UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 ______________________________________

 

Form 10-Q

 

OR

For the transition period from                 to                 

Commission file number 1-31614

 ______________________________________

 

VITESSE SEMICONDUCTOR CORPORATION

7414721 Calle PlanoCarga

Camarillo, California 93012

 

See accompanying notes to unaudited consolidated financial statements.

See accompanying notes to unaudited consolidated financial statements.

 

See accompanying notes to unaudited consolidated financial statements.

See accompanying notes to unaudited consolidated financial statements.

NOTE 1-THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES

Description of Business

Vitesse Semiconductor Corporation (“Vitesse,” the “Company,” “us”“us,” or “we”) is a leading supplier of high-performance integrated circuits (“ICs”) that are used primarily by manufacturers of networking systems for Carrier and Enterprise networking applications. Vitesse designs, develops and markets a diverse portfolio of high-performance, low-power and cost-competitive semiconductor products for these applications.

Vitesse was incorporated in the state of Delaware in 1987. Our headquarters are located at 7414721 Calle Plano,Carga, Camarillo, California, and our phone number is (805) 388-3700. Our stock trades on the NASDAQ Global Market under the ticker symbol VTSS.

Fiscal Year

Our fiscal year is October 1 through September 30.

Basis of Presentation

Foreign Currency Translation

The functional currency of our foreign subsidiaries is the United States dollar; however, our foreign subsidiaries transact in local currencies. Consequently, assets and liabilities are translated into United States dollars at the exchange rate on the balance sheet date. Revenues and expenses are translated at the average exchange rate prevailing during the period. Foreign currency transaction and translation gains and losses are included in results of operations.

Use of Estimates

The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and disclosures made in the accompanying notes to the unaudited consolidated financial statements. Management regularly evaluates estimates and assumptions related to revenue recognition, allowances for doubtful accounts, warranty reserves, inventory valuation reserves, stock-based compensation, compound embedded derivative valuation, purchased intangible asset valuations and useful lives, asset retirement obligations, and deferred income tax asset valuation allowances. These estimates and assumptions are based on current facts, historical experience and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. The actual results we experience may differ materially and adversely from our original estimates. To the extent there are material differences between the estimates and the actual results, our future results of operations will be affected.

Revenue Recognition

A portion of our product sales is made through distributors under agreements allowing for pricing credits and/or right of return. Our past history with these pricing credits and/or right of return provisions prevent us from being able to reasonably estimate the final price of our inventory to be sold and the amount of inventory that could be returned pursuant to these agreements. As a result, the fixed and determinable revenue recognition criterion has not been met at the time we deliver products allowing for pricing credits or right of returns. Accordingly, product revenuesrevenue from sales made through these distributors is not recognized until the distributors ship the product to their customers. We also maintain inventory, or hub arrangements, with certain customers. Pursuant to these arrangements, we deliver products to a customer or a designated third-party warehouse based upon the customer’s projected needs, but we do not recognize revenue unless and until the customer reports that it has removed our product from the warehouse and taken title and risk of loss.

From time-to-time, we may ship goods to our distributors with no pricing credits and/or no or limited right of return. Under these circumstances, at the time of shipment, product prices are fixed or determinable and the amount of future returns and pricing allowances to be granted in the future can be reasonably estimated and are accrued. Accordingly, revenues are recorded net of these estimated amounts.

We recognize revenue from the sale of patents when there is persuasive evidence of an arrangement, fees are fixed or determinable, delivery has occurred, and collectability is reasonably assured. All of the requirements are generally fulfilled upon execution of the patent sale arrangement.

License and contract revenues are recorded upon delivery of the technology when there is persuasive evidence of an arrangement, fees are fixed or determinable, delivery has occurred, and collectability is reasonably assured. The timing of delivery is dependent on, and varies with, the terms of each contract. Other than maintenance and support, there is no continuing obligation under these arrangements after delivery of the intellectual property. Deferred revenue is created when we bill a customer in accordance with a contract prior to having met the requirements for revenue recognition.

Certain of our agreements may contain support obligations. Under such agreements we provide unspecified bug fixes and technical support. No other upgrades, products, or post-contract support are provided. These arrangements may be renewable annually by the customer. Support revenue is recognized ratably over the period during which the obligation exists, typically 12 months or less.

We recognize royalty revenue in the period in which the licensee reports shipment of products incorporating our intellectual property components. Royalties are calculated on a per unit basis, as specified in our agreement with the licensee. We may, at our discretion and in accordance with our agreements, engage a third-party to perform royalty audits of our licensees. Any correction of royalties previously reported would occur when the results are resolved.

For multiple-element arrangements, we allocate revenuesrevenue to all deliverables based on their relative selling prices. In such circumstances, we use a hierarchy to determine the selling price to be used for allocating revenues to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”); (ii) third-party evidence of selling price (“TPE”); and (iii) best estimate of the selling price (“ESP”). VSOE generally exists only when we sell the deliverable separately and revenue is the price actually

accounting will not affect the amount of total revenue recognized for a particular sales arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could affect our results of operations.

In determining ESPs, we apply significant judgment as we weigh a variety of factors, based on the facts and circumstances of the arrangement. The facts and circumstances we may consider include, but are not limited to, prices charged for similar offerings, if any, our historical pricing practices as well as the nature and complexity of different technologies being licensed, geographies and the number of uses allowed for a given license.

Shipping and Handling Fees and Costs

Amounts billed to customers for shipping and handling is presented in product revenues. Costs incurred for shipping and handling are included in cost of revenues.

Engineering, Research and Development Costs

ResearchEngineering, research and development (“R&D”) costs are expensed when incurred. R&D expenses consist primarily of compensation expenses for employees and contractors engaged in research, design and development activities. R&D expenses also include costs include payrollof mask tooling, which we fully expense in the period, electronic design automation tools, software licensing contracts, subcontracting and related costs, materials, services and design tools used in product development,fabrication, depreciation and otheramortization, and overhead costs including facilities expenses.

Intellectual property purchased from third-parties is capitalized and computer equipment costs. Manufacturing costs associated withamortized over the developmentuseful life of a new fabrication process or a new product, including mask costs, are expensed until such time as these processes or products are proven through final testing and initial acceptance by the customer.

Marketing Costs

All of the costs related to marketing and advertising our products are expensed as incurred or at the time the marketing

Stock Based Compensation

We have elected to recognize compensation expense for all stock-based awards granted after September 30, 2005 on a straight-line basis over the requisite service period for the entire award. The amount of compensation expense recognized through the end of each reporting period is equal to the portion of the grant-date value of the awards that have vested, or for partially vested awards, the value of the portion of the award that is ultimately expected to vest for which the requisite services have been provided.

Other Income, Net 

Other income, net, consists of interest income, foreign exchange gains and losses, and other non-operating gains and losses.

Income Taxes

Net Loss per Share

Basic and diluted net loss per share is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding during the period.

For periods in each year. Net loss availablewhich we report net income, the weighted average number of shares used to calculate diluted income per share is inclusive of common stockholders is computed after deducting accumulated dividends on cumulativestock equivalents from unexercised stock options, restricted stock units, shares to be issued under our Employee Stock Purchase Plan (“ESPP”), convertible preferred stock, 2014 Debentures and fair value adjustments relatedthe Term B Loan. Unexercised stock options, restricted stock units, and unvested shares to be issued under our ESPP, are considered to be common stock equivalents if, using the treasury stock method, they are determined to be dilutive.

Under the two-class method of determining earnings for each class of stock, we consider the dividend rights and participating rights in undistributed earnings for each class of stock. The allocation of undistributed earnings to preferred stock. Potentialshares is equal to the amount of earnings per common shares are not included in the calculation of diluted loss per share because their effect is anti-dilutive.that would be distributed on an as-converted basis.

Risks and Uncertainties

Our future results of operations involve a number of risks and uncertainties. Factors that could affect our business or future results and cause actual results to vary materially from historical results include, but are not limited to, dependence on the highly cyclical nature of the semiconductor industry,industry; our high fixed costs,costs; declines in average selling prices,prices; decisions by our integrated deviceIC manufacturer customers to curtail outsourcing,outsourcing; our substantial indebtedness,indebtedness; our ability to fund liquidity needs,needs; our failure to maintain an effective system of internal controls,controls; product return and liability risks,risks; the absence of significant backlog in our business,business; our dependence on international operations and sales,sales; proposed changes to United States tax laws,laws; that our management information systems may prove inadequate, attractinginadequate; our ability to attract and retainingretain qualified employees,employees; difficulties consolidating and evolving our operational capabilities,capabilities; our dependence on materials and equipment suppliers,suppliers; our loss of customers,customers; adverse tax consequences,consequences; the development of new proprietary technology and the enforcement of intellectual property rights by or against us,us; the complexity of packaging and test processes competition,in our industry; competition; our need to comply with existing and future environmental regulations,regulations; and fire, flood or other calamity and continued control by existing stockholders.affecting us or others with whom we do business.

Financial instruments, which potentially subject us to concentrations of credit risk, consist principally of cash and accounts receivable. Cash consists of demand deposits maintained with several financial institutions, which often exceed Federal Deposit Insurance Corporation (“FDIC”) limits of $250,000. We have never experienced any losses related to these balances; however, our balances are significantly in excess of insured limits.

We currently purchase wafers from a limited number of vendors. Additionally, since we do not maintain manufacturing facilities, we depend upon close relationships with contract manufacturers to assemble our products. We believe there are other vendors who can provide the same quality wafers at competitive prices and other contract manufacturers that can provide comparable services at competitive prices. We anticipate the continued use of a limited number of vendors and contract manufacturers in the near future. We are also dependent upon third partiesthird-parties for our probe testing. Under our fabless business model, our long-term revenue growth is dependent on our ability to obtain sufficient external manufacturing capacity, including wafer production capacity. We believe that in addition to the vendors currently utilized by us, other vendors would be able to provide these services.

Accounts Receivable and Allowance for Doubtful Accounts

Inventory

Inventories are stated at lower of cost or market and consist of materials, labor and overhead. Inventory costs are determined using standard costs which approximate actual costs under the first-in, first-out method. Costs include the costs of purchased finished products, sorted wafers, and outsourced assembly, testing, and internal overhead. We evaluate inventories for excess quantities and obsolescence. Our evaluation considers market and economic conditions; technology changes, new product introductions, and changes in strategic business direction; and requires estimates that may include elements that are uncertain. In order to state the inventory at lower of cost or market, we maintain reserves against individual stocking units. Inventory write-downs, once established, are not reversed until the related inventories have been sold or scrapped. If future demand or market conditions are less favorable than our projections, a write-down of inventory may be required, and would be reflected in cost of goodsproduct revenues sold in the period the revision is made.

Property, Plant and Equipment

leasehold improvements. When property, plant and equipment is retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the accounts. Gains and losses from retirements and asset disposals are recorded in selling, general and administrative (“SG&A”) expenses.

Intangible Assets

Fair Value

Level 1: Observable inputs such as quoted prices for identical assets or liabilities in active markets;

Level 2: Other inputs observable directly or indirectly, such as quoted prices for similar assets or liabilities or market-corroborate inputs; and

Our assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of assets and liabilities and their placement within the fair value hierarchy.

Financial Instruments

Senior Term A Loan

At its inception, the fair value of the Term A Loan was computed using a cash flow analysis in which the periodic cash coupon payments and the principal payment at maturity were discounted to the valuation date using an appropriate market discount rate. The discount rate was determined by analyzing the seniority and securitization of the instrument, our financial condition, and observing the quoted bond yields in the fixed income market as of the valuation date. The valuation was determined using Level 3 inputs.

Senior Term B Loan

At its inception, the fair value of the Term B Loan was computed using a binomial lattice model. The valuation was determined using Level 3 inputs. The valuation model combined expected cash outflows with market-based assumptions regarding risk-adjusted yields, stock price volatility, recent price quotes, and trading information of our common stock into which the Term B Loan is convertible.

Convertible Subordinated Debt

The valuation methodologies we use as described above require considerable judgment and may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, although we believe our valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date.

Warranty

Contingencies

We assess our exposure to loss contingencies, including environmental, legal and income tax matters, and provide an accrual for exposure if it is judged to be probable and reasonably estimable. If the actual loss from a loss contingency differs from management’s estimates, results of operations could be adjusted upward or downward.

Recent Accounting Pronouncements

NOTE 2-COMPUTATION OF NET LOSS PER SHARE

The following potentially dilutive common shares are excluded from the computation of net loss per share.

NOTE 3-INVENTORY, NET

NOTE 4-DEBT 

Additional information about our debt is as follows:

The Term A Loan and Term B Loan (collectively, “Term A and B Loans”)Loans are collateralized by substantially all of our assets.

Debt Maturities

Maturity of our total aggregated outstanding debt is as follows:

Except for required repurchases upon a change in control or in the event of certain asset sales, as described in the applicable credit agreements, we are not required to make any sinking fund or redemption payments with respect to this debt.

NOTE 5-FAIR VALUE MEASUREMENTS AND DERIVATIVE LIABILITY

The following table provides a reconciliation of the beginning and ending balances for the compound embedded derivative measured at fair value on a recurring basis using significant unobservable inputs (Level 3):

The compound embedded derivative liability, which was included in long-term liabilities, represented the value of the equity conversion feature and a “make-whole” feature of the 2014 Debentures. The make-whole payment for foregone interest expired October 30, 2012, and upon its expiration, the compound embedded derivative no longer met the criteria for bifurcation as all components of the derivative were indexed to our own stock.

We measure the fair value of our Term A and B Loans and 2014 Debentures (“long-term debt”) carried at amortized/accreted cost quarterly for disclosure purposes.

The estimated fair values of our financial instruments are as follows:

NOTE 6-STOCKHOLDERS’ EQUITY

Authorized Capital Stock

NOTE 7-STOCK BASED COMPENSATION

Stock Options

The Compensation Committee of the Board of Directors determines the stock based compensation grants. The exercise price of options is the closing price on the date the options are granted. The fair value of each option grant is generally estimated on the date of the grant using the Black-Scholes option-pricing model.

Compensation cost related to our stock-based compensation planPlan and ESPP is as follows:

Activity in stock option awards is as follows:

 

The per share fair values of time-based stock options granted in connection with stock incentive plans have been estimated using the following weighted average assumptions:

Restricted Stock Units

Activity for our restricted stock award units is as follows:

Employee Stock Purchase Plan

NOTE 8-INCOME TAXES

 

NOTE 9-SEGMENT AND GEOGRAPHIC INFORMATION

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**Distributor

Net revenues by geographic area are as follows:

Revenues by geographic area are based upon the country of billing. The geographic location of distributors and third-party manufacturing service providers may be different from the geographic location of the ultimate end users.

We believe a substantial portion of the products billed to original equipment manufacturer (“OEM”) and third-party manufacturing service providers in the Asia Pacific region are ultimately shipped to end-markets in the United States and Europe.

We also classify our product revenues based on our three product lines: (i) Connectivity; (ii) Ethernet switching; and (iii) Transport processing. Product revenues by product line are as follows:

NOTE 10-COMMITMENTS AND CONTINGENCIES

From time-to-time, we are involved in legal proceedings in the ordinary course of business, including actions against us which assert or may assert claims or seek to impose fines and penalties in substantial amounts. Although the ultimate outcome of these matters cannot be determined, we believe that as of December 31, 2013, the final disposition of these proceedings will not have a material adverse effect on our financial position, results of operations, or liquidity. Related legal defense costs are expensed as incurred.

We have entered into various licensing agreements requiring primarily fixed fee royalty payments. Certain of these agreements contain provisions for the payment of guaranteed or minimum royalty amounts. In the event that we fail to pay any minimum annual royalties, these licenses may automatically be terminated.

We establish reserves for future product warranty costs that are expected to be incurred pursuant to specific warranty provisions with our customers. Our warranty reserves are established at the time of sale and updated throughout the warranty period based upon numerous factors including historical warranty return rates and expenses over various warranty periods.

We indemnify certain customers and our contract manufacturers against liability arising from third-party claims of intellectual property rights infringement related to our products. These indemnities appear in development and supply agreements with our customers as well as manufacturing service agreements with our contract manufacturers, are not limited in amount or duration and generally survive the expiration of the contract. Given that the amount of any potential liabilities related to such indemnities cannot be determined until an infringement claim has been made, we are unable to determine the maximum amount of losses that we could incur related to such indemnifications.

We have entered into indemnification agreements with our directors and executives, which require us to indemnify such individuals to the fullest extent permitted by Delaware law. Our indemnification obligations under such agreements are not limited in amount or duration. Certain costs incurred in connection with such indemnifications may be recovered under certain circumstances under various insurance policies. Given that the amount of any potential liabilities related to such indemnities cannot be determined until a lawsuit has been filed, we are unable to determine the maximum amount of losses that we could incur relating to such indemnities.

We have also entered into severance and change-of-control agreements with certain of our executives. These agreements provide for the payment of specific compensation benefits to such executives upon the termination of their employment

with us.

General Contractual Indemnities/Product Liability 

During the normal course of business, we enter into contracts with customers where we agreed to indemnify the other party for personal injury or property damage caused by our products. Our indemnification obligations under such agreements are not generally limited in amount or duration. Given that the amount of any potential liabilities related to such indemnities cannot be determined until a lawsuit has been filed, we are unable to determine the maximum amount of losses that we could incur relating to such indemnities. Historically, any amounts payable pursuant to such indemnities have not had a material negative effect on our business, financial condition or results of operations. We maintain general and product liability insurance which may provide a source of recovery to us in the event of an indemnification claim.

Cautionary Statement

 

This Quarterly Report contains forward-looking statements that involve risks and uncertainties. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statements that do not directly relate to historical or current fact. We use words such as “anticipates,” “believes,” “plans,” “expects,” “future,” “intends,” “may,” “should,” “estimates,” “predicts,” “potential,” “continue,” “becoming,” “transitioning,” and similar expressions to identify such forward-looking statements. Our forward-looking statements include statements as to our business outlook, revenues, margins, expenses, tax provision, capital resources sufficiency, capital expenditures, interest income, cash commitments, and expenses. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those referenced in the subsection entitled “Risk Factors” in Part II, Item 1A of this Report and Part I, Item 1A of our Annual Report, and similar discussions in our other SEC filings. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.

Overview

We are a leading supplier of high-performance ICs that are used primarily by manufacturers of networking systems for Carrier and Enterprise networking applications. We design, develop and market a diverse portfolio of high-performance, low-power and cost-competitive networking and connectivity IC solutions. For more than 2530 years, we have been a leader in the adoption of new technologies in Carrier and Enterprise networking.

Realization of Our Transition Strategy

WeOur accounting policy generally uses the “sell-through” model for sales to our distributors. The “sell-through” model recognizes revenue only upon shipment of the merchandise from our distributor to the final customer. As such, we may have also made progressvariability in our revenue from quarter-to-quarter as customers have substantial flexibility to reschedule backlog with of our distribution partners as part of the terms and conditions of sale. Our distributor sales were 52.7% , 51.6% and 44.6% of product revenue in fiscal 2013, 2012 and 2011, respectively.

In the normal course of business, we regularly assess our product portfolio to ensure it aligns with our strategy. At such time, we may determine to phase-out products and put them through “end-of-life”, or EOL. When we EOL a product, we typically provide up to six months notice for our customers to make a last-time-buy of product and six additional months to take receipt of that product. The EOL announcement can result in near-term increases in our revenues as customers typically respond to these announcements by making last-time-buys to ensure that they have adequate stock on hand to support their production forecast.

During the last three years, we accelerated our strategycomprehensive efforts to strengthenincrease our operational performanceproduct gross margins and execution.operating margins, which together have substantially increased our operating leverage. Our efforts in operations include reduction in materials costs and cycle times, improved product yields, implementation of programs such as lean manufacturing, and an enhanced customer-centric focus. As a fabless semiconductor company, we outsource the majority of our manufacturing. Our successful management of our supply chain has provided us with competitive materials pricing and effective lead times for the materials we purchase. We have sizable advantages due to lower fixed costs, reduced cycle times, and lower inventory resulting from our outsourcing of almost all of our wafer fabrication and assembly. During periods of strong demand, we could experience longer lead times, difficulties in obtaining capacity, and/or difficulty in meeting commitments for our required deliveries during periods of strong demand. Average margins vary widely within the lastmarkets we serve, with the Carrier networking market having the highest average margins and the Enterprise networking market having the lowest average margins. We endeavor to increase margins by providing products that have significant added value relative to our competition.

We have also streamlined our R&D and SG&A organizations, reducing expenses almost 25% over the past three years,fiscal years. We leverage top-level consultants to help us achieve short-term design goals while ensuring we acceleratedmaintain our comprehensive effortin-house engineering talent to reducedrive our operating expenses, which has substantially increased our operating leverage.overall corporate objectives.

Critical Accounting Policies and Estimates

Our accounting policies are more fully described in Note 1 of the unaudited consolidated financial statements. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We base our estimates on historical experience and on various other assumptions that we believe are reasonable in the circumstances. We regularly discuss with our audit committee the basis of our estimates. These estimates could change under different assumptions

or conditions.

Impact of Recent Accounting Pronouncements

For information with respect to recent accounting pronouncements and the impact of these pronouncements see “The Company and Its Significant Accounting Policies” footnote in the accompanying notes to the unaudited consolidated financial statements.

The following table sets forth certain Unaudited Consolidated Statements of Operations data for the periods indicated.

The percentages in the table are based on net revenues.