and compression processors for application delivery, cloud computing and wide area network optimization. In 2011, we introduced NEURON, a new search processor product family that targets a wide range of high performance, L2-L4 network search applications in enterprise and service provider infrastructure equipment. In 2011, we also introduced another new product family, the OCTEON Fusion, a single chip SoCs with up to 6x MIPS64 cores and up to 8x LTE/3G baseband DSP cores which enable macro base station class features for 19 -------------------------------------------------------------------------------- Table of Contents small cell base stations. In 2012, we introduced OCTEON III, Cavium's 48-core 2.5GHz multi-core processor family that can deliver up to 100Gbps of application processing, up to 120GHz of 64-bit compute processing per chip and can be connected in multi-chip configurations.

In August 2008, we acquired Star Communications, Inc. With the acquisition of Star, we added the Star ARM-based processors to our portfolio to address connected home and office applications and have since introduced our ECONA line of dual-core ARM processors that address a large variety of connected home and office applications.

In December 2008, we acquired W&W Communications, Inc. This acquisition launched us into the video processor market with our PureVu product line. These products address the need for video processing in wireless displays, teleconferencing, gaming and other applications.

In December 2009, we acquired MontaVista Software, Inc. This acquisition complements our broad portfolio of multi-core processors to deliver integrated and optimized embedded solutions to the market.

In October 2010, we acquired Celestial Systems, Inc. With the acquisition of Celestial Systems, we gained additional professional services such as Automotive Infotainment Systems, Digital Media product development and Android commercialization and support.

In January 2011, we acquired Wavesat Inc. This acquisition added multicore wireless digital system processing to our embedded processor product line.

In March 2011, we acquired Celestial Semiconductor, Ltd. With the acquisition of Celestial Semiconductor, we added a processor family targeted for the market of digital media players.

Since inception, we have invested heavily in new product development and our net revenue has grown from $7.4 million in 2004 to $259.2 million in 2011 driven primarily by demand in the enterprise network, data center and access and service provider markets and increased demand in the broadband and consumer markets. For the nine months ended September 30, 2012, our net revenue was $169.1 million. We expect sales of our products for use in the enterprise network, data center and access and service provider markets to continue to represent a significant portion of our revenue in the foreseeable future, however, we do expect growth in the broadband and consumer markets.

We primarily sell our products to OEMs, either directly or through their contract manufacturers. Contract manufacturers purchase our products only when an OEM incorporates our product into the OEM's product, not as commercial off-the-shelf products. Our customers' products are complex and require significant time to define, design and ramp to volume production. Accordingly, our sales cycle is long. This cycle begins with our technical marketing, sales and field application engineers engaging with our customers' system designers and management, which is typically a multi-month process. If we are successful, a customer will decide to incorporate our product in its product, which we refer to as a design win. Because the sales cycles for our products are long, we incur expenses to develop and sell our products, regardless of whether we achieve the design win and well in advance of generating revenue, if any, from those expenditures. We do not have long-term purchase commitments from any of our customers, as sales of our products are generally made under individual purchase orders. However, once one of our products is incorporated into a customer's design, it is likely to remain designed in for the life cycle of the product. We believe this to be the case because a redesign would generally be time consuming and expensive. We have experienced revenue growth due to an increase in the number of our products, an expansion of our customer base, an increase in the number of average design wins within any one customer and an increase in the average revenue per design win.

Our revenue from MontaVista is mainly from sale of software subscriptions of embedded Linux operating system, related development tools, support and professional services. The net revenue for our software and services are primarily derived from the sale of time-based software licenses, software maintenance and support, and from professional services arrangements and training.

Key Business Metrics for Semiconductor Products Design Wins. We closely monitor design wins by customer and end market on a periodic basis. We consider design wins to be a key ingredient in our future success, although the revenue generated by each design win can vary significantly. Our long-term sales expectations are based on internal forecasts from specific customer design wins based upon the expected time to market for end customer products deploying our products and associated revenue potential.

20 -------------------------------------------------------------------------------- Table of Contents Pricing and Margins. Pricing and margins depend on the features of the products we provide to our customers. In general, products with more complex configurations and higher performance tend to be priced higher and have higher gross margins. These configurations tend to be used in high performance applications that are focused on the enterprise network, data center, and access and service provider markets. We tend to experience price decreases over the life cycle of our products, which can vary by market and application. In general, we experience less pricing volatility with customers that sell to the enterprise and data center markets.

Sales Volume. A typical design win can generate a wide range of sales volumes for our products, depending on the end market demand for our customers' products. This can depend on several factors, including the reputation, market penetration, the size of the end market that the product addresses, and the marketing and sales effectiveness of our customer. In general, our customers with greater market penetration and better branding tend to develop products that generate larger volumes over the product life cycle. In addition, some markets generate large volumes if the end market product is adopted by the mass market.

Customer Product Life Cycle. We typically commence commercial shipments from nine months to three years following a design win. Once our product is in production, revenue from a particular customer may continue for several years.

We estimate our customers' product life cycles based on the customer, type of product and end market. In general, products that go into the enterprise network and data center take longer to reach volume production but tend to have longer lives. Products for other markets, such as broadband and consumer, tend to ramp relatively quickly, but generally have shorter life cycles. We estimate these life cycles based on our management's experience with providers of networking equipment and the semiconductor market as a whole.

Results of Operations Three and nine months ended September 30, 2012 and 2011 Our net revenue, cost of revenue, gross profit and gross margin for the periods presented were: Three months ended Nine months ended September 30, September 30, 2012 2011 change % 2012 2011 change % (in thousands) (in thousands) Net revenue $ 61,081 $ 67,729 $ (6,648 ) -9.8 % $ 169,111 $ 202,914 $ (33,803 ) -16.7 % Cost of revenue 24,796 27,172 (2,376 ) -8.7 % 77,553 80,695 (3,142 ) -3.9 % Gross Profit $ 36,285 $ 40,557 $ (4,272 ) -10.5 % $ 91,558 $ 122,219 $ (30,661 ) -25.1 % Gross Margin 59.4 % 59.9 % -0.5 % 54.1 % 60.2 % -6.1 % Net Revenue. Our net revenue consists primarily of sales of our semiconductor products to providers of networking equipment and their contract manufacturers and distributors. Initial sales of our products for a new design are usually made directly to providers of networking equipment as they design and develop their product. Once their design enters production, they often outsource their manufacturing to contract manufacturers that purchase our products directly from us or from our distributors. We price our products based on market and competitive conditions and periodically reduce the price of our products, as market and competitive conditions change, and as manufacturing costs are reduced. We do not experience different margins on direct sales to providers of networking equipment and indirect sales through contract manufacturers because in all cases we negotiate product pricing directly with the providers of networking equipment. To date, most of our revenue has been denominated in U.S.

dollars.

Our sole end customer representing greater than 10% of net revenue for the three and nine months ended September 30, 2012 and 2011 was Cisco. Cisco accounted for 24% and 23% of the net revenue for the three months ended September 30, 2012 and 2011, respectively, and 27% and 24% for the nine months ended September 30, 2012 and 2011, respectively.

Revenue and costs relating to sales to distributors are deferred if we grant more than limited rights of returns and price credits or if we cannot reasonably estimate the level of returns and credits issuable. We have an existing agreement with a certain distributor to distribute our products primarily in the United States. Given the terms of the distribution agreement, for sales to this distributor, revenue and costs are deferred until products are sold to its end customers. For the three months ended September 30, 2012 and 2011, 5.6% and 7.2%, respectively, and for the nine months ended September 30, 2012 and 2011, 5.6% and 5.9%, respectively, of our net revenues were from products sold by this distributor. Revenue recognition depends on notification from this distributor that product has been sold to its end customers.

Our distributors, other than the distributor discussed above, are used primarily to support international sale logistics in Asia, including importation and credit management. Total net revenue through these distributors was $19.3 million and $23.6 million for the three months ended September 30, 2012 and 2011, respectively, which accounted for 31.6% and 34.9% of net revenue, 21-------------------------------------------------------------------------------- Table of Contents respectively, and $55.6 million and $62.7 million for the nine months ended September 30, 2012 and 2011, respectively, which accounted for 32.9% and 30.9% of net revenue, respectively. The inventory at these distributors at the end of the period may fluctuate from time to time mainly due to the OEM production ramps and new customer demands. While we have purchase agreements with our distributors, the distributors do not have long-term contracts with any of the equipment providers. Our distributor agreements limit the distributor's ability to return product up to a portion of purchases in the preceding quarter. Given our experience, along with our distributors' limited contractual return rights, we believe we can reasonably estimate expected returns from our distributors.

Accordingly, we recognize sales through distributors at the time of shipment, reduced by our estimate of expected returns.

Revenue derived from licensing software and providing software maintenance, support and training amounted to $3.2 million and $4.1 million for the three months ended September 30, 2012 and 2011, respectively and $11.3 million and $15.1 million for the nine months ended September 30, 2012 and 2011, respectively. Revenue from professional service arrangements amounted to $3.6 million and $4.0 million for the three months ended September 30, 2012 and 2011, respectively, and $9.6 million and $17.3 million for the nine months ended September 30, 2012 and 2011, respectively.

Our net revenue decreased by $6.6 million or 9.8% and $33.8 million or 16.7% in the three and nine months ended September 30, 2012, respectively, compared to the same periods in 2011. The decrease in net revenue for the three months ended September 30, 2012 compared to the same period in 2011 was attributable mainly to the decrease in sales in our broadband and consumer market of $5.6 million and from our software and services of $1.6 million, which was partially offset by the increase in sales from our enterprise network; data center; and access and service provider markets, combined of $512,000. The decrease in net revenue for the nine months ended September 30, 2012 compared to the same period in 2011 was attributable to the decrease in sales of $13.5 million from our enterprise network; data center; and access and service provider markets, combined, decrease of $9.6 million in our broadband and consumer markets and decrease of $10.6 million from our software and services. The overall decrease in sales in our enterprise networks; data center; and access and service provider markets as well as our broadband and consumer markets were mainly due to the decline in demand for our products from our top 20 customers which was generally impacted by the timing of these customers' volume production of our design wins. The decrease in net revenue from our software and services was mainly driven by the timing of completion of existing large professional service agreements as well as a decrease in the rate of execution of new professional service contracts.

The following table is based on the geographic location of our customers including the original equipment manufacturers, contract manufacturers or the distributors who purchased our products and services. For sales to our distributors, their geographic location may be different from the geographic locations of the ultimate end customers. Sales by geography for the periods presented were: Three months ended September 30, Nine months ended September 30, 2012 2011 2012 2011 (in thousands) United States $ 18,091 $ 19,533 $ 51,089 $ 62,650 China 16,757 21,777 48,346 58,133 Taiwan 7,313 7,711 19,635 26,045 Japan 3,741 2,413 8,724 11,422 Malaysia 3,935 5,618 12,099 13,883 Korea 3,773 3,944 9,774 9,722 Other countries 7,471 6,733 19,444 21,059 Total $ 61,081 $ 67,729 $ 169,111 $ 202,914 Cost of Revenue and Gross Margin. We outsource wafer fabrication, assembly and test functions of our products. A significant portion of our cost of revenue consists of payments for the purchase of wafers and for assembly and test services, amortization of acquired intangibles and amortization related to capitalized mask costs. To a lesser extent, cost of revenue includes expenses relating to our internal operations that manage our contractors, stock-based compensation, the cost of shipping and logistics, royalties, inventory valuation expenses for excess and obsolete inventories, warranty costs and changes in product cost due to changes in sort, assembly and test yields. In general, our cost of revenue associated with a particular product declines over time as a result of yield improvements, primarily associated with design and test enhancements.

We use third-party foundries and assembly and test contractors, which are primarily located in Asia, to manufacture, assemble and test our semiconductor products. We purchase processed wafers on a per wafer basis from our fabrication suppliers, which are 22 -------------------------------------------------------------------------------- Table of Contents currently Taiwan Semiconductor Manufacturing Company, or TSMC, with the remaining manufacturing outsourced to Samsung Electronics, or Samsung, Fujitsu Microelectronics, or Fujitsu, and United Microelectronics Corporation, or UMC.

We also outsource the sort, assembly, final testing and other processing of our product to third-party contractors, primarily ASE Electronics in Taiwan, Malaysia and Singapore, as well as ISE Labs, Inc, in the United States. We negotiate wafer fabrication on a purchase order basis. There are no long-term agreements with any of these third party contractors. A significant disruption in the operations of one or more of these third party contractors would impact the production of our products for a substantial period of time, which could have a material adverse effect on our business, financial condition and results of operations.

Our gross margin has been and will continue to be affected by a variety of factors, including the product mix, average sales prices of our products, the amortization expense associated with the acquired intangible assets, the timing of cost reductions for fabricated wafers and assembly and test service costs, inventory valuation charges, the cost of fabrication masks that are capitalized and amortized, and the timing and changes in sort, assembly and test yields.

Overall gross margin is impacted by the mix between higher performance, higher margin products and services and lower performance, lower margin products and services. In addition, we typically experience lower yields and higher associated costs on new products, which improve as production volumes increase.

Gross margin decreased from 59.9% in the three months ended September 30, 2011 to 59.4% in the three months ended September 30, 2012, a decrease of 0.5% and decreased from 60.2% in the nine months ended September 30, 2011 to 54.1% in the nine months ended September 30, 2012, a decrease of 6.1%. The decrease in the overall gross margin percentage for the three and nine months ended September 30, 2012 compared to the same periods in 2011 was mainly due to overall decreases in revenue and shifts of product sales mix of our semiconductor products as we sold more of our lower performance products, which yield lower gross margins compared to our higher performance products. In addition, contributing to the overall decrease in gross margin for the nine months ended September 30, 2012 compared to the same period in 2011 were write-downs of Celestial product inventories of approximately $4.8 million during the first quarter of 2012.

Research and Development Expenses Research and development expenses primarily include personnel costs, engineering design development software and hardware tools, allocated facilities expenses and depreciation of equipment used in research and development, and stock-based compensation.

Total research and development expenses for the periods presented were: Three months ended Nine months ended September 30, September 30, 2012 2011 change % 2012 2011 change % (in thousands) (in thousands)Research and development expenses $ 26,185 $ 23,571 $ 2,614 11.1 % $ 79,366 $ 67,953 $ 11,413 16.8 % Percent of total net revenue 42.9 % 34.8 % 8.1 % 46.9 % 33.5 % 13.4 % Research and development expenses increased by $2.6 million or 11.0% in the three months ended September 30, 2012 and increased by $11.4 million or 16.8% in the nine months ended September 30, 2012 compared to the same periods in 2011.

Salaries and benefits remained flat for the three months ended September 30, 2012 but increased by $3.4 million for the nine months ended September 30, 2012 compared to the same periods in 2011. Total stock-based compensation and related taxes increased by $633,000 and $2.5 million for the three and nine months ended September 30, 2012, respectively, compared to the same periods in 2011. The increase in salaries and benefits resulted mainly from increased headcount, severance and other related benefits to certain employees affected by a work-force reduction and increase in and stock-based compensation and related taxes was mainly due to additional expense associated with the options and restricted stock unit grants. In addition, depreciation and amortization expense increased by $1.4 million and $3.9 million in the three and nine months ended September 30, 2012, respectively, compared to the same periods in 2011 mainly due to higher amortization expense from acquired technology licenses used for research and development projects. The remaining increase was due to higher facilities expenses, software maintenance costs and other miscellaneous research and development costs which resulted from increased research and development activities to support the development of our new products. Research and development headcount increased to 557 at September 30, 2012 compared to 544 at September 30, 2011. The remaining increase was due to higher facilities expenses, software maintenance costs and other miscellaneous research and development costs which resulted from increased research and development activities to support the development of our new products.

23-------------------------------------------------------------------------------- Table of Contents Sales, General and Administrative Expenses Sales, general and administrative expenses primarily include personnel costs, accounting and legal fees, information systems, sales commissions, trade shows, marketing programs, depreciation, allocated facilities expenses and stock-based compensation.

Total sales, general and administrative costs for the periods presented were: Three months ended Nine months ended September 30, September 30, 2012 2011 change % 2012 2011 change % (in thousands) (in thousands)Sales, general and administrative $ 19,213 $ 11,599 $ 7,614 65.6 % $ 50,186 $ 46,056 $ 4,130 9.0 % Percent of total net revenue 31.5 % 17.1 % 14.3 % 29.7 % 22.7 % 7.0 % Sales, general and administrative expenses increased by $7.6 million or 65.6% in the three months ended September 30, 2012 and $4.1 million or 9.0% in the nine months ended September 30, 2012, compared to the same periods in 2011. Excluding non-recurring credits of $4.4 million recognized in the first quarter of 2012 due to the receipt of proceeds from an escrow claim and $4.6 million credit recognized during the third quarter of 2011 due to the change in contingent earn-out liability related to the acquisition and the charge of $2.7 million loss on disposition of certain consumer product assets during the third quarter of 2012, total sales, general and administrative expenses increased by $321,000 or 2% and $1.3 million or 2% for the three and nine months ended September 30, 2012, respectively, compared to the same periods in 2011. The increase was mainly due to the higher stock-based compensation and related taxes of $242,000 and $3.1 million for the three and nine months ended September 30, 2012, respectively, compared to the same periods in 2011 as a result of additional expense associated with the options and restricted unit grants and vesting acceleration of certain option grant. Outside services, which includes legal, audit and consulting fees increased by $214,000 for the three months ended September 30, 2012 and decreased by $1.9 million for the nine months ended September 30, 2012 compared to the same periods in 2011 mainly due to the timing of when the costs were incurred generally related to acquisition of businesses.

Salaries and employee benefits decreased by $262,000 and $259,000 for the three and nine months ended September 30, 2012, respectively, compared to the same periods in 2011 mainly due to decreased headcount and lower cost incurred for retention and certain bonuses related to acquisition, which was partially or fully offset by severance and other related benefit cost to certain employees affected by a work-force reduction. Sales, general and administrative headcount decreased to 170 at September 30, 2012 from 186 at September 30, 2011.

Other income (expense), net. Other income (expense), net primarily includes interest expense associated with the installment payment of capital leases, foreign currency gains and losses, financing expenses and interest income on cash and cash equivalents.

Three months ended Nine months ended September 30, September 30, 2012 2011 change % 2012 2011 change % (in thousands) (in thousands) Interest expense $ (11 ) $ (55 ) $ 44 -80.0 % $ (65 ) $ (191 ) $ 126 -66.0 % Other, net (720 ) (53 ) (667 ) 1,258.5 % (828 ) (42 ) (786 ) 1,871.4 % Total other income (expense), net $ (731 ) $ (108 ) $ (623 ) 576.9 % $ (893 ) $ (233 ) $ (660 ) 283.3 % Other expense, net increased in the three and nine months ended September 30, 2012 compared to the same periods in 2011 mainly due to the loss of $835,000 attributable to portion of the loss of a variable interest entity of which the Company is the primary beneficiary (see Note 1 of notes to condensed consolidated financial statements and Item 5). The increase was partially offset by a higher foreign exchange gain as a result of balance sheet remeasurement and lower interest expense associated with installment payment of capitalized leases.

Benefit from Income Taxes. For the three and nine months ended September 30, 2012 and 2011, the tax benefit from income taxes was based on our estimated annual effective tax rate, plus any discrete items, in compliance with applicable guidance. We update our estimate of our annual effective tax rate at the end of each quarterly period. Our estimate takes into account estimations of annual pre-tax income, the geographic mix of pre-tax income and our interpretations of tax laws and the possible outcomes of current and future audits.

24 -------------------------------------------------------------------------------- Table of Contents The following table presents the benefit from income taxes and the effective tax rates for the respective periods presented: Three months ended Nine months ended September 30, September 30, 2012 2011 change % 2012 2011 change % (in thousands) (in thousands)Income (loss) before income taxes $ (9,844 ) $ 5,279 $ (15,123 ) -286.5 % $ (38,887 ) $ 7,977 $ (46,864 ) -587.5 % Benefit from income taxes (1,719 ) (752 ) (967 ) 128.6 % (5,094 ) (1,468 ) (3,626 ) 247.0 % Effective tax rate 17.5 % -14.2 % 31.7 % 13.1 % -18.4 % 31.4 % The benefit from income taxes for the three and nine months ended September 30, 2012 was primarily related to the year-to-date pre-tax losses and release of uncertain tax position reserves. The benefit from income taxes for the three and nine months ended September 30, 2012 was mainly attributable to a tax provision for federal, state and foreign income taxes reduced by a discrete tax benefit.

The discrete benefit in the three and six months ended September 30, 2011 was solely related to increased federal research and development credits that resulted from the exercise of compensatory stock options. The federal research and development credits expired at the end of 2011 and the related tax benefit was not included in the 2012 tax analysis.

The difference between the provision for (benefit from) income taxes that would be derived by applying the statutory rate to our loss before tax and the benefit from income taxes actually recorded for the three and nine months ended September 30, 2012 was primarily attributable to the impact of the difference in foreign tax rates, non-deductible stock-based compensation charges and other non-deductible items. The difference between the provision for (benefit from) income taxes that would have been derived by applying the statutory rate to our net income before tax and the benefit from income taxes actually recorded for the three and nine months ended September 30, 2011 was primarily attributable to the impact of the differential in foreign tax rates, non-deductible stock-based compensation charges and the federal research and development credit benefits.

Our net deferred tax assets relate predominantly to the United States tax jurisdiction. The valuation allowance is determined in accordance with the provisions of income taxes which require an assessment of both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are recoverable; such assessment is required on a jurisdiction-by-jurisdiction basis. During the year ended December 31, 2010, we released our valuation allowance against the United States federal deferred tax assets because we believed that sufficient positive evidence existed from historical operations and future projections to conclude that it was more-likely-than-not to fully realize our federal deferred tax assets. In making this determination, we considered all available evidence, both positive and negative. Such evidence include, among others, our history of losses and profitability, jurisdictional income recognition trends, taxable income adjusted for certain extraordinary and other items, the impact of acquisitions, forecasted income by jurisdiction, and tax planning strategies. As of December 31, 2011 and September 30, 2012, we believe that it is more-likely-than-not that a valuation allowance is not required against our United States federal deferred tax assets. We continue to maintain a full valuation allowance against our California and Massachusetts net deferred tax assets, which was $12.8 million as of December 31, 2011, because the likelihood of the realization of those assets has not become more-likely-than-not.

We continue to monitor the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a valuation allowance against the deferred tax assets that our estimate will not be ultimately recoverable. Recovery is dependent on generating sufficient taxable income in the future. Although recovery is not assured, we believe that it is more-likely-than-not that we will ultimately recover the $34.1 million of net deferred tax assets recorded on our consolidated balance sheets as of December 31, 2011 (other than that for California and Massachusetts), even in light of the losses in recent quarters due to the expectation of returning to profitability in the immediately succeeding years. However, should there be a change in our ability to recover its deferred tax assets, the tax provision would increase in the period in which the likelihood of recovery was less than more-likely-than-not.

As of September 30, 2012 and December 31, 2011, we had unrecognized tax benefits for income taxes associated with uncertain tax positions of $11.0 million and $11.2 million, respectively. If all of these unrecognized tax benefits were recognized, $9.8 million would reduce our effective tax rate. We are not anticipating any significant changes in unrecognized tax benefits in the next 12 months.

Our major jurisdictions in which we are subject to income tax reporting requirements are the U.S. federal, the states of California and Massachusetts, Japan, India, China and Singapore. We believe we are compliant with all income tax return filing and payment requirements in the major jurisdictions. As of September 30, 2012, we were not aware of any on-going tax audits in the major jurisdictions.

25 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Following is a summary of our working capital and cash and cash equivalents as of September 30, 2012 and December 31, 2011: As of As of September 30, 2012 December 31, 2011 (in thousands) Working capital $ 107,049 $ 111,427 Cash and cash equivalents $ 67,290 $ 63,225 Following is a summary of our cash flows from operating activities, investing activities and financing activities for the periods presented: Nine months ended September 30, 2012 2011 (in thousands) Net cash provided by operating activities $ 20,500 $ 29,062 Net cash used in investing activities $ (15,453 ) $ (43,816 ) Net cash used in financing activities $ (982 ) $ (1,337 ) Cash Flows from Operating Activities Net cash flows from operating activities decreased by $8.6 million from $29.1 million in the nine months ended September 30, 2011 compared to $20.5 million in the nine months ended September 30, 2012. Net loss after adjustments of non-cash operating items was $15.7 million cash inflow in the nine months ended September 30, 2012 compared to net income after adjustments of non-cash operating items of $43.8 million cash inflow in the nine months ended September 30, 2011. The decrease resulted mainly from lower net revenue which generated lower income from operations. Changes in assets and liabilities generated net cash inflow of $4.8 million for the nine months ended September 30, 2012 compared to a net cash outflow of $14.7 million for the nine months ended September 30, 2011. The significant changes in assets and liabilities for the nine months ended September 30, 2012 were mainly due to higher accounts payable due to the timing of payments to vendors and higher deferred revenue due to the timing of the receipt of subscription licenses and professional services billings from customers. In addition, total accounts receivable decreased due to the timing of collections from the customers.

Inventories increased mainly due to the timing of inventory build-up in anticipation for the expected future customer demands. The significant changes in assets and liabilities for the nine months ended September 30, 2011 were mainly due to higher accounts receivable as a result of higher net revenue and the timing of collection, which was partially offset by higher accounts payable as a result of timing of payments to vendors and higher inventory as a result of the timing of inventory build-up in anticipation for the expected future customer demands.

Cash Flows from Investing Activities Net cash used in investing activities for the nine months ended September 30, 2012 was $15.5 million resulted mainly from the payments made to purchase property and equipment of $11.3 million and purchase of intangible assets of $4.2 million. Net cash used in investing activities for the nine months ended September 30, 2011 was $43.8 million resulted mainly from cash payments made for business acquisitions of $30.8 million, purchases of property and equipment of $7.2 million and intangible assets of $5.8 million.

Cash Flows from Financing Activities Net cash used in financing activities for the nine months ended September 30, 2012 was $1.0 million which resulted mainly from principal payment of capital lease and technology license obligations of $7.6 million, partially offset by the proceeds from issuance of common stock upon exercise of options of $6.6 million. Net cash used in financing activities for the nine months ended September 30, 2011 was $1.3 million which resulted mainly from principal payment of capital lease and technology license obligations of $12.4 million, partially offset by the proceeds from issuance of common stock upon exercise of options of $11.1 million.

26 -------------------------------------------------------------------------------- Table of Contents Capital Resources Cash equivalents consist of an investment in a money market fund. As of September 30, 2012, we have not experienced any impairment charges due to such concentration of credit risk. We believe that our $67.3 million of cash and cash equivalents at September 30, 2012 and expected cash flows from operations will be sufficient to fund our projected operating requirements for at least twelve months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our engineering, sales and marketing activities, the timing and extent of our expansion into new territories, the timing of introductions of new products and enhancements to existing products and the continuing market acceptance of our products. Although we currently are not a party to any agreement with respect to potential material investments in, or acquisitions of, complementary businesses, services or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all.

Indemnities In the ordinary course of business, we have entered into agreements with customers that include indemnity provisions. Based on historical experience and information known as of September 30, 2012, we believe our exposure related to the above indemnities at September 30, 2012 is not material. We also enter into indemnification agreements with our officers and directors and our certificate of incorporation and bylaws include similar indemnification obligations to our officers and directors. It is not possible to determine the amount of our liability related to these indemnification agreements and obligations to our officers and directors due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement.

Off-Balance Sheet Arrangements During the periods presented, we did not have, nor do we currently have, any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Contractual Obligations The following table describes our commitments to settle contractual obligations in cash as of September 30, 2012: Payments Due By Period Remainder 1 to 3 4 to 5 More Than Total of 2012 Years Years 5 Years (in thousands) Operating lease obligations $ 18,908 $ 906 $ 9,119 $ 5,514 $ 3,369 Capital lease and technology license obligations 32,971 8,386 19,435 5,150 - Total $ 51,879 $ 9,292 $ 28,554 $ 10,664 $ 3,369 As of September 30, 2012, the liability for uncertain tax positions was $714,000. The timing of any payments which could result from these unrecognized tax benefits will depend upon a number of factors. Accordingly, the timing of payment cannot be estimated.

On October 26, 2012, we signed a secured convertible promissory note agreement to provide additional cash advance of $2.0 million to a an unrelated third party for a convertible note receivable. The payment was made on October 26, 2012.

In addition, we have other obligations for goods and services entered into in the normal course of business. These obligations, however, are either not enforceable or legally binding or are subject to change based on our business decisions.

Critical Accounting Policies and Estimates The preparation of our financial statements and accompanying disclosures in conformity with GAAP requires estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and the accompanying notes. The SEC has defined a company's critical accounting policies as policies that are most important to the portrayal of a company's financial condition and results of operations, and which require a company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified our most critical accounting policies and estimates to be as follows: (1) revenue recognition; (2) stock-based compensation; (3) inventory valuation; (4) accounting for income taxes; 27-------------------------------------------------------------------------------- Table of Contents (5) mask costs; (6) business combinations and (7) goodwill and purchased intangible assets. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information not presently available. Actual results may differ significantly from these estimates if the assumptions, judgments and conditions upon which they are based turn out to be inaccurate. Management believes that there have been no significant changes to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations, in our Annual Report on Form 10-K for the year ended December 31, 2011 filed on February 27, 2012, except for the adoption of the new standard on goodwill impairment effective January 1, 2012, as discussed in Note 1 of Unaudited Condensed Consolidated Financial Statements.

Recent Accounting Pronouncements Please refer to the recent accounting pronouncements listed in Note 1 of Unaudited Condensed Consolidated Financial Statements.

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