CLEARONE INC - Quarter Report: 2017 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

Commission file number: 001-33660

CLEARONE, INC.

(Exact name of registrant as specified in its charter)

Indicate by check whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [  ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding /12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X] No [  ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [  ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X]

The number of shares of ClearOne common stock outstanding as of November 3, 2017 was 8,414,153.

CLEARONE, INC.

QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2017

INDEX

PART I – FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

CLEARONE, INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except par value)

See accompanying notes

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND

COMPREHENSIVE INCOME (LOSS)

(Dollars in thousands, except per share amounts)

See accompanying notes

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands, except per share amounts)

See accompanying notes

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands, except per share amounts)

The following is a summary of supplemental cash flow activities:

See accompanying notes

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited - Dollars in thousands, except per share amounts)

1. Business Description, Basis of Presentation and Significant Accounting Policies

Business Description:

ClearOne, Inc., together with its subsidiaries (collectively, “ClearOne” or the “Company”), is a global company that designs, develops and sells conferencing, collaboration, streaming and digital signage solutions for audio and visual communications. The performance and simplicity of its advanced comprehensive solutions offer unprecedented levels of functionality, reliability and scalability.

Basis of Presentation:

The fiscal year for ClearOne is the 12 months ending on December 31^st. The consolidated financial statements include the accounts of ClearOne and its subsidiaries. All significant inter-company accounts and transactions have been eliminated.

These accompanying interim unaudited condensed consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and are not audited. Certain information and footnote disclosures that are usually included in financial statements prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) have been either condensed or omitted in accordance with SEC rules and regulations. The accompanying condensed consolidated financial statements contain all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of our financial position as of September 30, 2017 and December 31, 2016, the results of operations for the three and nine months ended September 30, 2017 and 2016, and the cash flows for the nine months ended September 30, 2017 and 2016. The results of operations for the three months and nine months ended September 30, 2017 and 2016 are not necessarily indicative of the results for a full-year period. These interim unaudited condensed consolidated financial statements should be read in conjunction with the financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2016 filed with the SEC.

Significant Accounting Policies:

The significant accounting policies were described in Note 1 to the audited consolidated financial statements included in the Company’s annual report on Form 10-K for the year ended December 31, 2016. There have been no changes to these policies during the nine months ended September 30, 2017 that are of significance or potential significance to the Company except for the treatment of patent defense costs described below.

Patent Defense Costs - The Company relies on patents and proprietary technology and seeks patent protection for products and production methods. The Company capitalizes external legal costs incurred in the defense of its patents when it believes that a future economic benefit will result from the defense and a successful outcome of the legal action is probable. These costs are amortized over the remaining estimated useful life of the patent, which is 15 to 17 years. The Company’s assessment of future economic benefit and/or the successful outcome of legal action related to patent defense involves considerable management judgment and a different outcome could result in material write-offs of the carrying value of these assets.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited - Dollars in thousands, except per share amounts)

Recent Accounting Pronouncements:

In May 2014, the FASB released Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), requiring an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The updated standard will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective and permits the use of either a full retrospective or retrospective with cumulative effect transition method. We plan to adopt the standard when it becomes effective for us beginning January 1, 2018. We currently anticipate adopting the standard using the modified retrospective method with a cumulative catch up adjustment and providing additional disclosures comparing results to previous rules. We continue to evaluate the impact of the new standard on our consolidated financial statements but anticipate this standard will have a material impact on our consolidated financial statements.

In February 2016, the FASB released ASU No. 2016-02, Leases (Topic 842) to bring transparency to lessee balance sheets. The ASU will require organizations that lease assets (lessees) to recognize assets and liabilities on the balance sheet for the rights and obligations created by all leases with terms of more than 12 months. The standard will apply to both types of leases-capital (or finance) leases and operating leases. Previously, GAAP has required only capital leases to be recognized on lessee balance sheets. The standard is effective for fiscal years beginning after December 15, 2018 and interim periods within fiscal years beginning after December 15, 2018. Early application will be permitted for all organizations. The Company has not yet selected a transition method and is currently evaluating the effect that the updated standard will have on the consolidated financial statements.

In March 2016, the FASB released ASU No. 2016-09, Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting. The standard is intended to simplify several areas of accounting for share-based compensation arrangements, including the income tax impact, classification on the statement of cash flows and forfeitures. ASU 2016-09 was effective for the Company on January 1, 2017. As a result of the adoption of ASU 2016-09, excess tax benefits or deficiencies related to stock-based compensation are now reflected in the Consolidated Statements of Operations as a component of the provision for income taxes, whereas they previously were recognized in additional paid-in capital. In addition, our Consolidated Statements of Cash Flows will now present, on a prospective basis, excess tax benefits as an operating activity. Finally, we have elected to account for forfeitures as they occur, rather than estimate expected forfeitures.

In August 2016, the FASB released ASU No. 2016-15, Classification of Certain Cash Receipts and Cash Payments, which addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. ASU 2016-15 is effective for the Company beginning January 1, 2018 and we are currently evaluating the impact that ASU 2016-15 will have on our consolidated financial statements.

In May 2017, the FASB issued ASU No. 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting. The new guidance provides clarity and reduces both (1) diversity in practice and (2) cost and complexity when applying the guidance in Topic 718, Compensation—Stock Compensation, to a change to the terms or conditions of a share-based payment award. The accounting standard update will be effective for The Company beginning January 1, 2018 on a prospective basis, and early adoption is permitted. The Company has not yet selected a transition method and is currently evaluating the effect that the updated standard will have on the consolidated financial statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited - Dollars in thousands, except per share amounts)

2. Earnings (Loss) Per Share

Earnings (loss) per common share is computed based on the weighted-average number of common shares outstanding and, when appropriate, dilutive potential common stock outstanding during the period. Stock options are considered to be potential common stock. The computation of diluted earnings (loss) per share does not assume exercise or conversion of securities that would have an anti-dilutive effect.

Basic earnings (loss) per common share is the amount of net earnings (loss) for the period available to each weighted-average share of common stock outstanding during the reporting period. Diluted earnings (loss) per common share is the amount of earnings (loss) for the period available to each weighted-average share of common stock outstanding during the reporting period and to each share of potential common stock outstanding during the period, unless inclusion of potential common stock would have an anti-dilutive effect.

The following table sets forth the computation of basic and diluted earnings (loss) per common share:

3. Marketable Securities

The Company has classified its marketable securities as available-for-sale securities. These securities are carried at estimated fair value with unrealized holding gains and losses included in accumulated other comprehensive income (loss) in stockholders’ equity until realized. Gains and losses on marketable security transactions are reported on the specific-identification method. Dividend and interest income are recognized when earned.

The amortized cost, gross unrealized holding gains, gross unrealized holding losses, and fair value for available-for-sale securities by major security type and class of securities at September 30, 2017 and December 31, 2016 were as follows:

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited - Dollars in thousands, except per share amounts)

Maturities of marketable securities classified as available-for-sale securities were as follows at September 30, 2017:

Debt securities in an unrealized loss position as of September 30, 2017 were not deemed impaired at acquisition and subsequent declines in fair value are not deemed attributed to declines in credit quality. Management believes that it is more likely than not that the securities will receive a full recovery of par value, although there can be no assurance that such recovery will occur. The available-for-sale marketable securities with continuous gross unrealized loss position for less than 12 months and 12 months or greater and their related fair values were as follows:

4. Goodwill and Intangible Assets

Goodwill

There was a decrease in goodwill during the three and nine months ended September 30, 2017 from $12,724 as of December 31, 2016 to $0 as of September 30, 2017 due to the impairment of goodwill. During the three months ended September 30, 2017, there was a decrease in the Company’s market capitalization which was determined to be a triggering event for potential goodwill impairment. Accordingly, the Company performed a goodwill impairment analysis. The Company utilized the market capitalization to estimate the fair value. Our total stockholders’ equity exceeded the estimated fair value. The failure of step one of the goodwill impairment test triggered a step two impairment test. As a result of step two of the impairment test, the Company determined the implied fair value of goodwill and concluded that the carrying value of goodwill exceeded its implied fair value as of September 30, 2017. Accordingly, an impairment charge of $12,724, which represents a full impairment charge, was recognized in the three months ended September 30, 2017.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited - Dollars in thousands, except per share amounts)

Intangible Assets

Intangible assets as of September 30, 2017 and December 31, 2016 consisted of the following:

The amortization of intangible assets for the three and nine months ended September 30, 2017 and 2016 was as follows:

During the three and nine months ended September 30, 2017 we recorded a $0.7 million charge for impairment of an intangible asset consisting of customer relationships.

The estimated future amortization expense of intangible assets is as follows:

5. Inventories

Inventories, net of reserves, as of September 30, 2017 and December 31, 2016 consisted of the following:

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited - Dollars in thousands, except per share amounts)

Long-term inventory represents inventory held in excess of our current (next 12 months) requirements based on our recent sales and forecasted level of sales. We expect to sell the above inventory, net of reserves, at or above the stated cost and believe that no loss will be incurred on its sale, although there can be no assurance of the timing or amount of any sales.

Current finished goods do not include distributor channel inventories in the amounts of approximately $1,394 and $1,530 as of September 30, 2017 and December 31, 2016, respectively. Distributor channel inventories represent inventories at distributors and other customers where revenue recognition criteria have not yet been achieved.

Net loss incurred on valuation of inventory at lower of cost or market value and write-off of obsolete inventory during the three months ended September 30, 2016 was $328. During the three months ended September 30, 2017 there was no write off on the valuation of inventory.

6. Share-based Compensation

Employee Stock Option Plans

The Company’s share-based incentive plans offering stock options primarily consists of two plans. Under both plans, one new share is issued for each stock option exercised. The plans are described below.

The Company’s 1998 Incentive Plan (the “1998 Plan”) was the Company’s primary plan through November 2007. Under this plan shares of common stock were made available for issuance to employees and directors. Through December 1999, 1,066,000 options were granted that would cliff vest after 9.8 years; however, such vesting was accelerated for 637,089 of these options upon meeting certain earnings per share goals through the fiscal year ended September 30, 2003. Subsequent to December 1999 and through March 2002, 1,248,250 options were granted that would cliff vest after 6.0 years; however, such vesting was accelerated for 300,494 of these options upon meeting certain earnings per share goals through the fiscal year ended September 30, 2005.

The Company’s 2007 Equity Incentive Plan (the “2007 Plan”) was restated and approved by the shareholders on December 12, 2015. Provisions of the restated 2007 Plan include the granting of up to 2,000,000 incentive and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units. Options may be granted to employees, officers, non-employee directors and other service providers and may be granted upon such terms as the Compensation Committee of the Board of Directors determines in their sole discretion.

Of the options granted subsequent to March 2002, all vesting schedules are based on 3 or 4-year vesting schedules, with either one-third or one-fourth vesting on the first anniversary and the remaining options vesting ratably over the remainder of the vesting term. Generally, directors and officers have 3-year vesting schedules and all other employees have 4-year vesting schedules. Additionally, in the event of a change in control or the occurrence of a corporate transaction, the Company’s Board of Directors has the authority to elect that all unvested options shall vest and become exercisable immediately prior to the event or closing of the transaction. All options outstanding as of September 30, 2017 had contractual lives of ten years.

Under the 1998 Plan, 2,500,000 shares were authorized for grant. As of September 30, 2017, there are no options outstanding under the 1998 Plan. The remaining 50,000 of these options were exercised on July 11, 2017.

As of September 30, 2017, there were 767,156 options outstanding under the 2007 Plan. As of September 30, 2017, the 2007 Plan had 471,500 authorized unissued options.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited - Dollars in thousands, except per share amounts)

A summary of the stock option activity under the Company’s plans for the nine months ended September 30, 2017 is as follows:

As of September 30, 2017, the total remaining unrecognized compensation cost related to non-vested stock options, net of forfeitures, was approximately $975, which will be recognized over a weighted average period of 1.99 years.

Stock Option Repurchase

From March 11, 2016 to March 17, 2016, the Company offered to repurchase eligible vested options to purchase shares under the 1998 Plan and the 2007 Plan from employees. The Company repurchased delivered options at a repurchase price equal to the difference between the closing market price on the date of the employee’s communication of accepting the repurchase offer and the exercise price of such employee’s delivered options, subject to applicable withholding taxes and charges. The Company repurchased 225,542 stock options from employees at an average purchase price of $7.77.

Employee Stock Purchase Plan

The Company issues shares to employees under the Company’s 2014 Employee Stock Purchase Plan (the “ESPP”). The ESPP was approved by the Company’s shareholders on December 12, 2014. As of September 30, 2017, 471,160 of the originally approved 500,000 shares were available for offerings under the ESPP. Offering periods under the ESPP commence on each January 1 and July 1, and continue for a duration of six months. The ESPP is available to all employees who do not own, or not are deemed to own, shares of stock making up an excess of 5% of the combined voting power of the Company and its subsidiaries. During each offering period, each eligible employee may purchase shares under the ESPP after authorizing payroll deductions. Under the ESPP, each employee may purchase up to the lesser of 2,500 shares or $25 of fair market value (based on the established purchase price) of the Company’s stock for each offering period. Unless the employee has previously withdrawn from the offering, his or her accumulated payroll deductions will be used to purchase common stock on the last business day of the period at a price equal to 85% (or a 15% discount) of the fair market value of the common stock on the first or last day of the offering period, whichever is lower.

Share-based compensation expense related to ESPP has been recorded as follows:

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited - Dollars in thousands, except per share amounts)

7. Shareholders’ Equity

Stock Repurchase Program

On March 9, 2016, the Board of Directors of the Company authorized the repurchase of up to $10,000 of the Company’s outstanding shares of common stock under a stock repurchase program. In connection with the repurchase authorization, the Company was authorized to complete the repurchase through open market transactions or through an accelerated share repurchase program, in each case to be executed at management’s discretion based on business and market conditions, stock price, trading restrictions, acquisition activity and other factors. The repurchase program may be suspended or discontinued at any time without prior notice. The transactions effectuated to date occurred in open market purchases.

On March 1, 2017, the Board of Directors of the Company renewed and extended the repurchase program for up to an additional $10,000 of common stock over the next twelve months. In connection with the repurchase extension authorization, the Company was authorized to complete the repurchase through open market transactions or through an accelerated share repurchase program, in each case to be executed at management’s discretion based on business and market conditions, stock price, trading restrictions, acquisition activity and other factors. The repurchase program may be suspended or discontinued at any time without prior notice. The transactions effectuated to date occurred in open market purchases.

Cash Dividends

On August 7, 2017, the Company declared a cash dividend of $0.07 per share of ClearOne common stock paid September 7, 2017 to shareholders of record as of August 22, 2017.

Changes in Shareholders’ Equity

The following table summarizes the change in shareholders’ equity during the three and nine months ended September 30, 2017 and 2016, respectively:

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited - Dollars in thousands, except per share amounts)

8. Fair Value Measurements

The fair value of the Company’s financial instruments reflects the amounts that the Company estimates it will receive in connection with the sale of an asset or pay in connection with the transfer of a liability in an orderly transaction between market participants at the measurement date (exit price). The fair value hierarchy prioritizes the use of inputs used in valuation techniques into the following three levels:

Level 1 - Quoted prices in active markets for identical assets and liabilities.

Level 2 - Observable inputs other than quoted prices in active markets for identical assets and liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. This category generally includes U.S. Government and agency securities; municipal securities; mutual funds and securities sold and not yet settled.

Level 3 - Unobservable inputs.

The substantial majority of the Company’s financial instruments are valued using observable input. The following table sets forth the fair value of the financial instruments re-measured by the Company as of September 30, 2017 and December 31, 2016:

9. Income Taxes

The Company’s forecasted effective tax benefit rate at September 30, 2017 is 36.1%, a 0.9% decrease from the 37.0% effective tax rate recorded at December 31, 2016. The forecasted effective tax benefit rate of 36.1% excludes jurisdictions for which no benefit from forecasted current year losses is anticipated. Including losses from such jurisdictions results in a forecasted effective tax benefit rate of 30.1%. Our forecasted effective tax rate could fluctuate significantly on a quarterly basis and could change, to the extent that earnings in countries with tax rates that differ from that of the U.S. differ from amounts anticipated at September 30, 2017.

After a discrete tax expense of $145, the effective tax benefit rate for the quarter ended September 30, 2017 is 29.0%. The discrete tax expense of $145 is primarily attributable to changes in income tax reserves related to research and development tax credits.

10. Subsequent Events

On November 8, 2017 the Company announced a quarterly cash dividend for the third quarter of 2017 at $0.07 per share to be paid on December 6, 2017 to shareholders of record as of November 22, 2017.

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This report on Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements in this report, other than statements of historical fact, are forward-looking statements for purposes of these provisions, including any projections of earnings, revenues or other financial items, any statements of the plans and objectives of management for future operations, any statements concerning proposed new products or services, any statements regarding future economic conditions or performance, and any statements of assumptions underlying any of the foregoing. All forward-looking statements included in this report are made as of the date hereof and are based on information available to us as of such date. We assume no obligation to update any forward-looking statement. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expects,” “plans,” “anticipates,” “intends,” “believes,” “estimates,” “potential,” or “continue,” or the negative thereof or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements contained herein are based upon reasonable assumptions at the time made, there can be no assurance that any such expectations or any forward-looking statement will prove to be correct. Our actual results will vary, and may vary materially, from those projected or assumed in the forward-looking statements. Future financial condition and results of operations, as well as any forward-looking statements, are subject to inherent risks and uncertainties, many of which we cannot predict with accuracy and some of which we might not anticipate, including, without limitation, product recalls and product liability claims; infringement of our technology or assertion that our technology infringes the rights of other parties; termination of supplier relationships, or failure of suppliers to perform; inability to successfully manage growth; delays in obtaining regulatory approvals or the failure to maintain such approvals; concentration of our revenue among a few customers, products or procedures; development of new products and technology that could render our products obsolete; market acceptance of new products; introduction of products in a timely fashion; price and product competition, availability of labor and materials, cost increases, and fluctuations in and obsolescence of inventory; volatility of the market price of our common stock; foreign currency fluctuations; changes in key personnel; work stoppage or transportation risks; integration of business acquisitions; and other factors referred to in our reports filed with the SEC, including our Annual Report on Form 10-K for the year ended December 31, 2016. All subsequent forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. Additional factors that may have a direct bearing on our operating results are discussed in Part I, Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2016.

BUSINESS OVERVIEW

ClearOne is a global company that designs, develops and sells conferencing, collaboration, and network streaming & signage solutions for voice and visual communications. The performance and simplicity of our advanced, comprehensive solutions offer unprecedented levels of functionality, reliability and scalability.

We derive most of our revenue from professional audio conferencing products by promoting our products in the professional audio visual channel. We have extended our total addressable market from installed audio conferencing market to adjacent complementary markets – microphones, video collaboration and networked media streaming. We have achieved this through strategic technological acquisitions as well as by internal product development.

During the nine months ended September 30, 2017, we were awarded two new patents, one of which was our innovative patent on a system and method involving the combination of echo cancellation, beamforming microphone arrays, and smart beam selection--the technology underpinning the ‘acoustic intelligence’ of our ground-breaking Beamforming Microphone Array. We continued to take the necessary steps to enforce this strategic patent to remedy having to compete against our own patented technology, and to defend the validity of our patents.

During the nine months ended September 30, 2017, our efforts primarily centered on shipping remaining models in our newly introduced next-gen DSP conferencing platform and Beamforming Microphone Array, and promoting the transition from our legacy Converge Pro 1 (CP1) platform to the new Converge Pro 2 (CP2) platform.

Overall revenue declined in the three and nine months ended September 30, 2017 when compared to the three and nine months ended September 30, 2016 notwithstanding a large order that was fulfilled in the quarter ended September 30, 2017. The declines in revenue from professional audio products and unified communications end points more than offset the increase in revenue from video products. Our gross profit margin decreased to 59% from 63% for the nine months ended September 30, 2017 and 2016, respectively. Gross profit margin decrease was primarily due to the decrease in the mix of higher margin products and the price reductions associated with transition from CP1 to CP2 partially offset by the absence of inventory scrapping costs in 2017. Our gross profit margin increased to 62% from 59% for the three months ended September 30, 2017 and 2016, respectively. The increase is primarily due to the significantly higher margin enjoyed by the large order fulfilled in the third quarter of 2017 and the absence of inventory scrapping costs in the third quarter of 2017 compared to third quarter of 2016.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Industry conditions

We operate in a very dynamic and highly competitive industry which is dominated on the one hand by a few players with respect to certain products like traditional video conferencing appliances while on the other influenced heavily by a fragmented reseller market consisting of numerous regional and local players. The industry is also characterized by the influx of venture capitalist funded start-ups and private companies keen to win market share even at the expense of mounting financial losses.

Economic conditions, challenges and risks

The audio-visual products market is characterized by intense competition and rapidly evolving technology. Our competitors vary within each product category. Our professional audio communication products, which contribute the most to our revenue, continues to be ahead of the competition despite the reduction in revenues through our transition from the CP1 platform to the next generation CP2 platform. Our strength in this space is largely due to our industry leading conferencing technologies and the full suite of professional microphone products, especially Beamforming Microphone Arrays. Despite our strong leadership position in the professional audio communications products market, we face challenges to revenue growth due to the limited size of the market and pricing pressures from new competitors attracted to the commercial market. Our revenues from our flagship professional audio conferencing products continue to suffer due to the delay in transitioning from our old CP1 platform to CP2 platform and due to increased competition for our beamforming microphones from competitors who are infringing our patents.

Revenue from our video products in the overall revenue mix has been improving on the back of a strong growth for our video products in 2016 that has continued in 2017. We face intense competition in this market from well-established market leaders as well as emerging players rich with marketing funds. We expect our strategy of combining Spontania, our cloud-based video conferencing product, Collaborate, our appliance based media collaboration product and our high-end audio conferencing technology to provide growth in revenue in the near future. We believe we are also well positioned to capitalize on the continuing migration away from the traditional hardware based video conferencing systems to software based video conferencing applications.

We derive a portion of our revenue (about 49%) from international operations and expect this trend to continue in the future. Most of our revenue from outside the U.S. is billed in US Dollars and is not exposed to any significant currency risk. In spite of the U.S. dollar losing strength against other currencies, a strong U.S. dollar would make our products less competitive.

Deferred Revenue

Each quarter-end, we evaluate the inventory in the distribution channel through information provided by certain of our distributors. The level of inventory in the channel fluctuates up or down each quarter based upon our distributors’ individual operations. Accordingly, each quarter-end revenue deferral is calculated and recorded based upon the underlying channel inventory at quarter-end. Deferred revenue was approximately $3.9 million as of September 30, 2017, compared to $3.8 million of deferred revenue as of June 30, 2017 and $3.9 million of deferred revenue as of December 31, 2016.

A detailed discussion of our results of operations follows below.

Results of Operations for the three and nine months ended September 30, 2017 and 2016

The following table sets forth certain items from our unaudited condensed consolidated statements of operations (dollars in thousands) for the three and nine months ended September 30, 2017 (“2017-Q3”) and 2016 (“2016-Q3”), respectively, together with the percentage of total revenue which each such item represents:

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Revenue

Our revenue decreased by $2.3 million, or 18%, to $10.6 million in 2017-Q3 compared to $12.9 million in 2016-Q3. The 66% increase in revenue from video products was more than offset by a 30% decline in professional audio conferencing revenue and a 25% decline in revenue from unified communication (UC) end points. For the nine months ended September 30, 2017, revenue decreased by $5.4 million, or 14%, to $32.5 million, as compared to $37.9 million for the nine months ended September 30, 2016. The 51% increase in revenue from video products was more than offset by a 21% decline in professional audio conferencing revenue and a 26% decline in revenue from unified communication (UC) end points. During the nine months ended September 30, 2017, premium audio conferencing products declined the most while media collaboration products increased the most. The decline in revenue from professional audio conferencing products was mostly due to decline in revenue from legacy CP1 products and reductions in CP1 pricing effected in the last quarter of 2016. The share of professional audio communications products (which includes microphone products but not premium products) in our product mix declined from 77% in 2016-Q3 to 66% in 2017-Q3. The increase in revenue from video products was due to the success of Unite camera and favorable reception to the new Collaborate SKUs containing integrated audio solutions. Share of video products in the revenue increased from 12% in 2016-Q3 to 24% in 2017-Q3, while share of UC end points in the revenue declined from 11% in 2016-Q3 to 10% in 2017-Q3.

During 2017-Q3, revenue declined in the US, Canada, South East Asia, Japan, Korea and some parts of Europe while revenue from China, the Middle East, India, Australia and some part of Europe grew. Asia Pacific including Middle East increased by 43%; Europe and Africa declined by 3% and Americas declined by about 37%. The revenue decline was primarily caused by the delay in the transition to our next generation audio platform, CP2, combined with price reduction offered to stimulate customer interest and sales in the legacy CP1 products. Revenue was also negatively affected by less than robust infrastructure and capital equipment spending. In spite of the generally less than robust infrastructure spending, we did complete the sale to a major project by a Chinese entity. This caused the revenue increase for the Asia Pacific region quarter-over-quarter. We believe we will return to a growth path once the transition from CP1 platform to the newer CP2 platform occurs. However, we anticipate that the growth will depend on the speed at which our customers transition to the new platform and the economic recovery in certain key markets which remains weak.

Costs of Goods Sold and Gross Profit

Cost of goods sold (“COGS”) includes expenses associated with finished goods purchased from outsourced manufacturers, the manufacture of our products (including material and direct labor), our manufacturing and operations organization, property and equipment depreciation, warranty expense, freight expense, royalty payments, and the allocation of overhead expenses.

Our gross profit for the three months ended September 30, 2017 was approximately $6.5 million or 62% compared to approximately $7.7 million, or 59%, for the three months ended September 30, 2016. Gross margin for the three months ended September 30, 2017 improved primarily due to the significantly higher margin enjoyed by the large order fulfilled in the third quarter of 2017 and the absence of inventory scrapping costs in the third quarter of 2017. Our gross profit for the nine months ended September 30, 2017 was approximately $19.3 million, or 59%, compared to approximately $23.8 million, or 63%, for the nine months ended September 30, 2016. Gross margin declined for the nine months ended September 30, 2017 primarily due to the following reasons: (1) price reductions made to CP1 products to encourage CP1 sales and (2) decline in higher margin professional audio conferencing products in the mix partially offset by the absence of inventory scrapping costs in 2017.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Our profitability in the near-term continues to depend significantly on our revenues from professional audio conferencing products. We hold long-term inventory and if we are unable to sell our long-term inventory, our profitability might be affected by inventory write-offs and price mark-downs.

Operating Expenses

Operating income, or income from operations, is the surplus after operating expenses are deducted from gross profits. Operating expenses include sales and marketing (“S&M”) expenses, research and product development (“R&D”) expenses and general and administrative (“G&A”) expenses. Total operating expenses were $20.0 million for the three months ended September 30, 2017 compared to $6.2 million for the three months ended September 30, 2016. Total operating expenses were $34.4 million for the nine months ended September 30, 2017, of which $13.4 million was related to the impairment of the goodwill and intangibles in Q3 2017, compared to $19.1 million for the nine months ended September 30, 2016. The following contains a more detailed discussion of expenses related to sales and marketing, research and product development, general and administrative, and other items.

Sales and Marketing - S&M expenses include sales, customer service, and marketing expenses such as employee-related costs, allocations of overhead expenses, trade shows, and other advertising and selling expenses.

S&M expenses for the three months ended September 30, 2017 increased to $3.0 million from $2.4 million for the three months ended September 30, 2016. The increase was mainly due to increases in inventories used for customer demonstrations, higher commission expenses booked in the third quarter of 2017, higher marketing expenses related to tradeshows, and increased spending in employee related expenses. S&M expenses for the nine months ended September 30, 2017 increased to $8.4 million from $7.7 million for the nine months ended September 30, 2016. The increase was primarily due to an increase in headcount and employee related expenses, increases in inventories used for customer demonstrations and increase in marketing expenses related to tradeshows partially offset by decline in commissions paid to independent agents.

Research and Product Development - R&D expenses include research and development, product line management, engineering services, and test and application expenses, including employee related costs, outside services, expensed materials, depreciation, and an allocation of overhead expenses.

R&D expenses were approximately $2.3 million for the three months ended September 30, 2017, as compared to $2.1 million for the three months ended September 30, 2016. The increase was primarily due to increase in employee costs related to salaries, benefits and patent bonuses. R&D expenses were approximately $6.9 million for the nine months ended September 30, 2017, as compared to $6.5 million for the nine months ended September 30, 2016. The increase was primarily due to an increase in employee-related costs mainly salaries and benefits expenses.

General and Administrative - G&A expenses include employee-related costs, professional service fees, allocations of overhead expenses, litigation costs, and corporate administrative costs, including costs related to finance and human resources.

G&A expenses decreased approximately 26% to $1.2 million for the three months ended September 30, 2017 compared with approximately $1.7 million in 2016. The reduction was primarily due to the decrease in legal costs. G&A expenses increased approximately 14% to $5.6 million for the nine months ended September 30, 2017 compared with approximately $4.9 million in 2016. The increase in G&A expenses was primarily due to increases in legal expenses and consulting fees partially offset by a decline in salaries and bonuses.

Impairment of Goodwill and an intangible asset - Based on the results of the Company’s recent impairment analysis triggered by the fall in the Company’s stock price and recent financial results, the Company determined that goodwill and an intangible asset consisting of customer relationships were impaired and recognized a charge of $12.7 million towards goodwill impairment and $0.7 million towards the intangible asset impairment for the three and nine months ended September 30, 2017.

Other income (expense), net

Other income (expense), net, includes interest income, interest expense, and foreign currency changes.

Provision for income taxes

During the nine months ended September 30, 2017, we accrued income taxes at the forecasted effective tax benefit rate of 36.1% as compared to the forecasted effective tax rate of 32.3% used during the nine months ended September 30, 2016. The 3.8% increase in the forecasted effective tax rate was primarily due to projected income in 2016, yet projected losses in 2017. As a result, tax benefits, such as the research and development tax credit, increased the benefit rate in 2017. In addition, a discrete tax expense of $145 thousand is primarily attributable to changes in income tax reserves related to research and development tax credits.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

LIQUIDITY AND CAPITAL RESOURCES

As of September 30, 2017, our cash and cash equivalents were approximately $3.0 million, a decrease of approximately $9.1 million compared to cash and cash equivalents of approximately $12.1 million as of December 31, 2016. Our working capital was $26.8 million and $30.8 million as of September 30, 2017 and December 31, 2016, respectively.

Net cash used in operating activities was approximately $7.6 million for the nine months ended September 30, 2017, an increase of cash used of approximately $15.0 million from $7.4 million of cash provided by operating activities in the nine months ended September 30, 2016. The increase was primarily due to an increase in cash outflows due to change in operating assets and liabilities of $9.2 million and a reduction in net income of $14.1 million offset by an increase in non-cash charges of $8.3 million.

Net cash provided by investing activities was $4.4 million for the nine months ended September 30, 2017 compared to net cash flows used by investing activities of $1.8 million during the nine months ended September 30, 2016, an increase in cash provided of $6.2 million. The increase was primarily due to an increase in net sales of marketable securities of approximately $7.2 million, offset by $1.0 million in purchases of property and equipment and intangibles.

Capitalization of patent defense costs. We capitalize external legal costs incurred in the defense of our patents when we believe that a significant, discernible increase in value will result from the defense and a successful outcome of the legal action is probable. When we capitalize patent defense costs we amortize the costs over the remaining estimated useful life of the patent, which is 15 to 17 years. During the three and nine months ended September 30, 2017 we paid $845 thousand, in gross legal costs related to the defense of our patents and $845 thousand of such costs were capitalized.

Net cash used in financing activities was approximately $5.9 million during the nine months ended September 30, 2017 primarily consisted of cash outflows of $4.4 million on repurchase and cancellation of stock, $1.7 million for dividend payments partially offset by $0.1 million proceeds from stock based compensation programs. Net cash used in financing activities was approximately $6.8 million during the nine months ended September 30, 2016 primarily consisted of cash outflows of $6.9 million on repurchase and cancellation of stock and stock options, $1.4 million for dividend payments offset by $1.5 million proceeds from stock based compensation programs.