OPNET TECHNOLOGIES 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 related to our financial condition and results of operations for the three and six months ended September 30, 2012 and 2011 should be read in conjunction with the condensed consolidated financial statements and the related notes included elsewhere in this report. You should also read the following discussion and analysis in conjunction with the consolidated financial statements and the related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in the Annual Report on Form 10-K for the fiscal year ended March 31, 2012, filed with the Securities and Exchange Commission, or SEC, on June 8, 2012. This discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions and our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under the "Risk Factors" section of our Form 10-K for the fiscal year ended March 31, 2012 and in subsequent SEC filings. We caution readers not to place undue reliance on any such forward-looking statements, which are made pursuant to the Private Securities Litigation Reform Act of 1995, as amended, and, as such, speak only as of the date made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, after the date of this Form 10-Q.

Overview OPNET Technologies, Inc. is a provider of application performance management, or APM, and network performance management solutions. Our software products address application performance management, network operations, capacity management, and network research and development. Our customers include corporate enterprises, government and defense agencies, network service providers, and network equipment manufacturers. Our software products and related services are designed to help our customers make better use of resources, reduce operational problems and improve competitiveness.

We operate in one reportable industry segment, the development and sale of computer software products and related services. While our operations are principally in the United States, we also have subsidiaries in Belgium, France, Germany, the United Kingdom, Singapore, and Australia, registered offices in China and the United Arab Emirates, and an office in Japan. We primarily depend upon our direct sales force to generate revenue in the United States. Sales outside the United States are made through our international sales team as well as third-party distributors and value-added resellers, who generally are responsible for providing technical support and service to customers within their territory.

Our revenue is derived from three primary sources: (1) products, (2) product updates, technical support and services, and (3) professional services, which include consulting and training services for customers without current maintenance agreements. Product revenue represents all fees earned from granting customers licenses to use our software and fees associated with hardware platforms used to deliver some software products, but excludes revenue derived from product updates, which are included in product updates, technical support, and services revenue. Our software master license agreement provides our customers with the right to use our software either perpetually, which we refer to as perpetual licenses, or during a defined term, generally for one to four years, which we refer to as term licenses. For the six months ended September 30, 2012 and 2011, perpetual licenses represented approximately 96% and 93%, respectively, of product revenue. Product updates, technical support, and services revenue represents fees associated with the sale of unspecified product updates, technical support and when-and-if available training under our maintenance agreements. Substantially all of our product arrangements generate both product revenue and product updates, technical support, and services revenue. We offer professional services, under both time-and-material and fixed-price agreements, primarily to facilitate the adoption of our software products.

We consider our consulting services to be an integral part of our business model as they are centered on our software product offerings. Because our consulting services facilitate the adoption of our software product offerings, we believe that they ultimately generate additional sales of product licenses.

The key strategies of our business plan include increasing sales both to new customers and to existing customers, increasing deal size by selling modules and introducing new software products, improving our sales and marketing execution, establishing alliances to extend our market reach, increasing our international presence, and increasing profitability. We have focused our sales, marketing, and other efforts on corporate enterprise and United States government opportunities and, to a much lesser extent, service provider and network equipment manufacturer opportunities. Our focus and strategies are designed to increase revenue and profitability. Because of the uncertainty surrounding the amount and timing of revenue growth, we expect to need to closely control the increases in our total expenses as we implement these strategies.

On October 28, 2012, the Company entered into an Agreement and Plan of Merger (the "Merger Agreement") with Riverbed Technology, Inc., a Delaware corporation ("Riverbed") and Octagon Acquisition Corp., a Delaware corporation and wholly owned subsidiary of Riverbed ("Acquisition Sub"). Under the terms of the Merger Agreement, Acquisition Sub will commence an exchange offer (the "Offer") to acquire all of the outstanding shares of the Company's common stock in exchange for consideration, per share of the Company's common stock, comprised of (i) $36.55, net to the seller in cash and (ii) 0.2774 of a share of Riverbed common stock ((i) and (ii) together, the "Offer Price"), without interest. Following the consummation of the Offer, Acquisition Sub will merge with and into the Company with the Company surviving as a wholly owned subsidiary of Riverbed (the "Transaction"). Upon the Merger being effective, shares of the Company's common stock not tendered and accepted pursuant to the Offer (other than shares of the Company's common stock owned directly or indirectly by the Company, Riverbed or Acquisition Sub, or any of their respective subsidiaries, or shares of the Company's common stock as to which appraisal rights have been perfected in accordance with applicable law), will be cancelled and converted into the right to receive the Offer Price. Upon consummation of the Merger: (i) the Company's outstanding options will be converted into equity awards of Riverbed on substantially equivalent terms; and (ii) the Company's outstanding restricted stock and restricted stock units will be assumed by Riverbed and converted into the right to receive the Offer Price on substantially equivalent terms.

Consummation of the Offer is subject to various conditions set forth in the Merger Agreement, including, among others: (i) at least a majority of shares of OPNET Common Stock then outstanding (calculated on a fully-diluted basis) being tendered in the Offer; (ii) the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended; (iii) the absence of any Company Material Adverse Effect (as defined in the Merger Agreement); (iv) the registration statement for Riverbed's common stock issuable in connection with the Offer and the Merger being declared effective by the SEC; and (v) the receipt by Riverbed of sufficient proceeds to consummate the Offer.

20 -------------------------------------------------------------------------------- Table of Contents Summary of Our Sequential Quarter-Over-Quarter Financial Performance The following table summarizes information derived from our unaudited condensed consolidated financial statements and other key metrics: Three Months Ended September 30, June 30 , Amount Percentage 2012 2012 Change Change (dollars in thousands, except per share data) Statement of Operations Data: Total revenue $ 47,060 $ 44,031 $ 3,029 6.9 % Total cost of revenue $ 11,047 $ 9,776 $ 1,271 13.0 % Gross profit $ 36,013 $ 34,255 $ 1,758 5.1 % Gross profit as a percentage of total revenue (gross margin) 76.5 % 77.8 % Total operating expenses $ 29,917 $ 28,066 $ 1,851 6.6 % Income from operations $ 6,096 $ 6,189 $ (93 ) (1.5 )% Income from operations as a percentage of total revenue (operating margin) 13.0 % 14.1 % Net income $ 3,855 $ 3,794 $ 61 1.6 % Diluted net income per common share $ 0.17 $ 0.16 $ 0.01 6.3 % Other Operations Data: Total employees (period end) 669 654 15 2.3 % Total average employees 657 623 34 5.5 % Total consultants (period end) 104 96 8 8.3 % Total quota-carrying sales persons (excluding directors and inside sales representatives) (period end) 94 90 4 4.4 % Financial Condition and Liquidity Data: Cash, cash equivalents, and marketable securities (period end) $ 94,598 $ 102,372 $ (7,774 ) (7.6 )% Cash flows (used)/provided by operating activities $ (4,887 ) $ 7,125 $ (12,012 ) (168.6 )% Total deferred revenue (period end) $ 53,100 $ 53,193 $ (93 ) (0.2 )% Our increase in total revenue in the three months ended September 30, 2012, or Q2 fiscal 2013, from the three months ended June 30, 2012, or Q1 fiscal 2013, was principally due to an increase in product revenue of $1.9 million and a $902,000 increase in product updates, technical support and services revenue.

The increase in product revenue was principally due to an increase in product sales to corporate enterprise customers and, to a lesser extent, an increase in sales to network equipment manufacturers. The increases were partially offset by a decrease in product sales to United States government customers. Total revenue generated from sales to United States government customers decreased by $3.2 million during Q2 fiscal 2013 as compared to Q1 fiscal 2013. The percentage of total revenue from United States government customers decreased to 26.1% in Q2 fiscal 2013 from 35.1% in Q1 fiscal 2013.

Our international revenue was $9.6 million and $8.8 million for Q2 fiscal 2013 and Q1 fiscal 2013, respectively. The increase in international revenue was primarily the result of an increase in product sales to corporate enterprise customers. As a percentage of total revenue, international revenue increased slightly from 20.0% to 20.4% during Q2 fiscal 2013. We expect international revenue to continue to account for a significant portion of our total revenue in the future. Sales to corporate enterprises accounted for the largest portion of our international revenue during Q2 fiscal 2013. We believe that continued growth and profitability will require further expansion of our sales, marketing and customer service functions in international markets.

21-------------------------------------------------------------------------------- Table of Contents Our gross profit increased to $36.0 million for Q2 fiscal 2013 from $34.3 million for Q1 fiscal 2013. The increase in gross profit was primarily due to the $1.9 million increase in product revenue. Our gross margin decreased to 76.5% in Q2 fiscal 2013 from 77.8% in Q1 fiscal 2013. The decrease in our gross margin was principally due to an increase in hardware costs associated with increased sales of our AppResponse Xpert products. The following table summarizes the gross margins on revenue for Q2 fiscal 2013 and Q1 fiscal 2013: Gross Margin Q2 Fiscal 2013 Q1 Fiscal 2013 Product 82.8 % 85.4 % Product updates, technical support and services 90.7 % 90.4 % Professional services 32.7 % 33.3 % During Q2 fiscal 2013, as compared to Q1 fiscal 2013, we experienced a decrease in cash, cash equivalents, and marketable securities of $7.8 million. The decline was principally related to cash used in operating activities of $4.9 million and, to a lesser extent, cash dividends paid of $3.5 million. Cash used in operating activities was largely due to an increase in accounts receivable resulting from 55% of our revenue during the quarter being generated in the third month.

Seasonality Our product revenue tends to be seasonal. Product revenue from corporate enterprise customers, which represents the largest portion of our product revenue, has historically been the highest in the quarter ending December 31, our third fiscal quarter. Corporate enterprise customers typically operate on a calendar year end. As a result, it has been our experience that they often spend the remaining portion of their budgets in the December quarter.

In addition, European buying patterns have historically resulted in a decline in product sales in the summer months followed by increased product sales in our third fiscal quarter, reflecting European vacation practices and the resulting delay in product purchase activities until the conclusion of the summer vacation season. Corporate enterprise customers represent the largest portion of our sales to customers in Europe.

The increase in product revenue from corporate enterprise customers and European customers in the quarter ended December 31 has historically more than offset the sequential decline in product sales to the United States government during the same quarter. Product revenue from United States government customers has historically been highest in the quarter ending September 30, which coincides with the United States government fiscal year-end, and reflects higher demand for product purchases prior to the end of their fiscal year. United States government product purchases then typically decline sequentially in the quarter ending December 31. Despite this trend during Fiscal 2013, we expect that the quarter ended June 30 will be the highest quarter for United States government customer revenue primarily due to strong United States government sales during that quarter and weaker sales during the quarter ended September 30. We believe the weaker sales during the quarter ended September 30 was the result of federal budget constraints.

While we expect these historical trends to continue, they could be affected by a number of factors, including the relative proportions of our business conducted with government compared to commercial customers and domestic compared to European customers, a decline in general economic conditions, changes in the timing or amounts of United States government spending resulting from budget constraints or other factors, and our continued expansion into international markets.

Trends That May Affect Business and Future Results We anticipate the following trends and patterns over the next several quarters: Total Revenue. We believe the current overall economic environment is showing signs of improvement but parts of the world economy, including countries comprising the European Union, appear to be declining. Our ability to generate increased revenue domestically and internationally will depend largely upon continued improvement in overall economic conditions. We expect future growth opportunities in product revenue and product updates, technical support and services revenue to come from sales to corporate enterprise customers and the United States government, as we believe our products offer competitive advantages in these markets. Our ability to generate increased revenue from United States government customers will be impacted by the length and severity of budget constraints. We expect product revenue and product updates, technical support and services revenue from sales to service providers and network equipment manufacturers to fluctuate from quarter to quarter with the potential for periods of declining revenue. Our ability to increase professional services revenue will depend in part on our ability to attract and retain additional qualified consultants, including those with security clearances. We believe that continued increases in the proportion of sales of our APM products, as compared to our other products, could cause the percentage of our total revenue attributable to professional services revenue to decline and might also cause an absolute decline in professional services revenue because our APM products generally require less consulting time to implement. As a result of these factors, we believe that we will likely experience fluctuations in quarterly revenue.

Gross Profit Margin. Our overall gross profit margin will continue to be affected by the proportion of total revenue generated from products and product updates, technical support and services, as revenue from these sources has substantially higher gross margins than the gross margin on revenue from professional services. Our overall gross profit margin will also be affected by the proportion of our product revenue that is derived from products delivered on hardware platforms, the amount of fees paid to indirect channel partners and the profitability of individual consulting engagements. Amortization of technology associated with acquisitions of technology that we may make in future periods may also affect our gross profit margin.

22-------------------------------------------------------------------------------- Table of Contents Research and Development Expenses. We believe that continued investment in research and development will be required to maintain our competitive position and broaden our software product lines, as well as enhance the features and functionality of our current software products, especially our APM products. We believe there is more competition in the markets served by our APM products as compared to the markets for our other products. We made personnel investments in research and development during fiscal 2012, and we plan to continue making investments in additional personnel during fiscal 2013. We expect that the absolute dollar amount of these expenses will continue to grow but generally decrease as a percentage of total revenue in future periods, although our ability to decrease these expenses as a percentage of revenue will depend upon our ability to increase our revenue, among other factors.

Sales and Marketing Expenses. We depend upon our direct sales model to generate revenue and believe that increasing the size of our quota-carrying sales team is essential for long-term growth. During fiscal 2012, we focused on improving the productivity of our sales force and only made modest investments in additional direct sales personnel. We have begun to accelerate our hiring of quota-carrying salespeople as compared to fiscal 2012 in order to address what we believe is a large and growing market for our products. We also plan to increase expenditures in areas we believe will enhance the visibility of our products in the marketplace, especially our APM products. While we expect that the absolute dollar amount of sales and marketing expenses will increase in fiscal 2013 as compared to fiscal 2012, our ability to lower these expenses as a percentage of revenue will depend upon increases in our revenue.

General and Administrative Expenses. We expect the dollar amount of general and administrative expenses to increase as we continue to expand our operations but generally decrease as a percentage of total revenue in future periods. Our ability to decrease these expenses as a percentage of revenue will depend upon increases in our revenue, among other factors.

Operating Margin. Since a significant portion of our product arrangements close in the latter part of each quarter, we may not be able to adjust our cost structure in the short-term to respond to lower than expected revenue, which would adversely impact our operating margin and earnings. We remain committed to increasing profitability and generating long-term growth. As the economy improves, we plan to strategically increase research and development and marketing expenditures in order to maintain our products' competitive advantages and increase market share. While we intend to strategically increase expenditures in certain areas, we intend to closely monitor and control overall operating expenses in order to maximize our operating margin.

Critical Accounting Policies and Use of Estimates The accompanying discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these financial statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from the estimates we make with respect to these and other items that require our estimates.

We have identified the accounting policies that are critical to understanding our historical and future performance, as these policies affect the reported amounts of revenue and the more significant areas involving management's judgments and estimates. These critical accounting policies relate to revenue recognition and deferred revenue, stock-based compensation, fair value measurement of cash equivalents and marketable securities, valuation of intangible assets and impairment review of goodwill, software development costs, and income taxes. These policies, and our procedures related to these policies, are described in our Annual Report on Form 10-K for the fiscal year ended March 31, 2012, filed with the SEC on June 8, 2012.

23-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth items from the condensed consolidated statements of operations expressed as a percentage of total revenue for the periods indicated: Three Months Ended Six Months Ended September 30, September 30, 2012 2011 2012 2011 Revenue: Product 46.8 % 49.1 % 46.3 % 48.8 % Product updates, technical support and services 38.1 36.8 38.4 36.6 Professional services 15.1 14.1 15.3 14.6 Total revenue 100.0 100.0 100.0 100.0 Cost of revenue: Product 8.1 9.4 7.4 7.8 Product updates, technical support and services 3.5 3.3 3.6 3.4 Professional services 10.2 8.9 10.3 9.3 Amortization of acquired technology and customer relationships 1.7 1.3 1.6 1.3 Total cost of revenue 23.5 22.9 22.9 21.8 Gross profit 76.5 77.1 77.1 78.2 Operating expenses: Research and development 23.3 21.7 23.4 22.3 Sales and marketing 32.3 32.1 32.3 31.7 General and administrative 7.9 6.0 7.9 7.7 Total operating expenses 63.5 59.8 63.6 61.7 Income from operations 13.0 17.3 13.5 16.5 Interest and other expense, net 0.0 (0.0 ) 0.0 (0.1 ) Income before provision for income taxes 13.0 17.3 13.5 16.4 Provision for income taxes 4.8 5.9 5.1 5.5 Net income 8.2 % 11.4 % 8.4 % 10.9 % Revenue Product Revenue. Product revenue was $22.0 million and $20.6 million for the three months ended September 30, 2012 and 2011, respectively, representing an increase of 6.8%. The increase was primarily due to growth in sales to corporate enterprise customers and, to a lesser extent, network manufacturing customers which was partially offset by a decrease in sales to United States government customers. Product revenue was $42.1 million and $40.0 million for the six months ended September 30, 2012 and 2011, respectively, representing an increase of 5.2%. The increase was primarily due to growth in sales to corporate enterprise customers and, to a lesser extent, network manufacturing customers which was partially offset by a decrease in sales to United States government customers. The increase in product revenue for the three and six month periods ended September 30, 2012 was principally due to growth in sales of our APM products. We believe the decrease in product revenue from United States government customers for the three and six month periods ended September 30, 2012 reflects heightened federal budget constraints.

Product Updates, Technical Support and Services Revenue. Product updates, technical support and services revenue was $18.0 million and $15.4 million for the three months ended September 30, 2012 and 2011, respectively, representing an increase of 16.5%. Product updates, technical support and services revenue was $35.0 million and $30.1 million for the six months ended September 30, 2012 and 2011, respectively, representing an increase of 16.3%. Product updates, technical support and services revenue growth rates are affected by the overall product revenue growth rates, as well as the annual renewal of maintenance contracts by existing customers. The increase in product updates, technical support and services revenue for both periods reflect increases in the overall customer installed base. Growth in the overall customer installed base generally increases the demand for annual renewals of maintenance contracts.

24-------------------------------------------------------------------------------- Table of Contents The dollar amount of our deferred revenue under our maintenance contracts at the end of each quarter is a key factor in determining the near-term growth of our product updates, technical support and services revenue. The balance of deferred revenue under our maintenance contracts generally increases when we sell product licenses and when we sell renewals of annual maintenance contracts. The amount of deferred revenue under our maintenance contracts was $46.7 million and $40.3 million at September 30, 2012 and 2011, respectively. The amount of deferred revenue under our maintenance contracts will generally be recognized as product updates, technical support and services revenue over the life of each individually purchased maintenance contract, which is typically a twelve-month period.

Professional Services Revenue. The components of professional services revenue for the three and six months ended September 30, 2012 and 2011 are as follows: Three Months Ended, Six Months Ended, September 30, September 30, 2012 2011 2012 2011 (in thousands) Consulting services revenue $ 7,008 $ 5,853 $ 13,575 $ 11,857 Training revenue 103 56 397 178 Professional services revenue $ 7,111 $ 5,909 $ 13,972 $ 12,035 Professional services revenue was $7.1 million and $5.9 million for the three months ended September 30, 2012 and 2011, respectively, representing an increase of 20.3%. Consulting services revenue accounted for 98.6% and 99.1% of professional services revenue for the three months ended September 30, 2012 and 2011, respectively. The percentage of total consulting revenue from United States government customers for the three months ended September 30, 2012 and 2011 was 46.3% and 49.0%, respectively. Professional services revenue was $14.0 million and $12.0 million for the six months ended September 30, 2012 and 2011, respectively, representing an increase of 16.1%. Consulting services revenue accounted for 97.2% and 98.5% of professional services revenue for the six months ended September 30, 2012 and 2011, respectively. The percentage of total consulting revenue from United States government customers for the six months ended September 30, 2012 and 2011 was 47.0% and 52.6%, respectively. The increase in professional services revenue for the three and six month period ended September 30, 2012 was principally the result of an increase in average hourly billing rates for our consultants who provide consulting services. The increase in average hourly billing rates was due to an increase in the percentage of our professional services revenue being derived from commercial customers as compared to United States government customers during the three and six month periods ended September 30, 2012 as compared to the prior fiscal year.

This increase was principally due to the growing proportion of product sales and related implementation services provided to commercial customers relative to United States government customers. Average hourly billing rates for consulting services are generally higher for commercial customers than for United States government customers.

International Revenue.

Our international revenue was $9.6 million and $9.4 million for the three months ended September 30, 2012 and 2011, respectively, representing an increase of 2.3%. Our international revenue as a percentage of total revenue was 20.4% and 22.4% for the three months ended September 30, 2012 and 2011, respectively. Our international revenue was $18.4 million and $20.0 million for the six months ended September 30, 2012 and 2011, respectively, representing a decrease of 8.0%. Our international revenue as a percentage of total revenue was 20.2% and 24.3% for the six months ended September 30, 2012 and 2011, respectively. The absolute dollar increase in international revenue for the three months ended September 30, 2012 was principally due to an increase in sales of our APM products to corporate enterprise customers. The absolute dollar decrease in international revenue for the six months ended September 30, 2012 was principally due to a decrease in sales to service providers, corporate enterprise customers, and international government customers. We believe the decrease in international revenue for the six months ended September 30, 2012 was related to the economic instability in Europe. Revenue from corporate enterprise customers accounted for the largest percentage of international revenue for the three and six month periods ended September 30, 2012 and 2011.

Our international revenue is primarily generated in Europe and Asia.

25-------------------------------------------------------------------------------- Table of Contents Cost of Revenue.

The following table sets forth, for each component of revenue, the cost of such component of revenue as a percentage of the related revenue for the periods indicated: Three Months Ended, Six Months Ended, September 30, September 30, Cost of Revenue: 2012 2011 2012 2011 Product 17.3 % 19.1 % 16.0 % 16.0 % Product updates, technical support and services 9.3 % 9.0 % 9.5 % 9.4 % Professional services 67.3 % 63.5 % 67.0 % 63.3 % Cost of product revenue consists primarily of the cost of hardware platforms associated with the delivery of some software products, royalties, fees paid to indirect channel partners and, to a lesser extent, media, manuals, and distribution costs. Cost of product updates, technical support and services revenue consists principally of personnel-related costs necessary to provide technical support and training to customers with active maintenance contracts on a when-and-if-available basis, royalties, media, and distribution costs. Cost of professional services revenue consists principally of personnel-related costs necessary to provide consulting and training to customers without active maintenance contracts. Gross margins on product revenue and product updates, technical support and services revenue are substantially higher than gross margins on professional services revenue, due to the low cost of delivering software products and providing technical support and maintenance compared with the relatively high personnel costs associated with providing consulting services and customer training.

Cost of Product Revenue. Cost of product revenue was $3.8 million and $3.9 million for the three months ended September 30, 2012 and 2011, respectively.

The decrease of 3.4% was the principally the result of a $277,000 decrease in third party royalties, which was slightly offset by a $155,000 increase in costs related to hardware platforms used to deliver our AppResponse Xpert software products and other hardware used in conjunction with our AppResponse Xpert software products. The increase in hardware costs reflects growth in sales of our AppResponse Xpert products. Total hardware platform costs for the three months ended September 30, 2012 and 2011 was $3.4 million and $3.2 million, respectively. Gross margin on product revenue increased to 82.8% for the three months ended September 30, 2012, compared to 80.9% for the same period in fiscal 2012. The increase in gross margin for the three months ended September 30, 2012 was due to extending a larger than normal discount to a customer that made a significant purchase in September 2011. Cost of product revenue was $6.7 million and $6.4 million for the six months ended September 30, 2012 and 2011, respectively. The increase of 5.2% was principally the result of a $800,000 increase in costs related to hardware platforms used to deliver our AppResponse Xpert software products and other hardware used in conjunction with our AppResponse Xpert software products, which was partially offset by a $496,000 decrease in third-party royalties. The increase in hardware costs reflects growth in sales of our AppResponse Xpert products. Total hardware platform costs for the six months ended September 30, 2012 and 2011 was $6.1 million and $5.3 million, respectively. Gross margin on product revenue was 84.0% for the six months ended September 30, 2012 and 2011.

Cost of Product Updates, Technical Support and Services Revenue. Cost of product updates, technical support and services revenue was $1.7 million and $1.4 million for the three months ended September 30, 2012 and 2011, respectively.

Gross margin on product updates, technical support and services revenue decreased to 90.7% for the three months ended September 30, 2012, from 91.1% for the same period in fiscal 2012. Stock-based compensation expense allocated to cost of product updates, technical support and services was $17,000 and $9,000 for the three months ended September 30, 2012 and 2011, respectively. Cost of product updates, technical support and services revenue was $3.3 million and $2.8 million for the six months ended September 30, 2012 and 2011, respectively.

Gross margin on product updates, technical support and services revenue decreased to 90.5% for the six months ended September 30, 2012, from 90.6% for the same period in fiscal 2012. The increase in the cost of product updates, technical support and services revenue for the three and six months ended September 30, 2012 was primarily the result of an increase in compensation costs associated with providing when-and-if-available training under our maintenance contracts. Stock-based compensation expense allocated to cost of product updates, technical support and services was $33,000 and $15,000 for the six months ended September 30, 2012 and 2011, respectively.

Cost of Professional Services Revenue. Cost of professional services revenue was $4.8 million and $3.8 million for the three months ended September 30, 2012 and 2011, respectively. The increase of 27.6% was primarily the result of an increase in staffing levels, which was necessary to better align our headcount and resource skill sets with external demand for our consulting services. Gross margin on professional services revenue decreased to 32.7% for the three months ended September 30, 2012 from 36.5% for the same period in fiscal 2012.

Stock-based compensation expense allocated to cost of professional services was $33,000 and $18,000 for the three months ended September 30, 2012 and 2011, respectively. Cost of professional services revenue was $9.4 million and $7.6 million for the six months ended September 30, 2012 and 2011, respectively. The increase of 26 -------------------------------------------------------------------------------- Table of Contents 22.9% was primarily the result of an increase in staffing levels, which was necessary to better align our headcount and resource skill sets with external demand for our consulting services. Gross margin on professional services revenue decreased to 33.0% for the six months ended September 30, 2012 from 36.7% for the same period in fiscal 2012. Stock-based compensation expense allocated to cost of professional services was $60,000 and $38,000 for the six months ended September 30, 2012 and 2011, respectively.

Operating Expenses Research and Development. Research and development expenses were $11.0 million and $9.1 million for the three months ended September 30, 2012 and 2011, respectively, representing an increase of 20.9%. The increase in research and development expenses for the three months ended September 30, 2012 as compared to the same period in fiscal 2012, was principally due to a $1.4 million increase in compensation expense due to increased staffing levels necessary to develop new products and enhance and maintain existing products. Stock-based compensation expense allocated to research and development was $699,000 and $296,000 for the three months ended September 30, 2012 and 2011, respectively.

Research and development expenses were $21.3 million and $18.3 million for the six months ended September 30, 2012 and 2011, respectively, representing an increase of 16.5%. The increase in research and development expenses for the six months ended September 30, 2012 as compared to the same period in fiscal 2012 was principally due to a $2.3 million increase in compensation expense due to increased staffing levels necessary to develop new products and enhance and maintain existing products. Stock-based compensation expense allocated to research and development was $1.2 million and $561,000 for the six months ended September 30, 2012 and 2011, respectively.

Sales and Marketing. Sales and marketing expenses were $15.2 million and $13.5 million for the three months ended September 30, 2012 and 2011, respectively.

The increase of 13.1% was largely due to a $1.6 million increase in compensation and sales commissions resulting from sales growth which was partially offset by a $175,000 decrease in conference and trade show expense. Stock-based compensation expense allocated to sales and marketing was $395,000 and $152,000 for the three months ended September 30, 2012 and 2011, respectively. Sales and marketing expenses were $29.5 million and $26.1 million for the six months ended September 30, 2012 and 2011, respectively. The increase of 13.0% was largely due to a $2.3 million increase in compensation and sales commissions resulting from sales growth and a $264,000 increase in travel expense related to an increase in sales activities following the global economic downturn. Stock-based compensation expense allocated to sales and marketing was $664,000 and $279,000 for the six months ended September 30, 2012 and 2011, respectively.

General and Administrative. General and administrative expenses were $3.7 million and $2.5 million for the three months ended September 30, 2012 and 2011, respectively. The increase of 47.6% was largely due to a $410,000 increase in discretionary bonus expense, a $230,000 increase in base compensation, a $200,000 increase in legal services, a $106,000 increase in stock-based compensation, and a $101,000 increase in bad debt expense. Stock-based compensation expense allocated to general and administrative expense was $237,000 and $131,000 for the three months ended September 30, 2012 and 2011, respectively. General and administrative expenses were $7.2 million and $6.3 million for the six months ended September 30, 2012 and 2011, respectively. The increase of 14.1% was largely due to a $459,000 increase in base compensation, a $236,000 increase in legal services, an $188,000 increase in stock-based compensation expense, and a $158,000 increase in professional services related to our acquisition of Clarus, which was partially offset by a $217,000 decrease in bad debt expense. Stock-based compensation expense allocated to general and administrative expense was $439,000 and $252,000 for the six months ended September 30, 2012 and 2011, respectively.

Interest and Other Income (Expense), net. Interest and other income (expense), net, was income of $34,000 for the three months ended September 30, 2012. There was no interest and other income for the three months ended September 30, 2011.

Interest and other income (expense), net, was income of $44,000 and an expense of $59,000 for the six months ended September 30, 2012 and 2011, respectively.

The net change for the three and six months ended September 30, 2012, as compared to the same periods in fiscal 2012, was primarily the result of realized foreign currency gains and losses and an increase in other income.

Provision for Income Taxes. Our effective tax rate was 37.1% and 34.1% for the three months ended September 30, 2012 and 2011, respectively. Our effective tax rate was 38.0% and 33.5% for the six months ended September 2012 and 2011, respectively. Our tax rate differed from the statutory tax rate in the three and six month periods ended September 30, 2012 largely due to state income taxes, the difference between United States and foreign tax rates, the domestic production activities deduction, and book compensation under our ESPP not deductible for tax purposes.

The increase in our effective tax rate for the three and six month periods ended September 30, 2012, as compared to the same periods in the prior fiscal year, was principally due to the research and development tax credit not being available to us during the three and six month periods ended September 30, 2012.

The tax credit expired on December 31, 2011.

27-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Since inception, we have funded our operations primarily through cash provided by operating activities and through the sale of equity securities. As of September 30, 2012, we had cash, cash equivalents and marketable securities totaling $94.6 million.

Net cash provided by operating activities was $2.2 million and $1.5 million for the six months ended September 30, 2012 and 2011, respectively. Net cash provided by operating activities is primarily derived from net income, as adjusted for non-cash items such as depreciation and amortization expense, and changes in operating assets and liabilities. The increase in net cash provided by operating activities during the six months ended September 30, 2012 as compared to the same period the prior fiscal year, was primarily attributable to an increase in stock based compensation, an increase in deferred income taxes, and an increase in accrued liabilities, which was partially offset by an increase in accounts receivable and a decrease in net income.

Net cash used in investing activities was $16.7 million and $11.6 million for the six months ended September 30, 2012 and 2011, respectively. For the six months ended September 30, 2012, we used funds of $10.8 million to acquire Clarus, $19.9 million to purchase marketable securities, and funds of $5.0 million to purchase property and equipment. We received proceeds of $19.0 million from the sale or maturity of investments during the six months ended September 30, 2012. For the six months ended September 30, 2011, we used funds of $34.5 million to purchase marketable securities, and funds of $3.3 million to purchase property and equipment. We also received proceeds of $26.2 million from the maturity of investments during the six months ended September 30, 2011.

Net cash used in financing activities was $2.9 million and $1.3 million for the six months ended September 30, 2012 and 2011, respectively. During the six months ended September 30, 2012, we used funds of $6.9 million to pay a quarterly cash dividend of $0.15 per share to stockholders of record on June 14, 2012 and September 12, 2012. During the six months ended September 30, 2011, we used funds of $5.4 million to pay a quarterly cash dividend of $0.12 per share to stockholders of record on June 15, 2011 and September 15, 2011. We used $133,000 and $309,000 to acquire 5,006 and 8,199 shares of our common stock during the six months ended September 30, 2012 and 2011, respectively. During the six months ended September 30, 2012 and 2011, all of the shares that were acquired were shares withheld from employees to satisfy the minimum statutory tax withholding obligations with respect to the income recognized by these employees upon the vesting of their restricted stock shares during the applicable period. Cash provided by financing activities generally reflects the proceeds received from the exercise of stock options and the sale of common stock under our ESPP. During the six months ended September 30, 2012 and 2011, respectively, we received proceeds of approximately $1.8 million and $1.3 million and issued 250,198 and 138,417 shares of common stock, respectively, pursuant to employee and director exercises of stock options. During the six months ended September 30, 2012 and 2011, respectively, we received proceeds of approximately $956,000 and $923,000 and issued 42,558 and 36,673 share of common stock, respectively, pursuant to the issuance of common stock under our ESPP.

Excess tax benefits from the exercise of stock options are presented as a cash flow from financing activities. For the six months ended September 30, 2012 and 2011, excess tax benefits from the exercise of stock options were $1.4 million and $2.2 million, respectively. The payment of dividends has been suspended under the terms of a definitive agreement we signed with Riverbed Technology, Inc. on October 28, 2012. See Note 13, "Subsequent Events", for additional details.

Contractual Obligations We have commitments under contractual arrangements to make future payments for goods and services. These contractual arrangements secure the rights to various assets and services to be used in the future in the normal course of business.

For example, we are contractually committed to make minimum lease payments for the use of property under operating lease agreements. In accordance with current accounting rules, the future rights and related obligations pertaining to such contractual arrangements are not reported as assets or liabilities on our consolidated balance sheets. Our liability for unrecognized tax benefits under Financial Accounting Standards Board Accounting Standards Codification 740 is reported in current and long-term other income taxes on our consolidated balance sheets. We expect to fund these contractual arrangements with our cash, cash equivalents and marketable securities as well as cash generated from operations in the normal course of business.

As of September 30, 2012, we did not have any capital lease obligations. For more information regarding our office space, see our Annual Report on Form 10-K for the fiscal year ended March 31, 2012, filed with the SEC on June 8, 2012.

We expect working capital needs to increase in the foreseeable future in order for us to execute our business plan and growth strategies. We anticipate that operating activities, as well as expected capital expenditures incurred in the normal course 28 -------------------------------------------------------------------------------- Table of Contents of business, will constitute a material use of our cash resources. In addition, we may utilize cash resources to fund acquisitions or investments in complementary businesses, technologies or products as well as repurchase our common stock in accordance with our stock repurchase program authorized by our Board of Directors in January 2005, and the payment of dividends to our stockholders.

We believe that our current cash and cash equivalents, marketable securities, and cash generated from operations will be sufficient to meet our anticipated cash requirements for working capital, capital expenditures, and dividends through the next twelve months and the foreseeable future.

Off-Balance Sheet Arrangements As of September 30, 2012, we did not have any off-balance sheet arrangements with unconsolidated entities or related parties, and, accordingly, there are no off-balance sheet risks to our liquidity and capital resources from unconsolidated entities.

Contingencies We are involved in other claims and legal proceedings arising from our normal operations. We do not expect these matters, individually or in the aggregate, to have a material effect on our financial condition, results of operations, or cash flows.

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