You should read the following discussion of our financial condition and results of operations together with our consolidated financial statements and the related notes and other financial information included elsewhere in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report on Form 10-K, particularly in the section titled "Risk Factors" under Part I, Item IA above. Company Overview Our mission is to deliver high-speed coherent optical interconnect products that transform communications networks, relied upon by cloud infrastructure operators and content and communication service providers, through improvements in performance and capacity and reductions in associated costs. By implementing optical interconnect technology in a silicon-based platform, a process we refer to as the siliconization of optical interconnect, we believe we are leading a disruption that is analogous to the computing industry's integration of multiple functions into a microprocessor. Our products fall into three product groups: embedded modules, pluggable modules and semiconductors. Our embedded module and pluggable module product groups consist of optical interconnect modules with transmission speeds ranging from 100 to 1,200 gigabits per second, or Gbps, for use in long-haul, metro and inter-data center markets. Our semiconductor product group consists of our low-power coherent digital signal processor application-specific integrated circuits, or DSP ASICs, and our silicon photonic integrated circuits, or silicon PICs, which are either integrated into our embedded and pluggable modules or sold to customers on a standalone basis for integration into internally developed or other merchant modules. Our modules perform a majority of the digital signal processing and optical functions in optical interconnects and offer low power consumption, high density and high speeds at attractive price points. Through the use of standard interfaces, our modules can be easily integrated with customers' network equipment. The advanced software in our modules enables increased configurability and automation, provides insight into network and connection point characteristics and helps identify network performance problems, all of which increase flexibility and reduce operating costs. Merger with Cisco Systems OnJuly 8, 2019 , we entered into an Agreement and Plan of Merger, or the Original Merger Agreement, with Cisco Systems, Inc., aCalifornia corporation, or Parent, andAmarone Acquisition Corp. , aDelaware corporation and a wholly owned subsidiary of Parent, or Merger Sub. OnJanuary 14, 2021 , we entered into an Amended and Restated Agreement and Plan of Merger, or the Amended and Restated Merger Agreement, with Parent and Merger Sub, which amended and restated the Original Merger Agreement in its entirety. The Amended and Restated Merger Agreement provided, subject to its terms and conditions, for our acquisition by Parent at a price of$115.00 per share of our common stock,$0.0001 par value per share, each a Share, in cash, without interest and subject to deduction for any required withholding tax, or the Merger. The Company's Board of Directors unanimously approved the Merger and the Amended and Restated Merger Agreement and recommended that stockholders adopt the Amended and Restated Merger Agreement. The Merger was completed onMarch 1, 2021 , following approval of the Amended and Restated Merger Agreement by our stockholders at our special meeting of stockholders. As a result of the completion of the Merger, we became a wholly owned subsidiary of Parent and are no longer a publicly held corporation, our common stock will be delisted from The Nasdaq Global Select Market and deregistered under the Securities Exchange Act of 1934, as amended, and we will no longer are required to file periodic reports with theSEC . See Part I, Item 1, "Merger with Cisco Systems" in this Annual Report on form 10-K for additional discussion of the Merger. We recorded$2.4 million and$7.6 million of acquisition-related costs during the years endedDecember 31, 2020 and 2019, respectively, in sales, general and administrative expense within our consolidated statements of operations. Impact of COVID-19 Our global operations expose us to risks associated with public health crises, epidemics and pandemics, such as the novel coronavirus, severe acute respiratory syndrome coronavirus 2, SARS-CoV-2, and the coronavirus disease, COVID-19. We cannot at this time predict the impact that the COVID-19 pandemic will have on our financial condition and operations, although we are continuing to monitor our supply chain and customer demand for COVID-19 related changes. In this time of uncertainty, we are staying in close communication with our customers and other business partners and have taken steps to mitigate the impact of the COVID-19 pandemic on our operations and financial results. In addition, in response to the COVID-19 pandemic, we have modified our business practices to include company-wide travel and visitor restrictions, work- 49 -------------------------------------------------------------------------------- from-home policies, social distancing and various other recommended preventive measures, including additional cleaning and disinfection procedures within our facilities, daily self-health assessments or, where required by local law, onsite health screening and temperature taking, support for local contact tracing efforts, and the required use of face masks or cloth face coverings when onsite at our facilities. As additional information about COVID-19 and how it is transmitted becomes available, we may implement further measures that we determine are in the best interests of our employees, customers, partners, vendors and suppliers, or that are required or recommended by federal, state or local authorities. While the COVID-19 pandemic did not have a material impact on the Company's financial results for the year endedDecember 31, 2020 , the extent to which the COVID-19 pandemic could impact our results of operations going forward depends on future developments that are highly uncertain and cannot be predicted, including the adverse impact of negative economic conditions created or exacerbated by the pandemic, new information that may emerge concerning the severity of the virus and required or voluntary actions to contain its impact. Due to the inherent uncertainty of this unprecedented and evolving situation, we are unable to predict with any confidence the likely impact of COVID-19 on our future business, results of operations and financial condition. Additional information regarding COVID-19 related risks and uncertainties may be found in the section titled "Risk Factors" under Part I, Item 1A in this Annual Report on Form 10-K. Key Factors Affecting our Performance We believe that our future success will depend on many factors, including our ability to expand sales of our products to our existing customers, expand our customer base and drive the adoption of our products in adjacent markets. While these areas present significant opportunity, they also present risks that we must manage to ensure successful results. See Part I, Item 1A, "Risk Factors" in this Annual Report on form 10-K for a discussion of these risks. If we are unable to address these challenges, our business could be adversely affected.Network Service Provider Investment in High-Speed Optical Equipment. Cloud and service providers are continuing to invest in higher capacity networks to support the continued growth in demand for data traffic. We believe that 100 to 1,200 Gbps coherent optical technologies will continue to replace older technologies in long-haul, metro and inter-data center networks. Our business and results depend on the continued investment by network service providers in these advanced networks. Expanding Sales to Existing Customer Base. We expect that a substantial portion of our future sales will be follow-on sales to existing customers. One of our sales strategies is to maintain a high level of customer satisfaction by delivering our products with compelling value propositions. We believe that our current customers present us with significant opportunities for additional product sales given the existing and expected market share of these customers and our prior sales experience with them. We also believe that our customers will continue to design our products into their network equipment products in an effort to maintain and potentially grow their market share over time as growth in the overall market for optical interconnect technology continues to grow. Our customers have historically shown a high propensity to purchase new products from us over multiple quarters and in many cases over multiple years. In addition, several of our customers have elected to integrate an increasing number of our products into their network equipment product lines. Adding New Customers. We believe that the metro and inter-data center markets are still in the early stages of adoption. We intend to add new customers over time by continuing to invest in our technology and business development team to capitalize on these new opportunities and through potential strategic transactions. Our products and technology have accelerated the rate at which optical interconnect technology can be easily deployed and designed into newer generation network equipment, thus making it easier to integrate our products across many system applications. Generally, we educate prospective customers in these markets about the technical merits and capabilities of our products, the potential cost savings of our products and the costs of designing and utilizing internally developed solutions. We build relationships with prospective customers at all levels in a customer's organizational hierarchy. We believe that customer references combined with our product and technology strengths and capabilities have been, and will continue to be, an important factor in winning new business. Selling More Highly Integrated and Higher-Performance Products. Our results of operations have been, and we believe will continue to be, affected by our ability to design and sell more highly integrated products with improved performance and increased functionality. We aim to grow our revenue and expand our margins by enabling customers to transition from previously deployed 10 and 40 Gbps solutions to our 100 to 1,200 Gbps modules and demonstrate the value proposition to the growing number of metro and inter-data center network equipment designers and manufacturers. Our ability to maintain our current revenue levels and sustain our gross margins will depend, in part, upon our continued sales of our newer, more integrated and higher performance products, and our quarterly results of operations can be significantly impacted by the mix of products sold during the period. 50 -------------------------------------------------------------------------------- Investing in Research and Development for Growth. We believe that the market for our optical interconnect technology products is still in the early stages of adoption and we intend to continue investing for long-term growth. We expect to continue to invest heavily in coherent digital signal processing, optics integration, silicon photonics, hardware engineering and software, all of which afford ongoing vertical integration of components into our core technologies. By investing in research and development, we believe we will be well positioned to continue to design new products and grow our business and take advantage of our large market opportunity. We expect that our results of operations will be impacted by the timing and size of these investments. Customer Concentration. Our five largest customers, which differed by period, collectively accounted for 76% of our revenue in 2020, 81% of our revenue in 2019 and 74% of our revenue in 2018. We expect continued variability in our customer concentration and timing of sales on a quarterly and annual basis. In addition, we have provided, and may in the future provide, annual and semi-annual pricing reductions and pricing discounts to large volume customers, which may result in lower margins for the period in which such sales occur. Our gross margins may also fluctuate as a result of the timing of such sales and the mix of products sold to large volume customers. Key Components of our Results of Operations Revenue We derive substantially all of our revenue from the sale of our products, which we sell through our direct sales force. We sell a substantial majority of our products to network equipment manufacturers for ultimate sale to communications and content service providers and data center and cloud infrastructure operators, which we refer to together as cloud and service providers, and we expect network equipment manufacturer customers to be the primary market for our products for the foreseeable future. Our negotiated terms and conditions of sale do not allow for product returns. Our revenue is affected by changes in the number, product mix and average selling prices of our products. Our product revenue is typically characterized by a life cycle that begins with sales of pre-production samples and prototypes followed by the sale of early production models with higher average selling prices and lower volumes, followed by broader market adoption, higher volumes, and average selling prices that are lower than initial levels. In addition, our product revenue may be affected by contractual commitments to significant customers that obligate us to reduce the selling price of our products on an annual or semi-annual basis. Cost of Revenue Our cost of revenue is comprised primarily of the costs of procuring goods from our contract manufacturers and other suppliers. In addition, cost of revenue includes assembly, test, quality assurance, warranty and logistics-related fees, impacts of manufacturing yield, depreciation, general overhead costs and costs associated with excess and obsolete inventory. Personnel-related expenses include salaries, benefits and stock-based compensation, as well as consulting fees for those personnel engaged in the management of our contract manufacturers, new product manufacturing activities, logistical support, manufacturing and test engineering and supply chain management. Gross Profit Our gross profit has been, and may in the future be, influenced by several factors including changes in product mix, sales of more highly integrated products, target end markets for our products, pricing due to competitive pressure and favorable and unfavorable changes in production costs, including global demand for electronic components used in our products. As some products mature and unit volumes increase, the average selling prices of those products may decline. These declines often coincide with improvements in manufacturing yields and lower wafer, component, assembly and test costs, which lower production costs and may offset some of the margin reduction that results from lower selling prices. We anticipate that our newer modules, which integrate our silicon PIC, will contribute higher gross profit over time than some of our older products, because the integration of our silicon PIC into these products eliminates the need for us to purchase several high-cost discrete components for the same level of functionality, thus improving margins on these products. In addition, we have shifted the manufacturing of our products to contract manufacturers located in lower-cost regions, which generally decreases the cost of the manufacturing of these products and correspondingly improves margins. However, the priorU.S. Administration made, and the currentU.S. Administration may make, significant changes toU.S. trade policy, including the revision, renegotiation, or termination of various multilateral trade agreements under whichU.S. companies currently exchange products and services around the world, and the imposition of new taxes on certain goods imported intothe United States or other adverse consequences on companies importing certain goods intothe United States . Since we rely primarily upon non-U.S. 51 -------------------------------------------------------------------------------- manufacturers to make our products, such steps could make our products more expensive and less competitive in the U.S. market. These changes could significantly increase our cost of manufacturing our products and decrease our margins. There can be no assurance that pending or future legislation or executive action inthe United States will not be enacted. See Part I, Item 1A, "Risk Factors" in this Annual Report on Form 10-K under the heading "Risks Related to our Business and Industry-Changes inU.S. trade policies could disrupt global supply, manufacturing and customer relationships, which may materially increase costs of components contained in our products, increase our manufacturing costs and make our products more expensive or unavailable in foreign markets" for further information. Although we primarily procure and sell our products inU.S. dollars, our contract manufacturers incur many costs, including labor and component costs, in other currencies. To the extent that the exchange rates move unfavorably for our contract manufacturers, they may try to pass resulting costs on to us, which could have a material effect on our future average unit costs. Our gross profit may fluctuate from period to period as a result of changes in average selling prices related to new product introductions, existing product transitions into larger scale commercial volumes, maturity of a product within its life cycle, the effect of prototype and sample sales and the resulting mix of modules or semiconductors within our product groups. In future periods, we may hedge certain significant transactions denominated in currencies other than theU.S. dollar. Operating Expenses We classify our operating expenses as research and development and sales, general and administrative expenses. •Research and development expenses consist primarily of salary and benefit expenses, including stock-based compensation, for employees and costs for contractors engaged in research, design and development activities incurred directly, and with support from, external vendors, such as outsourced research and development costs, as well as costs for prototypes, depreciation, purchased intellectual property, facilities and travel. In future periods, we may hedge certain significant outsourced research and development transactions denominated in currencies other than theU.S. dollar. Over time, we expect our research and development costs to increase in absolute dollars as we continue making significant investments in developing new products and new technologies, including with respect to increased performance and smaller industry-standard form factors. •Sales, general and administrative expenses include salary and benefit expenses, including stock-based compensation, for employees and costs for contractors engaged in sales, marketing, customer service, technical support, and general and administrative activities, as well as the costs of legal and other professional service expenses, trade shows, marketing programs, promotional materials, bad debt expense, facilities, general liability insurance and travel. In the years endedDecember 31, 2020 and 2019, this also included acquisition-related costs related to the Merger. Over time, we expect our sales, general and administrative expenses to increase in absolute dollars primarily due to our continued efforts to expand our business. Other Income, Net Other income, net primarily consists of interest income earned on our cash and investment balances and foreign currency transaction gains and losses. To date, we have not utilized derivatives to hedge our foreign exchange risk as we believe the risk to be immaterial to our results of operations. In future periods, we may hedge certain significant transactions denominated in currencies other than theU.S. dollar as we expand our international operations. Provision (Benefit) for Income Taxes We are subject to income taxes inthe United States and foreign jurisdictions in which we do business. These foreign jurisdictions have statutory tax rates different from those inthe United States . Our effective tax rates will vary depending on the relative proportion of foreign toU.S. income, the absorption of foreign tax credits, changes in corporate structure, changes in the valuation of our deferred tax assets and liabilities and changes in tax laws and interpretations of those laws. We plan to regularly assess the likelihood of outcomes that could result from the examination of our tax returns by theIRS and other tax authorities to determine the adequacy of our income tax reserves and expense. Should actual events or results differ from our then-current expectations, charges or credits to our provision (benefit) for income taxes may become necessary. Any such adjustments could have a significant effect on our results of operations. See Part I, Item 1A, "Risk Factors" in this Annual Report on Form 10-K under the heading "Risks Related to our Business and Industry-The final determination of our income tax liability may be materially different from our income tax provision" for further information. Results of Operations 52 --------------------------------------------------------------------------------
The following tables set forth the components of our consolidated income statements for each of the periods presented and as a percentage of revenue for those periods. The period-to-period comparison of operating results is not necessarily indicative of results for future periods.
Year Ended December 31, 2020 2019 2018 (in thousands) Consolidated Income Statement Data: Revenue$ 583,451 $ 464,663 $ 339,891 Cost of revenue(1) 299,351 243,981 192,771 Gross profit 284,100 220,682 147,120 Operating expenses: Research and development(1) 134,398 128,700 102,406 Sales, general and administrative(1) 60,386 80,581 51,864 Gain on disposal of property and equipment - - - Total operating expenses 194,784 209,281 154,270 Income (loss) from operations 89,316 11,401 (7,150) Total other income, net 5,527 10,240 6,746
Income (loss) before provision (benefit) for income taxes 94,843
21,641 (404) Provision (benefit) for income taxes 4,452 (11,198) (5,320) Net income$ 90,391 $ 32,839 $ 4,916 (1)Stock-based compensation included in the consolidated income statement data was as follows: Year Ended December 31, 2020 2019 2018 (in thousands) Cost of revenue$ 2,089 $ 2,047 $ 2,075 Research and development 21,499 21,383 17,564
Sales, general and administrative 10,075 11,723 9,975
Total stock-based compensation
Year Ended December 31, 2020 2019 2018 Revenue 100 % 100 % 100 % Cost of revenue 51 % 53 % 57 % Gross profit 49 % 47 % 43 % Operating expenses: Research and development 23 % 28 % 30 % Sales, general and administrative 10 % 17 % 15 % Gain on disposal of property and equipment - - - Total operating expenses 33 % 45 % 45 % Income (loss) from operations 15 % 2 % (2) % Total other income, net 1 % 2 % 2 % Income (loss) before provision (benefit) for income taxes 16 % 5 % - % Provision (benefit) for income taxes 1 % (2) % (2) % Net income 15 % 7 % 1 % Percentages in the table above are based on actual values. Totals may not sum due to rounding. Year EndedDecember 31, 2020 Compared to Year EndedDecember 31, 2019 Revenue 53 --------------------------------------------------------------------------------
Revenue by product type and the related changes during the years ended
Year Ended As a % of Year Ended As a % of Change in December 31, 2020 Total Revenue December 31, 2019 Total Revenue $ % (dollars in thousands) Embedded Modules $ 222,448 38 % $ 86,932 19 %$ 135,516 156 % Pluggable Modules 226,280 39 % 217,620 47 % 8,660 4 % Semiconductors 134,723 23 % 160,111 34 % (25,388) (16) % Total revenue $ 583,451 100 % $ 464,663 100 %$ 118,788 26 % Revenue increased by$118.8 million , or 26%, to$583.5 million in the year endedDecember 31, 2020 from$464.7 million in the year endedDecember 31, 2019 . The increase was primarily due to a$135.5 million increase in sales of our embedded modules and an$8.7 million increase in sales of our pluggable modules, partially offset by a$25.4 million decrease in sales of our semiconductors. In the years endedDecember 31, 2020 and 2019, we derived 23% and 34%, respectively, of our revenue from sales to customers with ship-to locations inChina . Cost of Revenue and Gross Profit Year Ended December 31, Change in 2020 2019 $ % (dollars in thousands) Cost of revenue$ 299,351 $ 243,981 $ 55,370 23 % Gross profit percentage 48.7 % 47.5 % Cost of revenue increased$55.4 million , or 23%, to$299.4 million in the year endedDecember 31, 2020 from$244.0 million in the year endedDecember 31, 2019 . The increase was mainly due to increased sales volumes. Our gross profit percentage increased to 48.7% in the year endedDecember 31, 2020 compared to 47.5% in the year endedDecember 31, 2019 . The increase in gross profit percentage was primarily due to the favorable impact of semi-fixed costs relative to the current period revenue volume, partially offset by an unfavorable impact of product mix. Research and Development Year Ended December 31, Change in 2020 2019 $ % (dollars in thousands) Research and development$ 134,398 $ 128,700 $ 5,698 4 % Research and development expense increased$5.7 million , or 4%, to$134.4 million in the year endedDecember 31, 2020 from$128.7 million in the year endedDecember 31, 2019 . The increase was primarily due to an$8.3 million increase in personnel-related and other costs as we continued investing in our product and technology roadmap and a$5.0 million increase in prototype development costs, partially offset by a$7.6 million decrease related to the timing of milestone payments associated with our development programs. Sales, General and Administrative Year Ended December 31, Change in 2020 2019 $ % (dollars in thousands) Sales, general and administrative$ 60,386 $ 80,581 $ (20,195) (25) % 54
-------------------------------------------------------------------------------- Sales, general and administrative expenses decreased$20.2 million , or 25%, to$60.4 million in the year endedDecember 31, 2020 from$80.6 million in the year endedDecember 31, 2019 . This decrease was primarily due to a$20.1 million decrease in professional services expense, which was primarily attributable to$17.5 million recorded in the year endedDecember 31, 2019 for estimated legal and settlement costs related to ongoing litigation matters as compared to an additional$8.0 million recorded in the year endedDecember 31, 2020 , and$7.6 million recorded in the year endedDecember 31, 2019 for acquisition-related costs as compared to an additional$2.4 million recorded in the year endedDecember 31, 2020 . Year Ended December 31, Change in 2020 2019 $ % (dollars in thousands) Total other income, net$ 5,527 $ 10,240 $ (4,713) (46) % Total other income, net decreased$4.7 million , or 46%, to$5.5 million during the year endedDecember 31, 2020 from$10.2 million in the year endedDecember 31, 2019 . This was primarily due to a decline in the interest rates applicable to the types of securities we were invested in during the year endedDecember 31, 2020 as compared toDecember 31, 2019 , as a result of monetary and fiscal policy responses to the impact of COVID-19 on the economy. Provision for (Benefit from) Income Taxes Year Ended December 31, Change in 2020 2019 $ % (dollars in thousands) Provision for (benefit from) income taxes$ 4,452 $ (11,198) $ 15,650 (140) % Effective tax rate 5 % (52) % 57 % The provision for income taxes for the year endedDecember 31, 2020 was$4.5 million compared to a benefit from income taxes of$11.2 million for the year endedDecember 31, 2019 . The provision for income taxes recorded in the year endedDecember 31, 2020 was primarily a result of our pre-tax income position, partially offset by the recognition of excess tax benefits from the taxable compensation on share-based awards recognized in the year endedDecember 31, 2020 and federal and state research and development credits. The benefit from income taxes recorded in the year endedDecember 31, 2019 was primarily a result of the recognition of excess tax benefits from the taxable compensation on share-based awards recognized during the year endedDecember 31, 2019 and federal and state research and development credits. Our historical provision for income taxes is not necessarily reflective of our future results of operations. Taxable income in any jurisdiction is dependent upon acceptance of our operational practices and intercompany transfer pricing by local tax authorities as being on an arm's length basis. Due to inconsistencies in application of the arm's length standard among taxing authorities, as well as lack of adequate treaty-based protection, transfer pricing challenges by tax authorities could, if successful, substantially increase our income tax expense. Year EndedDecember 31, 2019 Compared to Year EndedDecember 31, 2018 Revenue Revenue by product type and the related changes during the years endedDecember 31, 2019 and 2018 were as follows: Year Ended As a % of Year Ended As a % of Change in December 31, 2019 Total Revenue December 31, 2018 Total Revenue $ % (dollars in thousands) Embedded Modules $ 86,932 19 % $ 77,286 23 %$ 9,646 12 % Pluggable Modules 217,620 47 % 189,533 56 % 28,087 15 % Semiconductors 160,111 34 % 73,072 21 % 87,039 119 % Total revenue $ 464,663 100 % $ 339,891 100 %$ 124,772 37 % Revenue increased by$124.8 million , or 37%, to$464.7 million in the year endedDecember 31, 2019 from$339.9 million in the year endedDecember 31, 2018 . The increase was primarily due to an$87.0 million increase in sales of our semiconductors, a$28.1 million increase in sales of our pluggable modules and a$9.6 million increase in sales of our 55 -------------------------------------------------------------------------------- embedded modules. In the years endedDecember 31, 2019 and 2018, we derived 34% and 29%, respectively, of our revenue from sales to customers with ship-to locations inChina . Cost of Revenue and Gross Profit Year Ended December 31, Change in 2019 2018 $ % (dollars in thousands) Cost of revenue$ 243,981 $ 192,771 $ 51,210 27 % Gross profit percentage 47.5 % 43.3 % Cost of revenue increased$51.2 million , or 27%, to$244.0 million in the year endedDecember 31, 2019 from$192.8 million in the year endedDecember 31, 2018 . The increase was mainly due to increased sales volumes, partially offset by a favorable impact of fixed costs relative to the current period revenue volume. Our gross profit percentage increased to 47.5% in the year endedDecember 31, 2019 compared to 43.3% in the year endedDecember 31, 2018 . The increase in gross profit percentage was primarily the result of a favorable impact of fixed costs relative to the current period revenue volume. Research and Development Year Ended December 31, Change in 2019 2018 $ % (dollars in thousands) Research and development$ 128,700 $ 102,406 $ 26,294 26 % Research and development expense increased$26.3 million , or 26%, to$128.7 million in the year endedDecember 31, 2019 from$102.4 million in the year endedDecember 31, 2018 . This increase was primarily due to a$20.0 million increase in personnel-related and other costs as we continued investing in our product and technology roadmap and a$7.4 million increase related to the timing of milestone payments associated with our development programs, which were partially offset by a$1.1 million decrease in prototype development costs . Sales, General and Administrative Year Ended December 31, Change in 2019 2018 $ % (dollars in thousands) Sales, general and administrative$ 80,581 $ 51,864
Sales, general and administrative expenses increased$28.7 million , or 55%, to$80.6 million in the year endedDecember 31, 2019 from$51.9 million in the year endedDecember 31, 2018 . This increase was partially due to a$14.9 million increase in estimated legal and settlement costs related to ongoing litigation matters, a$7.6 million increase in acquisition-related costs related to the Merger, and a$6.2 million increase in personnel-related and other costs as we increased sales and customer support staffing and related support resources. Other Income, Net Year Ended December 31, Change in 2019 2018 $ % (dollars in thousands) Total other income, net$ 10,240 $ 6,746 $ 3,494 52 % 56
-------------------------------------------------------------------------------- Total other income, net increased$3.5 million , or 52%, to$10.2 million during the year endedDecember 31, 2019 from$6.7 million in the year endedDecember 31, 2018 , due to a$3.2 million increase in interest income earned on marketable securities. Benefit from Income Taxes Year Ended December 31, Change in 2019 2018 $ % (dollars in thousands)
Benefit from income taxes
110 % Effective tax rate (52) % 1,317 % (1,369) % The benefit from income taxes for the year endedDecember 31, 2019 was$11.2 million compared to$5.3 million for the year endedDecember 31, 2018 . The benefit from income taxes recorded in the year endedDecember 31, 2019 was primarily a result of the recognition of excess tax benefits from the taxable compensation on share-based awards recognized in the year endedDecember 31, 2019 and federal and state research and development credits. These tax benefits were partially offset by an increase inU.S. taxes on our pre-tax income position in the year endedDecember 31, 2019 . The benefit from income taxes recorded in the year endedDecember 31, 2018 was primarily a result of our pre-tax loss position in the year endedDecember 31, 2018 , the recognition of excess tax benefits from the taxable compensation on share-based awards recognized in the year endedDecember 31, 2018 and federal and state research and development credits. These tax benefits were partially offset by an increase inU.S. tax as a result of theU.S Tax Cuts and Jobs Act, or the Tax Act, which subjects foreign earnings toU.S. taxes. Our historical provisions for income taxes is not necessarily reflective of our future results of operations. Taxable income in any jurisdiction is dependent upon acceptance of our operational practices and intercompany transfer pricing by local tax authorities as being on an arm's length basis. Due to inconsistencies in application of the arm's length standard among taxing authorities, as well as lack of adequate treaty-based protection, transfer pricing challenges by tax authorities could, if successful, substantially increase our income tax expense. Liquidity and Capital Resources Year Ended December 31, 2020 2019 2018 (in thousands) Cash and cash equivalents$ 121,685 $ 36,617 $ 60,444 Marketable securities 469,076 434,761 339,424 Working capital 454,817 368,912 370,445 Net cash provided by operating activities 131,052 72,819 83,085 Net cash used in investing activities (48,160)
(103,579) (56,237) Net cash provided by (used in) financing activities 2,176 6,933 (33,899)
We fund our operations primarily through cash generated from operations. As ofDecember 31, 2020 , we had cash and cash equivalents totaling$121.7 million , marketable securities of$469.1 million and accounts receivable of$118.4 million . We believe our existing cash balances and anticipated cash flow from future operations will be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months and the foreseeable future. Our future capital requirements may vary materially from those currently planned and will depend on many factors, including our rate of revenue growth, the timing and extent of spending on research and development efforts and other business initiatives, purchases of capital equipment to support our growth, the expansion of sales and marketing activities, any expansion of our business through acquisitions of or investments in complementary products, technologies or businesses, the use of working capital to purchase additional inventory, the timing of new product introductions, market acceptance of our products and overall economic conditions. To the extent that current and anticipated future sources of liquidity are insufficient to fund our future business activities and requirements, we may be required to seek additional equity or debt financing. In the event additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us or at all. 57 -------------------------------------------------------------------------------- Operating Activities Net cash provided by operating activities consists primarily of net income adjusted for certain non-cash items, including depreciation expense, stock-based compensation expense, deferred income taxes, non-cash lease expense and other non-cash benefits, net, as well as the effect of changes in working capital. Net cash provided by operating activities was$131.1 million in the year endedDecember 31, 2020 , as compared to$72.8 million in the year endedDecember 31, 2019 . The increase of$58.2 million was primarily due to a$57.6 million increase in net income and a$15.5 million increase in non-cash expense items primarily related to changes in deferred income taxes. These increases were partially offset by a$14.9 million decrease in cash related to changes in operating assets and liabilities. Changes in cash flows related to operating assets and liabilities primarily consisted of a decrease of$13.3 million due to the timing of accounts receivable, a net decrease of$10.8 million in cash due to the timing of payments associated with our accounts payable and accrued liabilities, a net decrease in cash of$7.3 million related to prepaid expenses and other assets, a$1.3 million decrease in cash due to the timing of deferred revenue and a$0.7 million decrease in cash due to changes in our lease liabilities. These decreases were partially offset by an$18.1 million increase in cash due to a decreased inventory balance as compared toDecember 31, 2019 and a$0.8 million increase in cash due to the timing of payments of income taxes. Net cash provided by operating activities was$72.8 million in the year endedDecember 31, 2019 , as compared to$83.1 million in the year endedDecember 31, 2018 . The decrease of$10.3 million was primarily due to a$29.9 million decrease in cash related to changes in operating assets and liabilities and an$8.3 million decrease in non-cash expense items primarily consisting of deferred income taxes, stock-based compensation and non-cash lease expense, which was partially offset by a$27.9 million increase in net income. Changes in cash flows related to operating assets and liabilities primarily consisted of a$52.0 million decrease in cash due to an increased inventory balance as compared toDecember 31, 2018 , a$9.2 million decrease in cash due to the timing of deferred revenue, and a$4.5 million decrease in cash due to payments on our lease liabilities. These decreases were partially offset by a$30.0 million increase in cash due to the timing of payments associated with our accounts payable and accrued liabilities and a$10.6 million increase in cash due to the timing of payments of income taxes. Investing Activities Our investing activities have consisted primarily of purchases, sales and maturities of marketable securities and purchases of lab, engineering and computer equipment to support the development of new products and increase our manufacturing capacity to meet customer demand for existing products. In addition, our investing activities include expansion of, and certain improvements to, our leased facilities. We expect that we will continue to invest in these areas in line with growth in product demand. Net cash used in investing activities in the year endedDecember 31, 2020 was$48.2 million , as compared to$103.6 million in the year endedDecember 31, 2019 . This change was primarily attributable to a$56.5 million decrease in net purchases of marketable securities during the year endedDecember 31, 2020 , partially offset by a$1.0 million increase in property and equipment purchases. Net cash used in investing activities in the year endedDecember 31, 2019 was$103.6 million , as compared to$56.2 million in the year endedDecember 31, 2018 . The increase was primarily due to an increased investment of$50.2 million , net, into marketable securities during the year endedDecember 31, 2019 , partially offset by a$2.8 million decrease in property and equipment purchases. Financing Activities Our financing activities have consisted primarily of proceeds from the issuance of common stock under our stock-based compensation plans and payments to acquire treasury stock. Net cash provided by financing activities during the year endedDecember 31, 2020 was$2.2 million , as compared to$6.9 million during the year endedDecember 31, 2019 , attributable to proceeds from the issuance of common stock during the period. Net cash provided by financing activities during the year endedDecember 31, 2019 was$6.9 million , as compared to net cash used in financing activities of$33.9 million during the year endedDecember 31, 2018 primarily attributable to the repurchase of$39.7 million of treasury stock in the year endedDecember 31, 2018 pursuant to our stock repurchase program that expired onDecember 31, 2018 . 58 -------------------------------------------------------------------------------- Contractual Obligations and Commitments Our principal commitments consist of operating lease payments, purchase obligations, taxes payable as a result of the Tax Act and other tax liabilities arising from the ordinary course of business. The following table summarizes these contractual obligations atDecember 31, 2020 . Future events could cause actual payments to differ from these estimates. Payments due by period Less than 1 More Than Total Year 1-3 Years 3-5 Years 5 Years (in thousands) Operating lease liabilities, including imputed interest (1)$ 24,851 $ 4,518 $ 8,831 $ 6,883 $ 4,619 Purchase obligations (2) 97,165 97,165 $ - - $ - Income taxes payable (3) 7,117 837 3,663 2,617 - Unrecognized tax benefits (4) 3,713 - - - - Total$ 132,846 $ 102,520 $ 12,494 $ 9,500 $ 4,619 (1)We lease facilities and equipment under non-cancelable operating lease agreements. Refer to Note 9, Leases, of the "Notes to Consolidated Financial Statements" contained in Part II, Item 8 of this Annual Report on Form 10-K for more information about our leases. (2)Our purchase obligations primarily consist of outstanding purchase orders with our contract manufacturers for inventory and other third parties for the manufacturing of our wafers and semiconductors. Our relationships with these vendors typically allow for the cancellation of outstanding purchase orders, but require payments of all expenses incurred through the date of cancellation. Other obligations include future non-inventory purchases and commitments related to future fixed asset purchases. (3)Income taxes payable relates to taxes owed as a result of the one-time transition tax on earnings of certain foreign subsidiaries that were previously tax-deferred until the enactment of the Tax Act inDecember 2017 . The Tax Act allows the tax liability to be paid on an installment basis over eight years. The amount due in less than one year in the table above represents the transition tax amount owed in the short-term which is included in accrued liabilities on our consolidated balance sheet. (4)We had$7.9 million of uncertain tax positions as ofDecember 31, 2020 . Included in the balance of unrecognized tax benefits as ofDecember 31, 2020 are$3.7 million of tax benefits that, if recognized, would impact the effective tax rate, which have been accrued for as a long-term liability on our consolidated balance sheet. We are not able to provide reasonably reliable estimates of future payments relating to these obligations. Letters of Credit As ofDecember 31, 2020 , we had outstanding letters of credit of$0.9 million issued to cover the security deposits on the leases of theMaynard, Massachusetts , and theHolmdel, New Jersey facilities. Off-Balance Sheet Arrangements As ofDecember 31, 2020 , we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K. Critical Accounting Policies and Estimates Our management's discussion and analysis of financial condition and results of operations is based on our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted inthe United States of America . In preparing our consolidated financial statements, we make estimates, assumptions and judgments that can have a significant effect on our reported revenue, results of operations and net income, as well as on the value of certain assets and liabilities on our balance sheet during and as of the reporting periods. These estimates, assumptions and judgments are necessary because future events and their effects on our results and the value of our assets cannot be determined with certainty, and are made based on our historical experience and on other assumptions that we believe to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time. As the use of estimates is inherent in the financial reporting process, actual results could differ from those estimates. 59 -------------------------------------------------------------------------------- Revenue Recognition Our products are fully functional at the time of shipment and do not require production, modification or customization. We apply the following five step approach when recognizing revenue: (1) identify the contract with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract and (5) recognize revenue when a performance obligation is satisfied. The contract is generally a customer purchase order and the performance obligation is to deliver a specific quantity of products at specified prices, which represents the transaction price. Our agreements with our customers do not include rights of return. We recognize revenue when transfer of control to our customers occurs, which is generally when products are shipped from our manufacturing facilities or when delivered to the customer's named location, in an amount reflecting the consideration we expect to be entitled to. Inventories Inventories mainly consist of raw materials and finished goods which are purchased from contract manufacturers and other suppliers. Inventories are stated at the lower of cost or net realizable value on a first-in, first-out basis. Our assessment of net realizable value requires the use of estimates, including an assessment of excess or obsolete inventories. We determine excess and obsolete inventories based on an estimate of the future demand for our products within a specified time horizon, generally 12 months. The estimates used for future demand are also used for near-term capacity planning and inventory purchases, and are consistent with revenue forecast assumptions. If our demand forecast is greater than actual demand, we may be required to record an excess inventory charge reflected in cost of goods sold, which would decrease gross profit. Any excess or obsolete inventory write-downs taken establish a new cost basis for the underlying inventory and cannot be reversed if there are subsequent increases in our demand forecast. If we are later able to sell such inventory, any related reserves would be reversed in the period of sale. Commitments and Contingencies In the normal course of business, we may become subject to loss contingencies, such as legal proceedings and claims arising out of our business. An accrual for a loss contingency is recognized when it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. We expense legal costs associated with loss contingencies as they are incurred. Income Taxes We utilize the asset and liability method of accounting for income taxes under which we recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our consolidated financial statements and tax returns. Deferred tax assets and liabilities are determined based upon the differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities and for loss and credit carryforwards, using enacted tax rates expected to be in effect in the year in which the differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance if it is not more likely than not that these assets will be realized. We recognize the benefits of uncertain tax positions that have been taken or that we expect to take on income tax returns if such tax positions are more likely than not to be sustained. We follow the authoritative guidance regarding accounting for uncertainty in income taxes, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. We apply a variety of methodologies in making these estimates, including advice and studies performed by independent subject matter experts, evaluation of public actions taken by theIRS and other taxing authorities, as well as our own industry experience. We provide estimates for unrecognized tax benefits which may be subject to material adjustments until matters are resolved with taxing authorities or statutes expire. If our estimates are not representative of actual outcomes, our results of operations can be materially affected. We must assess the likelihood that some portion or all of our deferred tax assets will be recovered from future taxable income within the respective jurisdictions, and to the extent we believe that recovery does not meet the "more-likely-than-not" standard, we must establish a valuation allowance. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Some sources of future taxable income are objective while others involve subjective assessments. Assessing subjective income sources involves a review of our capability and willingness to implement certain tax planning strategies that will generate future taxable income and an assessment of our experience in forecasting future taxable income. Management's judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. In evaluating the need for a full or partial valuation allowance, all positive and negative evidence 60 -------------------------------------------------------------------------------- must be considered, and the weight of that evidence, including our forecasts of taxable income over the applicable carryforward periods, our current financial performance, our market environment and other factors. As of each reporting date, our management considers new evidence, both positive and negative, that could impact its view with regard to future realization of deferred tax assets. If we determine that our assessments on all or a portion of the deferred tax assets will change in a future period, we will record material adjustments to the provision for income taxes in that period. Stock-Based Compensation We recognize compensation expense for equity awards based on the grant date fair value of the award. For equity awards that vest based on a service condition, which constitute the majority of our outstanding equity awards, stock-based compensation expense is recognized on a ratable basis over the requisite service period. When an equity award contains a performance and/or market condition, we recognize stock-based compensation expense utilizing the accelerated attribution method. We use the Black-Scholes option pricing model to measure the fair value of our option awards when they are granted. Prior to our initial public offering we estimated the value of common stock at the grant date with the help of an independent third-party service provider. The expected volatility of employee option awards prior to 2017 was determined using the daily historical volatility of companies we consider to be our peers. For options awarded in 2018, we determined expected volatility using a blend of our historical volatility and the historical volatility of our peers. To determine our peer companies, we used the following criteria: optical telecommunications companies; similar histories and relatively comparable financial leverage; sufficient public company trading history; and in similar businesses and geographical markets. We used the stock price volatility over the expected term of our granted options to calculate the expected volatility. The expected term of employee option awards is determined using the average midpoint between vesting and the contractual term for outstanding awards, or "the simplified method," because we do not yet have a sufficient history of option exercises. We determine the risk-free interest rate on the grant date of the award based on the rate ofU.S. Treasury securities with maturities approximately equal to the estimated expected term of the awards. We have not paid dividends and do not anticipate paying a cash dividend in the foreseeable future and, accordingly, use an expected dividend yield of zero. The following table summarizes the assumptions, other than fair value of our common stock, relating to our stock options granted in the year endedDecember 31, 2018 . No stock options were granted in the years endedDecember 31, 2020 and 2019. Year Ended December 31, 2018 Risk-free interest rate 2.9% Expected dividend yield None Expected volatility 53.5% Expected term (in years) 6.3 We will continue to use judgment in evaluating the expected volatility and expected term utilized in our stock-based compensation expense calculations on a prospective basis. As we continue to accumulate additional data related to our common stock, we may refine our estimates of expected volatility and expected term, which could materially affect our future stock-based compensation expense to the extent we grant future stock option awards. Stock-based compensation is measured using the fair value of our common stock on the grant date for time-vested restricted stock units, or RSUs. During the years endedDecember 31, 2019 and 2018 we granted RSU awards to executives which had a market condition in addition to a service condition. Determining the amount of stock-based compensation to be recorded for these awards requires us to develop estimates to be used in calculating the grant-date fair value of the awards. We calculate the grant-date fair value of these awards using the Monte Carlo simulation valuation model. The Monte Carlo simulation model utilizes multiple input variables that determine the probability of satisfying the market conditions stipulated in the award grant and calculates the fair market value for the awards granted. The Monte Carlo simulation model also uses stock price volatility and other variables to estimate the probability of satisfying the market conditions, including the possibility that the market condition may not be satisfied, and the resulting fair value of the award. We use a blended rate of our actual historical volatility and our peers volatility to determine the volatility input in the Monte Carlo simulation model. 61 -------------------------------------------------------------------------------- The expense related to these awards is recognized on an accelerated basis over the vesting period of the awards which can vary. See Note 11, Stock Compensation Plans of the "Notes to Consolidated Financial Statements" contained in Part II, Item 8 of this Annual Report on Form 10-K for more information related to these market-based and performance-based awards. Recent Accounting Pronouncements Refer to Note 3, Summary of Significant Accounting Policies of the "Notes to Consolidated Financial Statements" contained in Part II, Item 8 of this Annual Report on Form 10-K for analysis of recent accounting pronouncements that are applicable to our business. Item 7A.Quantitative and Qualitative Disclosures About Market Risk Market risk is the risk of loss to future earnings, values or future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, exchange rates, commodity prices, equity prices and other market changes. We are exposed to market risks in the ordinary course of our business. These risks primarily include interest rate and foreign currency risks as follows: Interest Rate Sensitivity Our exposure to changes in interest rates relates primarily to interest earned on and the market value of our cash, cash equivalents and marketable securities. Our cash, cash equivalents and marketable securities consist of bank deposit accounts, money market funds,U.S. government agency debt securities, commercial paper, certificates of deposit, asset-backed securities and corporate debt securities. Our securities with fixed interest rates may have their market value adversely impacted by a rise in interest rates. As a result, we may suffer losses in principal if we are forced to sell securities that decline in market value due to changes in interest rates. However, because we classify our investments in debt securities as availableforsale, no gains or losses are recognized in the consolidated income statements unless such securities are sold prior to maturity or incur an other-than-temporary decline in fair value. An immediate 100 basis point change in interest rates would have a$3.1 million effect on the fair market value of our portfolio as ofDecember 31, 2020 . Our investment policy specifies credit quality standards for our investments and limits the amount of credit exposure from any single issue, issuer or type of investment. Foreign Currency Exchange Risk We are exposed to market risk related to changes in foreign currency exchange rates. Our operations outside ofthe United States incur a portion of their operating expenses in foreign currencies, principally the Euro, but these expenses are immaterial compared to our overall expenses. To date, the majority of our product sales and inventory purchases have been denominated inU.S. dollars. In addition, the functional currency of all of our entities is theU.S. dollar. Accordingly, we have limited exposure to foreign currency exchange rates. During the years endedDecember 31, 2020 , 2019 and 2018, we recorded foreign currency transaction losses of$0.2 million ,$0.2 million and$0.4 million , respectively. These foreign currency transaction losses have been recorded as a component of "other expense, net" in our consolidated income statements. We believe that a 10% change in the exchange rate between theU.S. dollar and Euro would not materially impact our operating results or financial position. To date, we have not entered into any foreign currency exchange contracts. In future periods, we may hedge certain significant transactions denominated in currencies other than theU.S. dollar as we expand our international operations. Inflation Risk We do not believe that inflation has had a material effect on our business. However, if global demand for the base materials utilized in our suppliers' components were to significantly increase for the components we purchase from our suppliers to manufacture our products, our costs could become subject to significant inflationary pressures, and we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, operating results and financial condition. 62
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