Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations (“MD&A”) should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this document. In addition to historical information, the MD&A contains forward-looking statements that involve risks and uncertainties. These forward-looking statements include, but are not limited to, those matters discussed under the heading “Forward-looking Statements.” Our actual results could differ materially from those anticipated by these forward‑looking statements due to various factors, including, but not limited to, those set forth under Item 1A. Risk Factors of this Form 10-K and elsewhere in this document.
This section of the Form 10-K generally discusses fiscal 2023 and 2022 items and year-to-year comparisons between fiscal 2023 and 2022. Discussions of fiscal 2021 items and year-to-year comparisons between fiscal 2022 and 2021 that are not included in this Form 10-K can be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022 filed with the SEC on February 27, 2023.
Overview
We are a leading provider of secure application solutions and services that enable a new generation of intelligently connected companies with the ability to continuously improve cyber protection and digital responsiveness across dynamic Information Technology (“IT”) and network infrastructures. Our product portfolio seeks to address many of the cyber protection challenges and solution requirements. The portfolio consists of six secure application solutions; Thunder Application Delivery Controller (“ADC”), Lightning Application Delivery Controller (“Lightning ADC”), Thunder Carrier Grade Networking (“CGN”), Thunder Threat Protection System (“TPS”), Thunder SSL Insight (“SSLi”) and Thunder Convergent Firewall (“CFW”), and two intelligent management and automation tools; Harmony Controller and aGalaxy TPS. Our solutions are available in a variety of form factors, such as optimized hardware appliances, bare metal software, containerized software, virtual appliances and cloud-native software. Our customers include leading service providers (cloud, telecommunications, multiple system operators, cable), government organizations, and enterprises.
We derive revenue from two sources: (i) products revenue, which includes hardware, perpetual software license and subscription offerings, which include term-based license agreements and software-as-a-service; and (ii) services revenue, which includes post contract support (“PCS”), professional services, and training. Revenue for term-based license agreements is recognized at a point in time when the Company delivers the software license to the customer and over time once the subscription term has commenced. For our software-as-a-service offerings, our customers do not take possession of the Company’s software but rather we provide access to the service via a hosting arrangement. Revenue in these arrangements is recognized over time as the services are provided. A substantial portion of our revenue is from sales of our products and services through distribution channel partners, such as resellers and distributors. Our customers predominantly purchase PCS services in conjunction with purchases of our products.
We sell our products globally to service providers and enterprises that depend on data center applications and networks to generate revenue and manage operations efficiently. We report two customer verticals: service providers, which accounted for 58% and 66% of our total revenue during 2023 and 2022, respectively, and enterprise, which accounted for 42% and 34% of our total revenue during 2023 and 2022, respectively. During 2023, we experienced an increase in demand from our enterprise customers and a decrease in demand from our service provider customers related to lower service provider capital spending and longer sales cycles. While we expect total demand to remain strong as the need for cybersecurity solutions continues to increase, we expect the demand shift trend from service provider to enterprise to continue in the near term. We report customer revenues in three broad geographic regions: the Americas, APJ and EMEA regions. The Americas region comprises the United States and all other countries in the Americas (excluding the United States). The APJ region comprises Japan and all other countries in APAC (excluding Japan). The EMEA region comprises Europe, Middle East and Africa. We believe this vertical and geographic view aligns with how we manage the business and maps our product portfolio to customer verticals.
Our end-customers operate in a variety of industries, including telecommunications, technology, industrial, retail, financial, gaming, education and government. Since inception, our customer base has grown rapidly.
We sell substantially all of our solutions through our high-touch sales organization as well as distribution channels, including distributors, value-added resellers and system integrators, and fulfill nearly all orders globally through such resellers. We believe this sales approach allows us to obtain the benefits of channel distribution, such as expanding our market coverage, while still maintaining face-to-face relationships with our end-customers. We outsource the manufacturing of our hardware
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products to original design manufacturers. We perform quality assurance and testing at our San Jose, Taiwan and Japan distribution centers, as well as at our manufacturers’ locations.
As a result of the nature of our target market and the current stage of our development, a substantial portion of our revenue comes from a limited number of large customers and service providers. Purchases from our ten largest end-customers accounted for 33%, 41% and 39% of our total revenue for 2023, 2022 and 2021, respectively. Sales to these large end-customers have typically been characterized by large but irregular purchases with long sales cycles. The timing of these purchases and the delivery of the purchased products are difficult to predict and rely upon customer growth and network enhancements. Consequently, any acceleration or delay in anticipated product purchases by or deliveries to our largest customers could materially impact our revenue and operating results in any quarterly period. This may cause our quarterly revenue and operating results to fluctuate from quarter to quarter and make them difficult to predict, as was the case in 2023.
We intend to continue to invest for long-term growth. We have invested and expect to continue to invest in our product development efforts to deliver new products and additional features in our current products to address customer needs. In addition, we may expand our global sales and marketing organizations, expand our distribution channel partner programs and increase awareness of our solutions on a global basis. Our investments in growth in these areas may affect our short-term profitability.
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Results of Operations
A summary of our consolidated statements of operations for the years ended December 31, 2023 and 2022 are as follows (dollars in thousands):
Years Ended December 31,
2023 2022 Increase (Decrease)
Amount Percent of Total Revenue Amount Percent of Total Revenue Amount Percent
Revenue:
Products $ 141,082 56.1 % $ 173,201 61.8 % $ (32,119) (18.5) %
Services 110,618 43.9 107,137 38.2 3,481 3.2 %
Total revenue 251,700 100.0 280,338 100.0 (28,638) (10.2) %
Cost of revenue:
Products 31,468 12.5 40,135 14.3 (8,667) (21.6) %
Services 16,494 6.6 16,697 6.0 (203) (1.2) %
Total cost of revenue 47,962 19.1 56,832 20.3 (8,870) (15.6) %
Gross profit 203,738 80.9 223,506 79.7 (19,768) (8.8) %
Operating expenses:
Sales and marketing 85,976 34.2 88,511 31.6 (2,535) (2.9) %
Research and development 55,229 21.9 58,398 20.8 (3,169) (5.4) %
General and administrative 23,885 9.5 23,518 8.4 367 1.6 %
Total operating expenses 165,090 65.6 170,427 60.9 (5,337) (3.1) %
Income from operations 38,648 15.4 53,079 18.8 (14,431) (27.2) %
Non-operating income (expense):
Interest income 5,078 2.0 1,304 0.5 3,774 289.4 %
Interest and other income (expense), net 69 — (1,667) (0.6) 1,736 (104.1) %
Total non-operating income (expense), net 5,147 2.0 (363) (0.1) 5,510 (1,517.9) %
Income before income taxes 43,795 17.4 52,716 18.7 (8,921) (16.9) %
Provision for income taxes 3,825 1.5 5,808 2.1 (1,983) (34.1) %
Net income $ 39,970 15.9 % $ 46,908 16.7 % $ (6,938) (14.8) %
Revenue
We derive revenue from two sources: (i) products revenue, which includes hardware, perpetual software license and subscription offerings, which include term-based license agreements and software-as-a-service; and (ii) services revenue, which includes post contract support (“PCS”), professional services, and training.
Our products revenue primarily consists of revenue from sales of our hardware appliances upon which our software is installed. Such software includes our ACOS software platform plus one or more of our ADC, CGN, TPS, SSLi or CFW solutions. Purchase of a hardware appliance includes a perpetual license to the included software. Additionally, a small portion of our products revenue comes from subscription revenue. We offer several products by subscription, primarily through either term-based license agreements or as a service through our cloud-based platform. With respect to sales of our hardware appliances, we recognize products revenue upon transfer of control, generally at the time of shipment, provided that all other revenue recognition criteria have been met. Revenue for term-based license agreements is recognized at a point in time when we deliver the software license to the customer and the subscription term has commenced. For our software-as-a-service offerings, our customers do not take possession of our software but rather we provide access to the service via a hosting arrangement. Revenue in these arrangements is recognized ratably as the services are provided. As a percentage of revenue, our
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products revenue may vary from quarter to quarter based on, among other things, the timing of orders and delivery of products, cyclicality and seasonality, changes in currency exchange rates and the impact of significant transactions with unique terms and conditions.
We generate services revenue from sales of post contract support (“PCS”), which is bundled with sales of products and technical services. We offer tiered PCS services under renewable, fee-based PCS contracts, primarily including technical support, hardware repair and replacement parts, and software upgrades on a when-and-if-available basis. We recognize services revenue ratably over the term of the PCS contract, which is typically one year, but can be up to seven years.
A summary of our total revenue is as follows (dollars in thousands):
Years Ended December 31,
2023 2022 Increase (Decrease)
Amount Percent of Total Revenue Amount Percent of Total Revenue Amount Percent
Revenue:
Products $ 141,082 56 % $ 173,201 62 % $ (32,119) (19) %
Services 110,618 44 107,137 38 3,481 3 %
Total revenue $ 251,700 100 % $ 280,338 100 % $ (28,638) (10) %
Revenue by geographic region:
Americas $ 132,745 53 % $ 148,673 53 % $ (15,928) (11) %
United States 113,766 45 % 129,397 46 % (15,631) (12) %
Americas-other 18,979 8 % 19,276 7 % (297) (2) %
APJ 77,606 31 % 89,702 32 % (12,096) (13) %
APAC 29,748 12 % 32,986 12 % (3,238) (10) %
Japan 47,858 19 % 56,716 20 % (8,858) (16) %
EMEA 41,349 16 % 41,963 15 % (614) (1) %
Total revenue $ 251,700 100 % $ 280,338 100 % $ (28,638) (10) %
Total revenue decreased by $28.6 million, or 10%, in 2023 compared to 2022. This decrease was due to a $32.1 million decrease in products revenue, partially offset by an increase of $3.5 million in services revenue.
Products revenue decreased $32.1 million, or 19%, in 2023 compared to 2022 primarily driven by lower demand from our service provider customers in the Americas, APAC and EMEA regions, partially offset by higher demand from enterprise customers in Japan.
Services revenue increased $3.5 million, or 3%, in 2023 compared to 2022. The increase was primarily attributable to the increase in PCS sales in connection with our increased installed customer base in the Japan, Americas and EMEA regions.
During 2023, $132.7 million, or 53% of total revenue, was generated from the Americas region, which represents an 11% decrease compared to 2022. The decrease was primarily due to lower products revenue driven by a decrease in demand from our service provider customers.
During 2023, $77.6 million, or 31% of total revenue, was generated from APJ, which represents a 13% decrease compared to 2022. The decrease was mainly due to decreased revenue from both our enterprise and service provider customers.
During 2023, $41.3 million, or 16% of total revenue, was generated from EMEA, which represented a 1% decrease compared to 2022. The decrease was primarily due to lower products revenue driven by a decrease in demand from our service provider customers driven by decreased demand.
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Cost of Revenue, Gross Profit and Gross Margin
Cost of Revenue
Cost of products revenue is primarily comprised of cost of third-party manufacturing services and cost of inventory for the hardware component of our products. Our component suppliers change their selling prices frequently in response to market trends, including industry-wide increases in demand. Cost of products revenue also includes warehouse personnel costs, shipping costs, inventory write-downs, certain allocated facilities and information technology infrastructure costs, and expenses associated with logistics and quality control.
Cost of services revenue is primarily comprised of personnel costs for our technical support, training and professional service teams. Cost of services revenue also includes the costs of inventory used to provide hardware replacements to end- customers under PCS contracts and certain allocated facilities and information technology infrastructure costs.
A summary of our cost of revenue is as follows (dollars in thousands):
Years Ended December 31, Increase (Decrease)
2023 2022 Amount Percent
Cost of revenue:
Products $ 31,468 $ 40,135 $ (8,667) (22) %
Services 16,494 16,697 (203) (1) %
Total cost of revenue $ 47,962 $ 56,832 $ (8,870) (16) %
Gross Margin
Gross margin may vary and be unpredictable from period to period due to a variety of factors. These may include the mix of revenue from each of our regions, the mix of our products sold within a period, discounts provided to customers, cost of inventory for the hardware component of our products, inventory write-downs and foreign currency exchange rates.
Our sales are generally denominated in U.S. dollars, however, in Japan they are denominated in Japanese yen.
Any of the factors noted above can generate either a favorable or unfavorable impact on gross margin.
A summary of our gross profit and gross margin is as follows (dollars in thousands):
Years Ended December 31,
2023 2022 Increase (Decrease)
Amount Gross Margin Amount Gross Margin Amount Gross Margin
Gross profit:
Products $ 109,614 77.7 % $ 133,066 76.8 % $ (23,452) 0.9 %
Services 94,124 85.1 % 90,440 84.4 % 3,684 0.7 %
Total gross profit $ 203,738 80.9 % $ 223,506 79.7 % $ (19,768) 1.2 %
Products gross margin percentage decreased by 0.9% in 2023 compared to 2022 primarily driven by changes in product and geographic mix.
Services gross margin percentage increased by 0.7% in 2023 compared to 2022 primarily due to a decrease in personnel-related support costs.
Operating Expenses
Our operating expenses consist of sales and marketing, research and development, general and administrative, and restructuring expenses. The largest component of our operating expenses is personnel costs which consist of wages, benefits, bonuses, and, with respect to sales and marketing expenses, sales commissions. Personnel costs also include stock-based compensation.
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A summary of our operating expenses is as follows (dollars in thousands):
Years Ended December 31, Increase (Decrease)
2023 2022 Amount Percent
Operating expenses:
Sales and marketing $ 85,976 $ 88,511 $ (2,535) (3) %
Research and development 55,229 58,398 (3,169) (5) %
General and administrative 23,885 23,518 367 2 %
Total operating expenses $ 165,090 $ 170,427 $ (5,337) (3) %
Sales and Marketing
Sales and marketing expenses are our largest functional category of operating expenses and primarily consist of personnel costs. Sales and marketing expenses also include the cost of marketing programs, trade shows, consulting services, promotional materials, demonstration equipment, depreciation and certain allocated facilities and information technology infrastructure costs.
The $2.5 million decrease in sales and marketing expenses in 2023 compared to 2022 was primarily due to decreases of $3.5 million in personnel costs as a result of a decrease in headcount and $0.4 million in marketing expenses, partially offset by increases of $0.9 million in credit loss expense and $0.5 million in travel-related expense.
In 2024, we expect sales and marketing expenses to increase from 2023 levels as we continue to apply a disciplined approach to focus our investments in areas that offer the greatest opportunities.
Research and Development
Research and development efforts are focused on new product development and on developing additional functionality for our existing products. These expenses primarily consist of personnel costs, and, to a lesser extent, prototype materials, depreciation and certain allocated facilities and information technology infrastructure costs. We expense research and development costs as incurred.
The $3.2 million decrease in research and development expenses in 2023 compared to 2022 was primarily due to a decrease of $8.5 million increase in personnel costs as a result of a decrease in headcount. This decrease was partially offset by increases of $3.4 million in depreciation expense and $1.9 million in consulting expense as the Company transitions to using non-employee consultants for certain research and development activities.
In 2024, we expect research and development expenses to increase from 2023 levels reflecting strategic investments in our growth priorities, including cybersecurity technology.
General and Administrative
General and administrative expenses primarily consist of personnel costs, professional services and office expenses. General and administrative personnel costs include executive, finance, human resources, information technology, facility and legal related expenses. Professional services primarily consist of fees for outside accounting, tax, legal, recruiting and other administrative services.
The $0.4 million increase in general and administrative expenses in 2023 compared to 2022 was primarily due to an increase of $1.3 million in professional services expense as a result of increases in accounting and tax fees. Additionally, facility expense increased $0.7 million primarily related to rent expense, equipment expense increased $0.4 million and depreciation expense increased $0.3 million. Partially offsetting these increases was a decrease of $1.6 million in office expenses as the Company paid catch-up tax fee in 2022 related to a property tax audit. Additionally, consulting expense decreased $0.7 million.
In 2024, we expect general and administrative expenses to increase from 2023 levels as we continue to apply a disciplined approach to focus our investments in areas that offer the greatest opportunities.
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Non-Operating Income (Expense) - Interest Income
Interest income consists primarily of interest income earned on our invested cash, cash equivalents and marketable securities.
Interest income was $5.1 million and $1.3 million in the years ended December 31, 2023 and 2022, respectively.
Non-Operating Income (Expense) - Interest and Other Income (Expense), Net
In the years ended December 31, 2023 and 2022, interest and other income (expense), net consisted primarily of foreign currency exchange gains and losses, which had a favorable change of $0.6 million in the year ended December 31, 2023 compared to 2022. Additionally, we recorded impairment expense of $1.0 million in the year ended December 31, 2022 related to an equity investment in a private company held by the Company.
Provision for (Benefit from) Income Taxes
We recorded income tax provisions of $3.8 million for the year ended December 31, 2023 and $5.8 million for the year ended December 31, 2022. Our deferred tax assets primarily consist of research and development credits, capitalized research and development expenses and accruals and reserves. The Company’s income tax provision for the years ended December 31, 2023 and 2022 primarily consisted of state and foreign income taxes.
See Note 9 Income Taxes, of the notes to consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further details regarding the Company’s taxes.
Liquidity and Capital Resources
As of December 31, 2023, we had cash and cash equivalents of $97.2 million, including $3.4 million held outside the United States in our foreign subsidiaries, and $62.1 million of marketable securities. We currently do not have any plans to repatriate our earnings from our foreign operations. As of December 31, 2023, we had working capital of $160.8 million, accumulated deficit of $90.5 million and total stockholders’ equity of $207.9 million.
We plan to continue to invest for long-term growth, and our investment may increase. We currently believe that our existing cash and cash equivalents and marketable securities will be sufficient to meet our anticipated cash needs for at least the next 12 months and beyond. Our future capital requirements will depend on many factors, including our growth rate, the expansion of sales and marketing activities, the timing and extent of spending to support development efforts, the introduction of new and enhanced product and service offerings and the continuing market acceptance of our products. In the event that additional financing is required from outside sources, we may not be able to raise such financing on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition could be adversely affected.
On September 8, 2022, we entered into a Common Stock Repurchase Agreement (the “Repurchase Agreement”) with Summit Partners Growth Equity Fund VIII-A, L.P., Summit Partners Growth Equity Fund VIII-B L.P., Summit Investors I, LLC and Summit Investors I (UK), L.P. (collectively, “Summit”). Pursuant to the Repurchase Agreement, we repurchased 3.5 million shares of common stock from Summit for approximately $44.6 million. The common shares repurchased are held in treasury and accounted for under the cost method.
On November 1, 2022, the Company announced its Board of Directors authorized a stock repurchase program of up to $50 million of its common stock over a period of twelve months, at which point it expired. On November 7, 2023, the Company announced its Board of Directors had authorized a stock repurchase program of up to $50 million of its common stock over a period of twelve months. As of December 31, 2023, the Company had $49.7 million available to repurchase shares. Under these repurchase programs, repurchased shares are held in treasury at cost. The Company’s stock repurchase programs do not obligate us to acquire any specific number of shares. Shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. To date, all repurchases under these programs, other than the repurchase from Summit, have occurred in the open market. During the year ended December 31, 2023, the Company repurchased 1.3 million shares for a total cost of $16.0 million. During the year ended December 31, 2022, the Company repurchased 6.1 million shares for a total cost of $79.3 million.
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In October 2021, our Board approved the initiation of a regular quarterly cash dividend on our common stock. The first dividend, in the amount of $0.05 per share of common stock outstanding, was paid in December 2021 and was treated as a return of capital, and on November 1, 2022, the Board of Directors increased the dividend amount to $0.06 per share. We currently anticipate that we will continue to pay comparable quarterly cash dividends in the future. However, the payment, amount and timing of future dividends remain within the discretion of our Board and will depend on our results of operations, financial condition, cash requirements, and other factors.
In addition, as described in Note 6 Commitments and Contingencies, in the notes to consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K, we may be currently, or may be from time to time, involved in ongoing litigation. Any adverse settlements or judgments in any litigation could have a material adverse impact on our results of operations, cash balances and cash flows in the period in which such events occur.
Statements of Cash Flows
The following table summarizes our cash flow related activities (in thousands):
Years Ended December 31,
2023 2022
Cash provided by (used in):
Operating activities $ 44,514 $ 66,100
Investing activities 13,608 11,087
Financing activities (28,849) (88,141)
Net increase (decrease) in cash and cash equivalents $ 29,273 $ (10,954)
Cash Flows from Operating Activities
Our cash provided by operating activities is driven primarily by sales of our products and management of working capital investments. Our primary uses of cash from operating activities have been for personnel-related expenditures, manufacturing costs, marketing and promotional expenses and costs related to our facilities. Our cash flows from operating activities will continue to be affected principally by the extent to which we increase spending on our business and our working capital requirements.
During the year ended December 31, 2023, cash provided by operating activities was $44.5 million, consisting of net income of $40.0 million and non-cash benefits totaling $22.8 million, partially offset by an unfavorable net change in operating assets and liabilities of $18.3 million. Our non-cash benefits primarily consisted of non-cash charges of $14.1 million for stock-based compensation and $9.3 million of depreciation and amortization expense. The net change in our operating assets and liabilities primarily reflects cash outflows from changes in accrued and other liabilities of $20.8 million, inventory of $6.3 million, accounts payable of $3.0 million and prepaid expenses and other assets of $1.9 million, partially offset by cash inflows from changes in deferred revenue of $14.3 million.
The unfavorable change in accounts receivable was due to the timing of collections from our customers. The favorable change in deferred revenues was attributable to the timing of service contract bookings.
During the year ended December 31, 2022, cash provided by operating activities was $66.1 million, consisting of net income of $46.9 million, partially offset by a non-cash benefit of $21.5 million and an unfavorable net change in operating assets and liabilities of $2.3 million. Our non-cash benefit consisted primarily of non-cash charges of $13.3 million for stock-based compensation and $7.4 million of depreciation and amortization expense. The net change in our operating assets and liabilities primarily reflects cash outflows from changes in accounts receivable of $10.1 million and accrued and other liabilities of $1.3 million, partially offset by cash inflows from changes in deferred revenue of $5.4 million, inventory of $2.0 million and prepaid expenses and other assets of $1.6 million.
The unfavorable change in accounts receivable was due to the timing of collections from our customers. The favorable change in deferred revenues was attributable to the timing of service contract bookings.
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Cash Flows from Investing Activities
During the year ended December 31, 2023, cash provided in investing activities was $13.6 million, consisting of proceeds from maturities of marketable securities of $64.5 million and proceeds from the sales of marketable securities of $45.4 million, partially offset by purchases of marketable securities of $85.4 million and capital expenditures of $10.9 million.
During the year ended December 31, 2022, cash used in investing activities was $11.1 million, consisting of purchases of marketable securities of $55.4 million and capital expenditures of $10.8 million, partially offset by proceeds from maturities of marketable securities of $71.0 million and sales of marketable securities of $6.3 million.
Cash Flows from Financing Activities
During the year ended December 31, 2023, cash used in financing activities was $28.8 million consisting primarily of $17.8 million of cash used for the payments of cash dividends and $16.0 million of cash used to repurchase our common stock in the open market, partially offset by $4.9 million of cash proceeds from common stock issuances under our equity incentive plans.
During the year ended December 31, 2022, cash used in financing activities was $88.1 million consisting primarily of $79.3 million of cash used to repurchase our common stock in the open market and from Summit, and $15.9 million used for the payments of cash dividends, partially offset by $7.0 million of cash proceeds from common stock issuances under our equity incentive plans.
Critical Accounting Estimates
Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates. Note 1, Description of Business and Summary of Significant Accounting Policies , in Notes to Consolidated Financial Statements in Item 8 of Part II of this Report, describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements.
We believe the following critical accounting policies require us to make significant judgments and estimates in the preparation of our consolidated financial statements.
Inventory
Inventory is stated at the lower of cost or net realizable value. Inventory cost is determined using a first-in, first-out method. We regularly evaluate inventory for excess and obsolete products. Most of our inventory provisions relate to excess quantities of certain products, based on our inventory levels and future product purchase commitments compared to assumptions based on management’s assessment of future demand and market conditions. Inventory write-downs, once established, are not reversed as they establish a new cost basis for the inventory. Inventory write downs are included as a component of cost of products revenue in the consolidated statements of operations.
Revenue Recognition
We derive revenue from two sources: (i) products revenue, which includes hardware, perpetual software license and subscription revenue; and (ii) services revenue, which includes post contract support (“PCS”), professional services, and training. Revenue for term-based license agreements is recognized at a point in time when the Company delivers the software license to the customer and the subscription term has commenced. For our software-as-a-service offerings, our customers do not take possession of the Company’s software but rather we provide access to the service via a hosting arrangement. Revenue in these arrangements is recognized ratably as the services are provided. A substantial portion of our revenue is from sales of our products and services through distribution channels, such as resellers and distributors. Our customers predominantly purchase PCS services in conjunction with purchases of our products.
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Revenue is recognized, net of applicable taxes, upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to be entitled to receive in exchange for those products or services. We apply the following five-step revenue recognition model:
• Identification of the contract, or contracts, with a customer
• Identification of the performance obligations in the contract
• Determination of the transaction price
• Allocation of the transaction price to the performance obligations in the contract
• Recognition of revenue when, or as, performance obligations are satisfied.
PCS revenue includes arrangements for software support and technical support for our products. PCS is offered under renewable, fee-based contracts, which includes technical support, hardware repair and replacement parts, bug fixes, patches, and unspecified upgrades on a when-and-if available basis. Revenue for PCS services is recognized on a straight-line basis over the service contract term, which is typically one year, but can be up to five years as there is no discernible pattern of transfer related to these promises. Billed but unearned PCS revenue is included in deferred revenue.
Professional service revenue primarily consists of the fees we earn related to installation and consulting services. We recognize revenue from professional services upon delivery or completion of performance. Professional service arrangements are typically short term in nature and are largely completed within 30 to 90 days from the start of service. Revenue is recognized for training when the training course is delivered.
Contracts with Multiple Performance Obligations
Most of our contracts with customers, other than renewals of PCS, contain multiple performance obligations with a combination of products and PCS. Products and PCS generally qualify as distinct performance obligations. Our hardware includes embedded ACOS software, which together deliver the essential functionality of our products. For contracts which contain multiple performance obligations, we allocate revenue to each distinct performance obligation based on the standalone selling price (“SSP”). Judgment is required to determine the SSP for each distinct performance obligation. We use a range of amounts to estimate SSP for products and PCS sold together in a contract to determine whether there is a discount to be allocated based on the relative SSP of the various products and PCS.
If we do not have an observable SSP, such as when we do not sell a product or service separately, then SSP is estimated using judgment and considering all reasonably available information such as market conditions and information about the size and/or purchase volume of the customer. We generally use a range of amounts to estimate SSP for individual products and services based on multiple factors including, but not limited to the sales channel (reseller, distributor or end-customer), the geographies in which our products and services are sold, and the size of the end-customer.
We account for multiple contracts with a single reseller as one arrangement if the contractual terms and/or substance of those agreements indicate that they may be so closely related that they are, in effect, parts of a single contract.
We may occasionally accept returns to address customer satisfaction issues even though there is generally no contractual provision for such returns. We estimate returns for sales to customers based on historical return rates applied against current-period shipments. Specific customer returns and allowances are considered when determining our sales return reserve estimate.
Consequently, we have chosen to apply the portfolio approach when possible, which we do not believe will happen frequently. Additionally, we will evaluate a portfolio of data, when possible, in various situations, including accounting for commissions, rights of return and transactions with variable consideration.
We report revenue net of sales taxes. We include shipping charges billed to customers in revenue and the related shipping costs are included in cost of product revenue.
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