TMCNet:  SILVER SPRING NETWORKS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

[August 08, 2013]

SILVER SPRING NETWORKS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our prospectus filed on March 13, 2013, pursuant to Rule 424(b) under the Securities Act of 1933, as amended ("Securities Act") with the SEC. In addition, the following discussion contains forward-looking statements that are based on our management's beliefs and assumptions and on information currently available to our management. Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly the section entitled "Risk Factors." Overview We provide a leading networking platform and solutions that enable utilities to transform the power grid infrastructure into the smart grid. The smart grid intelligently connects millions of devices that generate, control, monitor and consume power, providing timely information and control to both utilities and consumers. We believe that the application of networking technology to the power grid has the potential to transform the energy industry through better communication just as the application of networking technology to the computing industry enabled the Internet.


We believe the power grid is one of the most significant elements of contemporary industrial infrastructure that has yet to be extensively networked with modern technology. We were founded in 2002 to address this challenge, pioneering a fundamentally new approach to connect utilities with millions of devices on the power grid. We believe our technology will yield significant benefits to utilities, consumers and the environment, both in the near term and the future. These benefits include more efficient management of energy, improved grid reliability, capital and operational savings, the ability to pursue new initiatives, consumer empowerment, and assistance in complying with evolving regulatory mandates through reduced carbon emissions. We believe networking the power grid will fundamentally transform the world's relationship with energy.

The foundation of our technology is a standards-based and secure IP network. Our networking platform provides two-way communications between the utility back office and devices on the power grid. In addition to our networking platform, we offer a suite of solutions that run on top of our network and complementary services, all of which we collectively refer to as our Smart Energy Platform.

Our solutions include advanced metering, which allows utilities to automate a number of manual processes and improve operational efficiencies, offer flexible pricing programs to consumers, and improve customer service with faster outage detection and restoration; distribution automation, which provides utilities with real-time visibility into the health of the grid, enabling better management and control of power distribution assets to improve grid reliability; and demand-side management, which enables utilities to offer consumers a variety of programs and incentives to use energy more efficiently and reduce usage at times of peak demand. Our service offerings include professional services to implement our products, managed services and SaaS, to assist utilities with managing the network and solutions, and ongoing customer support. Our Smart Energy Platform comprises hardware, software and services and combines with devices manufactured by third-party partners to form end-to-end smart grid offerings. We have architected our networking platform to support multiple current and future smart grid solutions. As a result, we believe utilities can increase the value of their network investment as they deploy additional solutions on this network. Over the long term, we believe our networking platform has the potential to be extensible to areas beyond energy, including smart homes, smart buildings, and smart cities, thereby enabling the "internet of things". The "internet of things" refers to an architecture where physical devices gain the capacity to communicate with each other through the application of networking technology.

We market our Smart Energy Platform directly to utilities around the world.

Leading utilities have selected our networking platform to be the foundation of the smart grid. Since inception through December 31, 2012, we were awarded contracts to network more than 22 million Silver Spring-enabled devices that connect homes and businesses. Our utility customers, as of June 30, 2013, include: Atlantic City Electric Company, a subsidiary of Pepco Holdings Inc., or PHI; Baltimore Gas and Electric Company, or BG&E, a subsidiary of Exelon Corporation; CitiPower Pty and Powercor Australia Ltd., or CHED, subsidiaries of CHEDHA Holdings Pty Limited; Commonwealth Edison Company, a subsidiary of Exelon Corporation; CPFL Energia; CPS Energy; Delmarva Power and Light Company, a subsidiary of PHI; Florida Power & Light Company, or FPL, a subsidiary of NextEra Energy, Inc.; Guelph Hydro Electric Systems, Inc.; Jemena Electricity Networks (Vic) Ltd; Modesto Irrigation District, or MID; Oklahoma Gas and Electric Company, or OG&E, a subsidiary of OGE Energy Corp.; Pacific Gas and Electric Company, or PG&E, a subsidiary of PG&E Corporation; Potomac Electric Power Company, a subsidiary of PHI; Progress Energy Carolinas, Inc. and Progress Energy Florida, Inc., subsidiaries of Progress Energy, Inc.; Sacramento Municipal Utility District, or SMUD; and SP PowerAssets Limited, or Singapore Power. As of June 30, 2013, we had delivered 17.0 million Silver Spring-enabled devices that connect homes and businesses.

21-------------------------------------------------------------------------------- Table of Contents Financial Overview Revenue We derive revenue from sales of products and services that enable utility customers to deploy our Smart Energy Platform.

Our product revenue is derived from sales of hardware such as communications modules, access points, relays and bridges, and software. We sell our communications modules primarily to meter manufacturers, however when requested by our utility customers, we sell third-party devices such as meters integrated with our communications modules directly to our utility customers. In addition, we sell our other hardware and software products directly to our utility customers.

Our service revenue includes fees for professional services, managed services and SaaS, and ongoing customer support.

To date, a substantial majority of our revenue is attributable to a limited number of utility customer deployments of our advanced metering solution.

Our revenue includes amounts related to the utility customers' deployments that were billed directly to our meter manufacturers, as well as direct revenue from our utility customers. We expect that a limited number of utility customers will continue to account for a substantial portion of our revenue in future periods although these utility customers have varied and are likely to vary from period to period.

Substantially all of our customer arrangements include acceptance provisions that require testing of the network against specific performance criteria. Once we complete the required network testing and receive acceptance of the initial phase of deployment, we receive customer acceptances for follow-on phases of deployment on a routine basis, which leads to additional revenue until the completion of the specific customer deployment.

Cost of Revenue and Gross Profit (Loss) Product cost of revenue consists of contract manufacturing costs, including raw materials, component parts and associated freight, and normal yield loss in the period in which we recognize the related revenue. In addition, product cost of revenue includes compensation, benefits and stock-based compensation provided to our supply chain management personnel, and overhead and other direct costs, which are recognized in the period in which we recognize the related revenue.

Further, we recognize certain costs, including logistics costs, manufacturing ramp-up costs, expenses for inventory obsolescence, warranty obligations, lower of cost or market adjustments to inventory, and amortization of intangibles, in the period in which they are incurred or can be reasonably estimated. We record a lower of cost or market adjustment in instances where the selling price of the products delivered or expected to be delivered is less than cost. We also include the cost of third-party devices in cost of revenue in instances when our utility customers contract with us directly for such devices. In accordance with our accounting policies, we recognize product cost of revenue in the periods we recognize the related revenue.

Service cost of revenue includes compensation and related costs for our service delivery, customer operations and customer support personnel, facilities and infrastructure cost and depreciation, and data center costs. In accordance with our accounting policies, we recognize service cost of revenue in the period in which it is incurred even though the associated service revenue may be required to be deferred.

Our gross profit (loss) varies from period to period based on the volume, average selling prices, and mix of products and services recognized as revenue, as well as product and service costs, expense for warranty obligations, and inventory write-downs. The timing of revenue recognition and related costs, which depends primarily on customer acceptance, can fluctuate significantly from period to period and have a material impact on our gross profit and gross margin results.

Operating Expenses Operating expenses consist of research and development, sales and marketing, and general and administrative expenses, as well as amortization of acquired intangibles. Personnel-related expense represents a significant component of our operating expenses. Our regular full-time employee headcount grew from 566 employees as of December 31, 2012 to 589 as of June 30, 2013.

22-------------------------------------------------------------------------------- Table of Contents Research and Development Research and development expense represents the largest component of our operating expenses and consists primarily of: • compensation, benefits and stock-based compensation provided to our hardware and software engineering personnel, as well as facility costs and other related overhead; • cost of prototypes and test equipment relating to the development of new products and the enhancement of existing products; and • fees for design, testing, consulting, legal and other related services.

We expense our research and development costs as they are incurred.

Sales and Marketing Sales and marketing expense consists primarily of: • compensation, benefits, sales commissions and stock-based compensation provided to our sales, marketing and business development personnel, as well as facility costs and other related overhead; • marketing programs, including expenses associated with industry events and trade shows; and • travel costs.

General and Administrative General and administrative expense consists primarily of: • compensation, benefits and stock-based compensation provided to our executive, finance, legal, human resource and administrative personnel, as well as facility costs and other related overhead; and • fees paid for professional services, including legal, tax and accounting services.

Key Non-GAAP Financial Measures We believe that our results of operations under GAAP, when considered in isolation, may only provide limited insight into the performance of our business in any given period. As a result, we manage our business, make planning decisions, evaluate our performance and allocate resources by assessing non-GAAP measures such as non-GAAP revenue (billings), cost of non-GAAP revenue (billings), gross profit (loss) on non-GAAP revenue (billings), and adjusted EBITDA, in addition to other financial measures presented in accordance with GAAP. We believe that these non-GAAP measures offer valuable supplemental information regarding the performance of our business, and will help investors better understand the sales volumes, and gross margin and profitability trends, as well as the cash flow characteristics, of our business. These non-GAAP measures should not be considered in isolation from, are not a substitute for, and do not purport to be an alternative to, revenue, cost of revenue, gross profit (loss), net loss or any other performance measure derived in accordance with GAAP.

Non-GAAP revenue (billings) represents amounts invoiced for products for which ownership, typically evidenced by title and risk of loss, has transferred or services that have been provided to the customer, and for which payment is expected to be made in accordance with normal payment terms. Non-GAAP revenue (billings) excludes amounts for undelivered products, services to be performed in the future, and amounts paid or payable to customers. Non-GAAP revenue (billings) is initially recorded as deferred revenue and is recognized as revenue when all revenue recognition criteria have been met under our accounting policies as described in our Prospectus. We reconcile revenue to non-GAAP revenue (billings) by adding revenue to the change in deferred revenue in a given period.

Cost of non-GAAP revenue (billings) represents the cost associated with products and services that have been delivered to the customer, excluding stock-based compensation and amortization of intangibles. Cost of product shipments for which revenue is not recognized in the period incurred is recorded as deferred cost of revenue. Deferred cost of revenue is expensed in the statement of operations as cost of revenue when the corresponding revenue is recognized.

Costs related to services are expensed in the period incurred. We reconcile cost of revenue to cost of non-GAAP revenue (billings) by adding cost of revenue to the change in deferred cost of revenue, less stock-based compensation and amortization of intangibles included in cost of revenue, in a given period.

Gross profit (loss) on non-GAAP revenue (billings) is the difference between non-GAAP revenue (billings) and cost of non-GAAP revenue (billings).

23-------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA is net loss adjusted for changes in deferred revenue and deferred cost of revenue, other (income) expense, net, provision for income taxes, depreciation and amortization, stock-based compensation and certain other items management believes affect the comparability of operating results.

The non-GAAP financial measures set forth below for the three and six months ended June 30, 2013 and 2012 have been derived from our condensed consolidated financial statements. Reconciliations to the comparable GAAP measures are contained in the notes below.

Three Months Ended Six Months Ended June 30, June 30, 2013 2012 2013 2012 (unaudited, in thousands, except (unaudited, in thousands, except for percentages) for percentages) Non-GAAP revenue (billings)(1) $ 86,451 $ 74,033 $ 160,222 $ 133,536 Cost of non-GAAP revenue (billings)(2) 60,444 49,129 112,664 85,742 Gross profit (loss) on non-GAAP revenue (billings)(3) $ 26,007 $ 24,904 $ 47,558 $ 47,794 Gross margin on non-GAAP revenue (billings) 30 % 34 % 30 % 36 % Adjusted EBITDA(4) $ (2,306 ) $ 1,001 $ (8,890 ) $ (2,251 ) (1) The following table reconciles revenue to non-GAAP revenue (billings): Three Months Ended Six Months Ended June 30, June 30, 2013 2012 2013 2012 (unaudited, in thousands) (unaudited, in thousands) Revenue, net $ 103,510 $ 51,584 $ 157,213 $ 107,038 Change in deferred revenue, net of foreign currency translation (17,059 ) 22,449 3,009 26,498 Non-GAAP revenue (billings) $ 86,451 $ 74,033 $ 160,222 $ 133,536 (2) The following table reconciles cost of revenue to cost of non-GAAP revenue (billings): Three Months Ended Six Months Ended June 30, June 30, 2013 2012 2013 2012 (unaudited, in thousands) (unaudited, in thousands) Cost of revenue $ 55,260 $ 44,914 $ 98,829 $ 90,301 Change in deferred cost of revenue, net of foreign currency translation 7,763 4,903 23,186 (2,991 ) Less: Stock-based compensation included in cost of revenue (2,531 ) (640 ) (9,255 ) (1,472 ) Less: Amortization of intangibles included in cost of revenue (48 ) (48 ) (96 ) (96 ) Cost of non-GAAP revenue (billings) $ 60,444 $ 49,129 $ 112,664 $ 85,742 (footnotes continued on the next page) 24 -------------------------------------------------------------------------------- Table of Contents (3) The following table reconciles gross profit (loss) to gross profit on non-GAAP revenue (billings): Three Months Ended Six Months Ended June 30, June 30, 2013 2012 2013 2012 (unaudited, in thousands, except (unaudited, in thousands, except for percentages) for percentages) Gross profit $ 48,250 $ 6,670 $ 58,384 $ 16,737 Change in deferred revenue, net of foreign currency translation (17,059 ) 22,449 3,009 26,498 Change in deferred cost of revenue, net of foreign currency translation (7,763 ) (4,903 ) (23,186 ) 2,991 Stock-based compensation included in cost of revenue 2,531 640 9,255 1,472 Amortization of intangibles included in cost of revenue 48 48 96 96 Gross profit on non-GAAP revenue (billings) $ 26,007 $ 24,904 $ 47,558 $ 47,794 Gross margin on non-GAAP revenue (billings) 30 % 34 % 30 % 36 % (4) The following table reconciles net loss to adjusted EBITDA: Three Months ended Six Months ended June 30, June 30, 2013 2012 2013 2012 (unaudited, in thousands) (unaudited, in thousands) Net income (loss) $ 9,470 $ (23,407 ) $ (54,896 ) $ (41,839 ) Change in deferred revenue, net of foreign currency translation (17,059 ) 22,449 3,009 26,498 Change in deferred cost of revenue, net of foreign currency translation (7,763 ) (4,903 ) (23,186 ) 2,991 Other (income) expense, net 184 1,078 24,912 (2,247 ) Provision for income taxes 328 38 392 96 Depreciation and amortization 1,689 1,857 3,366 3,644 Stock-based compensation 10,845 3,889 37,513 8,606 Adjusted EBITDA $ (2,306 ) $ 1,001 $ (8,890 ) $ (2,251 ) Non-GAAP measures have limitations and should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. The most significant of these limitations include: • our non-GAAP measures do not reflect the effect of customer acceptance provisions as required under GAAP; • our non-GAAP measures do not reflect the effect of contingent revenue recognition limits due to potential refunds and penalty provisions related to future delivery or performance as required under GAAP; • our non-GAAP measures are based on contractual invoiced amounts and therefore do not reflect the effect of relative selling price allocations between separate units of accounting as required under GAAP; • our non-GAAP measures do not reflect the impact of issuing equity-based compensation to our management team and employees or in connection with acquisitions; • our non-GAAP measures do not reflect the impact of the amortization of acquired intangibles arising from acquisitions; • our non-GAAP measures do not reflect other (income) expense primarily related to gains and losses from the remeasurement of embedded derivative and preferred stock warrant liabilities, and interest expense or loss on conversion from our promissory notes; • our non-GAAP measures do not reflect income tax expense or legal settlement costs; • although depreciation and amortization are non-cash expenses, the assets being depreciated and amortized may have to be replaced in the future, and adjusted EBITDA does not reflect cash capital expenditure requirements for such replacements or for new capital expenditures; 25 -------------------------------------------------------------------------------- Table of Contents • our non-GAAP measures do not reflect changes in, or cash requirements for, our working capital needs; and • other companies, including companies in our industry, may not use such measures, may calculate non-GAAP measures differently or may use other financial measures to evaluate their performance, all of which reduce the usefulness of our non-GAAP measures as comparative measures.

26 -------------------------------------------------------------------------------- Table of Contents Results of Operations and Other Financial Measures The following table sets forth our condensed consolidated results of operations for the periods shown: Three Months Ended Six Months Ended June 30, June 30, 2013 2012 2013 2012 (unaudited, in thousands) (unaudited, in thousands) Condensed Consolidated Statements of Operations Data: Revenue, net $ 103,510 $ 51,584 $ 157,213 $ 107,038 Cost of revenue 55,260 44,914 98,829 90,301 Gross profit 48,250 6,670 58,384 16,737 Operating expenses: Research and development 18,752 15,422 43,871 31,392 Sales and marketing 8,637 6,619 19,090 14,910 General and administrative 10,879 6,920 25,015 14,425 Total operating expenses 38,268 28,961 87,976 60,727 Operating income (loss) 9,982 (22,291 ) (29,592 ) (43,990 ) Other income (expense), net (184 ) (1,078 ) (24,912 ) 2,247 Income (loss) before income taxes 9,798 (23,369 ) (54,504 ) (41,743 ) Provision for income taxes 328 38 392 96 Net income (loss) $ 9,470 $ (23,407 ) $ (54,896 ) $ (41,839 ) Revenue The following table sets forth our revenue for the periods shown: Three Months Ended Six Months Ended June 30, June 30, 2013 2012 Change 2013 2012 Change (unaudited, in thousands) (unaudited, in thousands) Product revenue $ 47,996 $ 43,958 $ 4,038 $ 89,716 $ 91,898 $ (2,182 ) Service revenue 55,514 7,626 47,888 67,497 15,140 52,357 Revenue, net $ 103,510 $ 51,584 $ 51,926 $ 157,213 $ 107,038 $ 50,175 Of the $103.5 million total revenue recognized in the three months ended June 30, 2013, 89%, or $92.6 million, was due to the receipt of customer acceptances and the performance of related services for follow-on phases of deployment of our networking platform and solutions from utility customers for which acceptance of initial phases of deployment was achieved prior to 2013, and 11%, or $10.9 million, was due to the receipt of customer acceptances of initial phases of deployment of our networking platform and solutions during 2013.

Revenue from our advanced metering solution and demand-side management and distribution automation solutions represented 94% and 6%, respectively, of total revenue for the three months ended June 30, 2013.

Of the $51.6 million total revenue recognized in the three months ended June 30, 2012, 99%, or $50.9 million, was due to the receipt of customer acceptances and the performance of related services for follow-on phases of deployment of our networking platform and solutions from utility customers for which acceptance of initial phases of deployment was achieved prior to 2012, and 1%, or $0.7 million, was due to the receipt of customer acceptances of initial phases of deployment of our networking platform and solutions during 2012. Revenue from our advanced metering solution and demand-side management and distribution automation solutions represented 88% and 12%, respectively, of total revenue for the three months ended June 30, 2012.

27-------------------------------------------------------------------------------- Table of Contents Of the $157.2 million total revenue recognized in the six months ended June 30, 2013, 93%, or $146.3 million, was due to the receipt of customer acceptances and the performance of related services for follow-on phases of deployment of our networking platform and solutions from utility customers for which acceptance of initial phases of deployment was achieved prior to 2013, and 7%, or $10.9 million, was due to the receipt of customer acceptances of initial phases of deployment of our networking platform and solutions during 2013. Revenue from our advanced metering solution and demand-side management and distribution automation solutions represented 91% and 9%, respectively, of total revenue for the six months ended June 30, 2013.

Of the $107.0 million total revenue recognized in the six months ended June 30, 2012, 94%, or $100.4 million, was due to the receipt of customer acceptances and the performance of related services for follow-on phases of deployment of our networking platform and solutions from utility customers for which acceptance of initial phases of deployment was achieved prior to 2012, and 6%, or $6.6 million, was due to the receipt of a customer acceptance of initial phase of deployment of our networking platform and solutions during 2012. Revenue from our advanced metering solution and demand-side management and distribution automation solutions represented 89% and 11%, respectively, of total revenue for the six months ended June 30, 2012.

The increase in revenue for follow-on phases of deployment for the three and six months ended June 30, 2013 as compared to three and six months ended June 30, 2012 was primarily due to the recognition of revenue of approximately $48.5 million that was previously deferred in accordance with our revenue recognition policy in connection with contingency provisions in an agreement with a customer that is nearing completion of its network optimization and deployment.

Product Revenue. The $4.0 million increase in product revenue for the three months ended June 30, 2013 as compared to the three months ended June 30, 2012 was due to an increase of $6.8 million resulting from the recognition of product revenue that was previously deferred subject to contingency provisions for a customer, partially offset by a net decrease of $2.8 million due to lower acceptance volumes partially offset by product mix.

The $2.2 million decrease in product revenue for the six months ended June 30, 2013 as compared to the six months ended June 30, 2012 was due to a net decrease of $9.0 million resulting from lower acceptance volumes partially offset by product mix. This decrease was partially offset by an increase of $6.8 million resulting from the recognition of product revenue that was previously deferred subject to contingency provisions for a customer.

Service Revenue. The $47.9 million increase in service revenue for the three months ended June 30, 2013 as compared to the three months ended June 30, 2012 was primarily due to an increase of $41.6 million resulting from the recognition of services revenue that was previously deferred subject to contingency provisions for a customer, and an increase of $5.0 million for services associated with the receipt of customer acceptances for initial phases of deployment of our networking platform and solutions. Revenue from managed services and SaaS, and professional services represented 36% and 17%, respectively, of total revenue for the three months ended June 30, 2013, and 8% and 7%, respectively, of total revenue for the three months ended June 30, 2012.

The $52.4 million increase in service revenue for the six months ended June 30, 2013 as compared to the six months ended June 30, 2012 was primarily due an increase of $41.6 million from the recognition of services revenue that was previously deferred subject to contingency provisions for a customer, and an increase of $6.3 million for services associated with the receipt of customer acceptances for initial phases of deployment of our advanced metering solution and distribution automation solution. Revenue from managed services and SaaS, and professional services represented 27% and 16%, respectively, of total revenue for the six months ended June 30, 2013, and 7% and 8%, respectively, of total revenue for the six months ended June 30, 2012.

We anticipate that total revenue in the three months ended September 30, 2013 will decrease sequentially and will fluctuate from period to period for the remainder of 2013 and beyond, and may lead to gross losses primarily due to the timing of when we expect to meet the completion and acceptance criteria in our customer arrangements.

Non-GAAP Revenue (billings) The following table sets forth our non-GAAP revenue (billings) for the periods shown: Three Months Ended Six Months Ended June 30, June 30, 2013 2012 Change 2013 2012 Change (unaudited, in thousands) (unaudited, in thousands)Non-GAAP revenue (billings) $ 86,451 $ 74,033 $ 12,418 $ 160,222 $ 133,536 $ 26,686 28 -------------------------------------------------------------------------------- Table of Contents The $12.4 million increase in non-GAAP revenue (billings) for the three months ended June 30, 2013 as compared to the three months ended June 30, 2012 was due to increases in billings of $8.2 million from changes in product mix partially offset by lower volumes and $4.2 million in services billings.

Non-GAAP revenue (billings) from our advance metering solution and demand-side management and distribution automation solutions represented 88% and 12%, respectively, of total billings for the three months ended June 30, 2013, and 91% and 9%, respectively, of total billings for the three months ended June 30, 2012.

Non-GAAP revenue (billings) from product, managed services and SaaS, and professional services represented 76%,11% and 13%, respectively, of total billings for the three months ended June 30, 2013, and 78%, 11% and 11%, respectively, of total billings for the three months ended June 30, 2012.

The $26.7 million increase in non-GAAP revenue (billings) for the six months ended June 30, 2013 as compared to the six months ended June 30, 2012 was due to increases in billings of $19.2 million from changes in product mix partially offset by lower volumes and $7.5 million in services billings.

Non-GAAP revenue (billings) from our advance metering solution and demand-side management and distribution automation solutions represented 90% and 10%, respectively, of total billings for the six months ended June 30, 2013, and 90% and 10%, respectively, of total billings for the six months ended June 30, 2012.

Non-GAAP revenue (billings) from product, managed services and SaaS, and professional services represented 76%,11% and 13%, respectively, of total billings for the six months ended June 30, 2013, and 77%, 11% and 12%, respectively, of total billings for the six months ended June 30, 2012.

Cost of Revenue and Gross Profit The following table sets forth our cost of revenue and gross profit (loss) for the periods shown: Three Months Ended Six Months Ended June 30, June 30, 2013 2012 Change 2013 2012 Change (unaudited, in thousands) (unaudited, in thousands)Product cost of revenue $ 39,565 $ 32,132 $ 7,433 $ 65,308 $ 65,512 $ (204 ) Service cost of revenue 15,695 12,782 2,913 33,521 24,789 8,732 Cost of revenue $ 55,260 $ 44,914 $ 10,346 $ 98,829 $ 90,301 $ 8,528 Product gross profit (loss) $ 8,431 $ 11,826 $ (3,395 ) $ 24,408 $ 26,386 $ (1,978 ) Service gross profit (loss) 39,819 (5,156 ) 44,975 33,976 (9,649 ) 43,625 Gross profit $ 48,250 $ 6,670 $ 41,580 $ 58,384 $ 16,737 $ 41,647 29 -------------------------------------------------------------------------------- Table of Contents In the three and six months ended June 30, 2013, we recognized $2.5 million and $9.3 million, respectively, of stock-based compensation expense in cost of revenue, as compared to $0.6 million and $1.5 million of stock-based compensation expense for the three and six months ended June 30, 2012, respectively. The increases are due to restricted stock units that vested in connection with our IPO, the modification of stock options held by employees as of the date of our IPO, expenses related to our 2013 corporate bonus program, equity awards granted at IPO that were previously communicated to employees but not granted during the period from February 2012 to the date of our IPO, and the implementation of our Employee Stock Purchase Plan that became effective at our IPO.

Product Cost of Revenue. The $7.4 million increase in product cost of revenue for the three months ended June 30, 2013 as compared to the three months ended June 30, 2012 was due to changes in product mix partially offset by lower acceptance volumes.

The $0.2 million decrease in product cost of revenue for the six months ended June 30, 2013 as compared to the six months ended June 30, 2012 was primarily due to a decrease of $3.6 million resulting from changes in product mix partially offset by lower acceptance volumes, offset by an increase of $1.9 million in stock-based compensation and, during the six months ended June 30, 2012, product cost of revenue was lower due to a $1.5 million higher benefit resulting from changes in estimates related to warranties.

Service Cost of Revenue. The $2.9 million increase in service cost of revenue for the three months ended June 30, 2013 as compared to the three months ended June 30, 2012 was due to an increase of $1.5 million in higher service costs and $1.4 million in stock-based compensation.

The $8.7 million increase in service cost of revenue for the six months ended June 30, 2013 as compared to the six months ended June 30, 2012 was primarily due to an increase of $5.9 million in stock based compensation and $2.9 million in higher service costs.

We anticipate that cost of revenue will increase in the three months ended September 30, 2013 as compared to the three months ended September 30, 2012, and will fluctuate for the remainder of 2013 and beyond. Changes in our service cost of revenue are disproportionate to changes in our service revenue because we recognize service cost of revenue in the period in which it is incurred even though the associated service revenue may be required to be deferred, as described under "Financial Overview-Cost of Revenue and Gross Profit (Loss)." Cost of Non-GAAP Revenue (billings) and Gross Profit on Non-GAAP Revenue (billings) The following table sets forth our cost of non-GAAP revenue (billings) for the periods shown: Three Months Ended Six Months Ended June 30, June 30, 2013 2012 Change 2013 2012 Change (unaudited, in thousands) (unaudited, in thousands) Cost of Non-GAAP revenue (billings) $ 60,444 $ 49,129 $ 11,315 $ 112,664 $ 85,742 $ 26,922 Cost of non-GAAP revenue (billings) increased by $11.3 million during the three months ended June 30, 2013 as compared to the three months ended June 30, 2012 primarily due to an increase of $10.2 million in product cost of non-GAAP revenue primarily due to changes in the mix of products shipped partially offset by lower volumes and an increase of $1.5 million in cost of services.

Cost of non-GAAP revenue (billings) increased by $26.9 million during the six months ended June 30, 2013 as compared to the six months ended June 30, 2012 primarily due to an increase of $24.6 million in product cost of billings primarily due to changes in the mix of products shipped partially offset by lower volumes and an increase of $2.9 million in cost of services.

The following table sets forth our gross profit (loss) on non-GAAP revenue (billings) for the periods shown: Three Months Ended Six Months Ended June 30, June 30, 2013 2012 Change 2013 2012 Change (unaudited, in thousands except (unaudited, in thousands except percentages) percentages)Gross profit on non-GAAP revenue (billings) $ 26,007 $ 24,904 $ 1,103 $ 47,558 $ 47,794 $ (236 ) Gross margin on non-GAAP revenue (billings) 30 % 34 % 30 % 36 % 30 -------------------------------------------------------------------------------- Table of Contents Gross profit on non-GAAP revenue (billings) increased by $1.1 million during the three months ended June 30, 2013 as compared to the three months ended June 30, 2012 primarily due to increases in gross profit of $2.7 million from services, offset by a decrease in gross profit of $1.6 million from changes in product mix.

For the three months ended June 30, 2013, gross margin on non-GAAP revenue (billings) was 30% as compared with 34% for the comparable period in 2012. The gross margin decline was driven primarily by changes in product mix, partially offset by an increase in gross profit from services.

Gross profit on non-GAAP revenue (billings) decreased by $0.2 million during the six months ended June 30, 2013 as compared to the six months ended June 30, 2012 due to a decrease in gross profit of $4.8 million from changes in product mix, partially offset by an increase in gross profit of $4.6 million from services.

For the six months ended June 30, 2013, gross margin on non-GAAP revenue (billings) was 30% as compared with 36% for the comparable period in 2012. The gross margin decline was driven primarily by changes in product mix, partially offset by an increase in gross profit from services.

We expect gross margin on non-GAAP revenue (billings) to fluctuate from period to period throughout 2013.

Operating Expenses The following table sets forth our operating expenses for the periods shown: Three Months Ended Six Months Ended June 30, June 30, 2013 2012 Change 2013 2012 Change (unaudited, in thousands) (unaudited, in thousands) Research and development $ 18,752 $ 15,422 $ 3,330 $ 43,871 $ 31,392 $ 12,479 Sales and marketing 8,637 6,619 2,018 19,090 14,910 4,180 General and administrative 10,879 6,920 3,959 25,015 14,425 10,590 Operating expenses $ 38,268 $ 28,961 $ 9,307 $ 87,976 $ 60,727 $ 27,249 Personnel-related expenses represent the most significant component of our operating expenses and increased from period to period. We intend to continue to manage our operating expenses in line with our existing cash and available financial resources and anticipate continued spending in future periods in order to execute our long-term business plan. In addition, the timing of additional hires could materially affect our operating expenses, both in absolute dollars and as a percentage of revenue.

In the three and six months ended June 30, 2013, we recognized $8.3 million and $28.3 million respectively of stock-based compensation expense in operating expenses, as compared to $3.2 million and $7.1 million for the three and six months ended June 30, 2012 respectively. The increases are due to restricted stock units that vested in connection with our IPO, the modification of stock options held by employees as of the date of our IPO, expenses related to our 2013 corporate bonus program, equity awards granted at IPO that were previously communicated to employees but not granted during the period from February 2012 to the date of our IPO, and the implementation of our Employee Stock Purchase Plan that became effective at our IPO.

Research and Development. The $3.3 million increase in research and development expense for the three months ended June 30, 2013 was primarily due to an increase of $2.5 million in stock-based compensation and $0.7 million in personnel-related expenses.

31 -------------------------------------------------------------------------------- Table of Contents The $12.5 million increase in research and development expense for the six months ended June 30, 2013 was primarily due to an increase of $10.7 million in stock-based compensation and an increase of $1.6 million in personnel-related expenses.

We intend to continue to invest significantly in our research and development efforts, which we believe are essential to enhancing our competitive position and developing new products. Accordingly, we expect research and development expense to increase in future periods and remain the largest component of our operating expenses.

Sales and Marketing. The $2.0 million increase in sales and marketing expense for the three months ended June 30, 2013 was primarily due to an increase of $0.9 million in personnel-related and commission expenses and $0.8 million in stock based compensation.

The $4.2 million increase in sales and marketing expense for the six months ended June 30, 2013 was primarily due to an increase of $3.2 million in total stock-based compensation.

We expect sales and marketing expense to increase in future periods as we hire new personnel and increase our global marketing and sales activities.

General and Administrative. The $4.0 million increase in general and administrative expense for the three months ended June 30, 2013 was primarily due to an increase of $1.8 million in stock-based compensation and $1.4 million in professional services due to increased legal expenses.

The $10.6 million increase in general and administrative expense for the six months ended June 30, 2013 was primarily due to an increase of $7.2 million in total stock-based compensation and an increase of $1.6 million in professional services due to increased legal expenses.

We expect general and administrative expense to increase as we incur additional costs related to operating as a publicly-traded company including increased audit, legal, regulatory and other related fees.

32-------------------------------------------------------------------------------- Table of Contents Operating Income (Loss) The following table sets forth our operating income (loss) for the periods shown: Three Months Ended Six Months Ended June 30, June 30, 2013 2012 Change 2013 2012 Change (unaudited, in thousands) (unaudited, in thousands) Operating income (loss) $ 9,982 $ (22,291 ) $ 32,273 $ (29,592 ) $ (43,990 ) $ 14,398 Operating income (loss) consists of gross profit less operating expenses. The $32.3 million increase in operating income for the three months ended June 30, 2013 was due to a $41.6 million increase in gross profit, partially offset by an increase in operating expenses of $9.3 million.

The $14.4 million decrease in operating loss for the six months ended June 30, 2013 was due to a $41.6 million increase in gross profit, partially offset by an increase in operating expenses of $27.2 million.

We expect to continue to incur operating losses in future periods as we continue to invest in our growth.

Other Income (Expense), Net The following table sets forth our other income (expense), net, for the periods shown: Three Months Ended Six Months Ended June 30, June 30, 2013 2012 Change 2013 2012 Change (unaudited, in thousands) (unaudited, in thousands) Interest expense $ (184 ) $ (1,229 ) $ 1,045 $ (1,236 ) $ (2,153 ) $ 917 Conversion of promissory notes and remeasurement of warrants and derivatives - 151 (151 ) (23,676 ) 4,400 (28,076 ) Other income (expense), net $ (184 ) $ (1,078 ) $ 894 $ (24,912 ) $ 2,247 $ (27,159 ) Other income (expense), net, for the three months ended June 30, 2013 consists of interest expense on our capital leases. For the three months ended June 30, 2012, other income (expense), net also consisted of interest expense from our convertible promissory notes of $1.0 million and to a lesser extent, changes in the fair value of preferred stock warrants and embedded derivatives.

Other income (expense), net, for the six months ended June 30, 2013 consists primarily of a $22.9 million loss on conversion of convertible promissory notes, $0.8 million loss on termination of warrants, and $1.1 million of interest expense on our convertible promissory notes and capital leases. For the six months ended June 30, 2012, other income (expense), net also consisted of changes in the fair value of our preferred stock warrants and embedded derivatives and interest expense on our convertible notes payable, both of which converted upon IPO (see Note 1 in the notes to condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information). We have historically invested our cash in money market accounts and U.S. Treasury bills. We anticipate continuing to invest in short-term and long-term marketable securities in the near term.

Provision for Income Taxes Since inception, we have incurred net losses and have not recorded provisions for U.S. federal and state income taxes, except state minimum taxes. We have not reported a benefit for federal and state income taxes in the condensed consolidated financial statements as the deferred tax asset arising from our net operating losses has been offset by a valuation allowance because it was more likely than not that the tax benefit of the net operating losses may not be realized. We have recorded a provision for foreign taxes associated with our foreign subsidiaries.

33 -------------------------------------------------------------------------------- Table of Contents Net Income (Loss) The following table sets forth our net income (loss) for the periods shown: Three Months Ended Six Months Ended June 30, June 30, 2013 2012 Change 2013 2012 Change (unaudited, in thousands) (unaudited,in thousands) Net loss $ 9,470 $ (23,407 ) $ 32,877 $ (54,896 ) $ (41,839 ) $ (13,057 ) Net income (loss) consists of operating income (loss) plus other income (expense), net, less provision for income taxes. The $32.9 million increase in net income for the three months ended June 30, 2013 was primarily due to the $32.3 million decrease in operating loss. The $13.1 million increase in net loss for the six months ended June 30, 2013 was primarily due to the $27.2 million increase in other expense primarily due to the $23.7 million loss on conversion of convertible notes and termination of warrants, offset by a $14.4 million decrease in operating loss.

For the six months ended June 30, 2013, we recorded a non-cash deemed dividend of $105.0 million related to anti-dilution provisions of certain shares of preferred stock that were triggered by the IPO. (See Note 6 in the notes to condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information).

We expect to continue to incur net losses in future periods as we continue to invest in our growth.

Liquidity and Capital Resources As of June 30, 2013 we had $125.0 million in cash and cash equivalents. We expect that operating expenses will constitute a material use of our cash balances. In the near term, we intend to continue to manage our operating expenses in line with our existing cash and available financial resources and anticipate increased spending in future periods in order to execute our long-term business plan. In addition, we may use cash to fund acquisitions or invest in other businesses, technologies or product lines. We have incurred net losses and negative cash flows from operating activities since our inception, and we expect we will continue to incur operating and net losses and cash flows to fluctuate from period to period in 2013 and beyond. We believe that our available cash balances and credit facilities will be sufficient to meet our presently anticipated working capital, capital expenditure and business expansion requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of customer wins and related billings and the expansion of our production capacity, as well as sales and marketing activities, timing and extent of spending on research and development efforts and the continuing market acceptance of our networking platform and solutions.

Prior to fiscal 2013, we funded our operations primarily through private sales of equity securities and debt financing and, more recently, cash generated from our IPO. In March 2013, we completed our IPO in which we issued and sold 5,462,500 shares of common stock at a public offering price of $17.00 per share.

We received net proceeds of $84.7 million after deducting underwriting discounts and commissions of $6.5 million and paid offering costs in the six months ended June 30, 2013 of $1.7 million, but before deducting previously paid and unpaid offering expenses of approximately $4.7 million. Concurrently with our IPO, we issued and sold in a private placement 705,881 shares of common stock at the IPO price of $17.00 per share. We received net proceeds of $12.0 million.

In addition, in connection with our IPO, our December 2011 Note and February 2012 Note together with accrued interest converted into 3,764,954 shares of common stock (see -Note 4 (Borrowings), to our condensed consolidated financial statements, included in Part 1, Item 1 of this Quarterly Report on Form 10-Q), and we paid $12.0 million in consideration for the termination of certain Series A and all Series C preferred stock warrants.

We have available a line of credit with a bank, which originally provided for advances and the issuance of letters of credit of up to $40 million. In May 2013, we amended our credit agreement to increase the available capacity from $40 million to $50 million. As of June 30, 2013, there were no borrowings outstanding under the credit agreement; however, $14.7 million of letters of credit were outstanding, leaving $35.3 million of available capacity for cash borrowings or additional letters of credit, subject to compliance with financial covenants and other customary conditions to borrowings. As of June 30, 2013 we were in compliance with the financial covenants in the credit agreement.

34-------------------------------------------------------------------------------- Table of Contents We are occasionally required to provide performance bonds to secure our performance under customer contracts. Our ability to obtain such bonds primarily depends upon our capitalization, working capital, past performance, management expertise and reputation and external factors beyond our control, including the overall capacity of the surety market. Surety companies consider those factors in relation to the amount of our tangible net worth and other underwriting standards that may change from time to time. Surety companies may require that we collateralize a percentage of the bond with our cash. Events that affect surety markets generally may result in bonding becoming more difficult to obtain in the future, or being available only at a significantly greater cost. In addition, some of our utility customers also require collateral in the form of letters of credit to secure performance or to fund possible damages as the result of an event of default under our contracts with them. If we enter into significant long-term agreements that require the issuance of letters of credit, our liquidity could be negatively impacted. Our inability to obtain adequate bonding or letters of credit and, as a result, to bid or enter into significant long-term agreements could have a material adverse effect on our future revenues and business prospects.

Cash Flows The following table sets forth the major sources and uses of cash for each of the periods set forth below (in thousands): Six Months Ended June 30, 2013 2012 Change (unaudited, in thousands) Cash used in operating activities $ (22,961 ) $ (28,081 ) $ 5,120 Cash used in investing activities (2,462 ) (2,993 ) 531 Cash provided by financing activities 77,747 30,563 47,184 Cash Flows from Operating Activities Operating activities used $23.0 million of cash during the six months ended June 30, 2013, primarily as a result of a net loss of $54.9 million, which was partially offset by non-cash stock-based compensation expense of $37.5 million, non-cash loss on conversion of convertible promissory notes and termination of warrants of $23.7 million, the change in our operating assets and liabilities of $(34.1) million, and depreciation and amortization of $3.4 million.

Operating activities used $28.1 million of cash during the six months ended June 30, 2012, primarily as a result of a net loss of $41.8 million and an adjustment for the non-cash gain associated with the remeasurement of preferred stock warrants and embedded derivatives of $4.4 million, which was partially offset by non-cash stock-based compensation expense of $8.6 million, the change in our operating assets and liabilities of $4.2 million, and depreciation and amortization of $3.6 million.

Cash Flows from Investing Activities Cash flows from investing activities primarily relate to capital expenditures to support our growth. Cash used in investing activities consisted primarily of cash used in the purchases of property and equipment and totaled $2.5 million and $3.0 million, for the six months ended June 30, 2013, and June 30, 2012, respectively.

Cash Flows from Financing Activities Cash provided by financing activities totaled $77.8 million during the six months ended June 30, 2013, and consisted primarily of $84.7 million in net proceeds from the sale of 5,462,500 shares of common stock in our IPO, $12.0 million proceeds from the sale of 705,881 shares of common stock in a private placement, partially offset by the payment of $12.0 million payment for the termination of certain Series A and Series C preferred stock warrants, and $6.2 million for taxes paid related to the net share settlement of equity awards.

35 -------------------------------------------------------------------------------- Table of Contents Cash provided by financing activities totaled $30.6 million during the six months ended June 30, 2012, and consisted primarily of $29.0 million in net proceeds from the issuance of a convertible note.

Concentration of Credit Risk We typically extend credit to our utility customers and meter manufacturers and do not require collateral or other security in support of accounts receivable. We attempt to mitigate the credit risk in our trade receivables through our credit evaluation process and payment terms. We analyze the need to reserve for potential credit losses and record allowances for doubtful accounts when necessary. As of June 30, 2013, BGE, Progress Energy, Secure Meters, and GE accounted for 25%, 17%, 14%, and 5%, respectively, of our accounts receivable, as compared to 26%, 15%, 16%, and 10%, respectively, as of December 31, 2012.

To date, we have not had any significant write-offs of uncollectable accounts receivable, and there was no material allowance for doubtful accounts as of June 30, 2013 and December 31, 2012.

Off-Balance Sheet Arrangements We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements (as that term is defined in Item 303(a)(4)(ii) of Regulation S-K) or other contractually narrow or limited purposes.

During the ordinary course of business, we provide standby letters of credit or other guarantee instruments to third parties as required for certain transactions initiated either by us or our subsidiaries. As of June 30, 2013, our financial guarantees that were not recorded on our balance sheet consisted of $14.7 million of standby letters of credit and $15.0 million of surety bonds related to performance guarantees, facility leases, workers compensation insurance, and a contract bid bond.

Contractual Obligations There were no material changes in our commitments under contractual obligations, as disclosed in "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in our Prospectus.

Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with GAAP. GAAP requires us to make certain estimates and judgments that affect the amounts reported in our financial statements. We base our estimates on historical experience, anticipated future trends and other assumptions we believe to be reasonable under the circumstances. Because these accounting policies require significant judgment, our actual results may differ materially from our estimates.

There have been no material changes in our critical accounting policies and estimates during the three months ended June 30, 2013 as compared to the critical accounting policies and estimates disclosed in "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in our Prospectus.

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