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TMCNet:  HITTITE MICROWAVE CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

[February 26, 2013]

HITTITE MICROWAVE CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) Our discussion and analysis of financial condition and results of operations contains "forward-looking" statements and information, which involve risks and uncertainties. Actual future results may differ materially. Statements indicating that we "expect," "estimate," "believe," "are planning" or "plan to" are forward-looking, as are other statements concerning future financial results, product offerings or other events that have not yet occurred. There are several important factors that could cause actual results or events to differ materially from those anticipated by the forward-looking statements. Such factors include those described below and in "Risk Factors." Although we have sought to identify the most significant risks to our business, we cannot predict whether, or to what extent, any of such risks may be realized. We also cannot assure that we have identified all possible issues which we might face. We undertake no obligation to update any forward-looking statements that we make, except as required by law.


Overview We were organized as a Massachusetts corporation in 1985 and reincorporated under the laws of Delaware in 1988. Since our founding, we have established a 28-year track record of innovation in RF, microwave and millimeterwave semiconductor technology. From 1985 to 1993, our principal activity was government-sponsored research and development relating to advanced, application-specific radio frequency integrated circuits, or RFICs, and monolithic microwave integrated circuits, or MMICs, primarily for military and other government-related programs. During this period, we developed many innovative technologies that we continue to incorporate in our products today.

In 1993, we began to transition our focus from government-sponsored research and development activities to the design, development and production of our own ICs, modules, subsystems and instrumentation. Our early products were custom MMICs designed for use in specific defense programs, such as radar applications.

In 1996, we published our first catalog, which contained 50 standard products, and began to expand our operations to support our growing commercial business.

We also established a dedicated direct technical sales force to promote our emerging standard product line.

In 2001, we opened our first international sales office, and began to focus on expanding our international business. We currently have sales and technical support staff in Canada, China, Egypt, Finland, Germany, India, Ireland, Japan, Korea, Norway, Sweden, Taiwan, Turkey and the United Kingdom, to complement our United States offices. In 2012, we derived 52.9% of our revenue from customers outside the United States.

In 2005, we completed our initial public offering of common stock. We also established our first remote design center in Istanbul, Turkey and acquired substantially all the assets and employees of Q-Dot, Inc., a research and development organization based in Colorado Springs, Colorado. In 2006, we opened a design center in Ottawa, Ontario, Canada.

In October 2007, we entered into a strategic agreement with Northrop Grumman Space Technology sector to market a specified list of existing Velocium products worldwide, to license related technology and to assume the associated customer relationships, at a cost of $7.1 million. In June 2010, we entered into an agreement to license certain millimeterwave technology from IBM at a cost of $6.6 million.

In January 2011, we acquired Arctic Silicon Devices, a developer of advanced mixed-signal IC technology, located in Trondheim, Norway, for approximately $10.4 million in cash. In September 2011, we opened design centers in Cairo, Egypt and Roanoke, Virginia. In 2012, we established our international operations center in Cork, Ireland.

As of December 31, 2012, we offer more than 1,000 standard products in our catalog and many more custom products, which may be categorized for descriptive purposes into 36 functional product lines.

44 -------------------------------------------------------------------------------- Table of Contents We employ a fabless business strategy, which means that we do not own a semiconductor fabrication facility, or fab, and purchase all of our semiconductor wafer requirements from third-party wafer fabrication facilities, known as foundries. We believe that our fabless business model enables us to access a broad range of technologies and quickly respond to new market opportunities, while significantly reducing our capital requirements.

2012 Management Summary º • º Our revenue was essentially flat in 2012, increasing 0.1% to $264.4 million compared to $264.1 million in 2011.

º • º Our gross profit was 73.7% of revenue in 2012 compared to 73.5% of revenue in 2011.

º • º Operating income declined to $107.2 million in 2012 compared to $121.1 million in 2011, primarily due to increased research and development expenses.

º • º Our net income per diluted share was $2.22 for 2012 compared to a net income per diluted share of $2.77 for 2011.

º • º We generated positive cash flow from operations of $68.1 million for 2012 compared to $81.0 million for 2011, primarily due to decreased profitability as a result of increased operating expenses.

Description of Our Revenue, Costs and Expenses Revenue. Our revenue is derived primarily from the sale of standard and custom products. We develop standard products from our own specifications, which we sell through our direct sales organization, our network of independent sales representatives, two distributors and our website. We also develop custom products to meet the specialized requirements of individual customers, which are sold by our direct sales organization.

We sell our products to OEMs that supply advanced electronic systems to commercial and military end users, and to these OEMs' contract manufacturers. In general, the decision to purchase our product is made by the OEM, which has designed our product into its system. In the event that we sell to an OEM's contract manufacturer, the contract manufacturer typically does not have discretion to replace our product with one from a different supplier.

Our sales cycle varies substantially, ranging from a period of a month or less when a customer selects a standard product from our selection guide or website, to as long as two years or more for custom products. In the sales process, our sales and application engineers work closely with the OEM customer to analyze the customer's system requirements and select an appropriate standard product or establish a technical specification for a custom product. In the case of a custom product, we also select a semiconductor process and foundry, and evaluate test wafers and finished components before manufacturing in commercial quantities can begin. Volume purchases of our products by an OEM customer, or its contract manufacturer, generally do not occur until the OEM customer has made the decision to begin production of the system incorporating our product.

Our receipt of substantial revenue from sales of a product to an OEM customer depends on that customer's commercial success in manufacturing and selling its system incorporating our product. It may take several years for a newly introduced standard product to generate substantial revenue, if ever. However, the life cycles of our standard products tend to be lengthy.

Although most of our revenue is derived from sales of our products, we also receive a small percentage of our revenue from customer-sponsored research and development activities. These activities range from pure research, in which we investigate IC design techniques on new semiconductor technologies at the request of a government agency or commercial customer, to custom development 45 -------------------------------------------------------------------------------- Table of Contents projects in which we are paid to enhance or modify an existing product or develop a new product to meet a customer's specifications.

Cost of revenue. Cost of revenue consists primarily of the cost of semiconductor wafers that we purchase from our third-party foundries and other materials such as packages, epoxies, connectors and production masks. Cost of revenue also includes personnel costs and overhead related to our manufacturing and engineering operations, including occupancy and equipment costs, shipping costs, charges for inventory excess and obsolescence and warranty obligations and amortization of related intangible assets.

Research and development. Research and development expense consists primarily of personnel costs of our research and development organization, third-party consulting costs, costs of development wafers, license fees for computer-aided design software, costs of development testing and evaluation, costs of developing automated test software, related occupancy and equipment costs and amortization of related intangible assets. We expense all research and development costs as incurred.

Sales and marketing. Sales and marketing expense consists primarily of personnel costs of our sales and marketing organization, sales commissions paid to independent sales representatives, costs of advertising, trade shows, corporate marketing, promotion, travel, related occupancy and equipment costs, amortization of related intangible assets and other marketing costs.

General and administrative. General and administrative expense consists primarily of personnel costs of our executive management, finance, and other administrative staff, outside professional fees including legal and accounting, related occupancy and equipment costs and other corporate expenses.

Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. By their nature, these estimates and judgments are subject to an inherent degree of uncertainty. On an ongoing basis, we re-evaluate our judgments and estimates, including those related to revenue recognition, uncollectible accounts receivable, inventories, fixed assets, intangible assets, stock-based compensation, income taxes, accrued expenses and other contingencies. We base our estimates and judgments on our historical experience and on other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making the judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates, and material effects on our operating results and financial position may result. The accounting policies described below are those which, in our opinion, involve the most significant application of judgment, or involve complex estimation, and which could, if different judgments or estimates were made, materially affect our reported results of operations.

Revenue recognition. We recognize revenue for the majority of our business when the following criteria have been met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the fee is fixed or determinable; and (4) collectibility is reasonably assured. Effective January 1, 2010 we adopted new guidance for arrangements that involve multiple elements, which is applicable to arrangements originating or materially modified after such date. This guidance eliminates the residual method of revenue allocation, and requires that we use our best estimate of selling price to allocate arrangement consideration between the deliverables in cases where neither vendor-specific objective evidence nor third-party evidence is available. For multiple element arrangements not subject to the new guidance we allocate arrangement consideration among the 46 -------------------------------------------------------------------------------- Table of Contents elements based on the relative fair values of those elements as determined using objective and reliable evidence of fair value. If the fair value of an undelivered element cannot be established, the arrangement is accounted for as a single unit of accounting and revenue is recognized when all performance obligations are met. We maintain a reserve for potential sales returns and allowances. Returns and customer credits, which historically have been immaterial, are recorded as a reduction to revenue. Rights of return are generally not included in sales arrangements. However, a portion of our sales are made to two distributors under agreements that provide for product return privileges. As a result, we defer recognition of revenue from sales to these distributors until the product is resold by the distributors.

Revenue from contracts with the United States government, government prime contractors and some commercial customers, under which we may design, develop, manufacture, or modify complex aerospace or electronic equipment or provide related services, is generally recorded on a percentage of completion basis using either units delivered or costs incurred as the measurement basis for progress toward completion. Estimated revenue in excess of amounts billed is reported as unbilled receivables. Contract accounting requires judgment in estimating costs and assumptions related to technical issues and delivery schedule. Contract costs include material, subcontract costs, labor and an allocation of indirect costs. The estimation of costs at completion of a contract is subject to numerous variables involving contract costs and estimates as to the length of time to complete the contract. Changes in contract performance and estimated gross margin, including the impact of final contract settlements, are recognized in the period in which the changes are determined.

Estimated losses on a contract are recognized in full in the period when they become known.

Allowance for doubtful accounts. We perform ongoing credit evaluations of our customers and adjust credit limits, as determined by our review of current credit information. We continuously monitor collections and payments from our customers and maintain an allowance for doubtful accounts based upon our historical experience, our anticipation of uncollectible accounts receivable and any specific customer collection issues that we have identified. While our credit losses have historically been within our expectations and the allowance established, we may not continue to experience the same credit loss rates that we have in the past.

Inventory. Inventory is stated at the lower of cost (first-in, first-out method) or market. We review the inventory and compare product costs with current market value, and write down any inventory with costs in excess of current market value to its net realizable value. Estimating demand is inherently difficult, particularly given the cyclical nature of the semiconductor industry, which can result in excess or obsolete inventory. This difficulty has increased as we transition from one of our principal foundries.

This transition has resulted in increased purchases of raw materials in order to ensure adequate supplies of affected products. Because these products have long lives, our estimates of future demand must cover longer than usual periods, which increases the risk that if actual demand is less than forecast, we may need to write off some or all of these advance purchases as excess or obsolete.

At December 31, 2012 and 2011, our raw material inventory includes $33.1 million and $12.9 million, respectively, of advance purchases of wafers from this foundry.

We recorded expense of $2.3 million, $2.0 million and $1.5 million in 2012, 2011 and 2010, respectively, to reduce inventory to its net realizable value.

Once we have written down inventory to its estimated net realizable value, we establish a new cost basis for that inventory and do not increase its carrying value due to subsequent changes in demand forecasts. Accordingly, if inventory previously written down is subsequently sold, we may realize improved gross profit margins on these transactions.

Goodwill. We test goodwill for impairment at least annually at the reporting unit level. In September 2011, the FASB issued new guidance which provides an entity the option to perform a qualitative assessment to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount prior to performing the two-step goodwill impairment test. If this is 47 -------------------------------------------------------------------------------- Table of Contents the case, the two-step goodwill impairment test is required. If it is more-likely-than-not that the fair value of a reporting is greater than its carrying amount, the two-step goodwill impairment test is not required. We adopted this guidance as of the fourth quarter of 2011.

If the two-step goodwill impairment test is required, first, the fair value of each reporting unit is compared to its book value. If the fair value of the reporting unit is less than its book value, we perform a hypothetical purchase price allocation based on the reporting unit's fair value to determine the fair value of the reporting unit's goodwill. Fair value is determined using a combination of present value techniques and market prices of comparable businesses.

Long-lived assets. We evaluate our long-lived assets for potential impairment whenever events or circumstances suggest that the carrying amount of an asset or group of assets is not recoverable. Our judgments regarding the existence of impairment indicators are based on market and operational performance. Indicators of potential impairment include: º • º a significant change in the manner in which an asset is used; º • º a significant decrease in the market value of an asset; º • º a significant adverse change in the business or industry in which the asset is used or sold; º • º a current period operating cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the asset; and º • º significant advances in our technologies that require changes in one or more of our manufacturing processes.

If we believe that an indicator of potential impairment exists, we test to determine whether the impairment recognition criteria have been met. To analyze a potential impairment, we project undiscounted future cash flows over the remaining life of the asset or the primary asset in the asset group, using a probability-weighted multiple scenario approach, reflecting a range of possible outcomes. If these projected cash flows are less than the carrying amount, an impairment loss is recognized based on the fair value of the asset or asset group less any costs of disposition. Evaluating the impairment requires judgment by our management to estimate future operating results and cash flows. If different estimates were used, the amount and timing of asset impairments could be affected. We charge impairments of the long-lived assets to operations if our evaluations indicate that the carrying values of these assets are not fully recoverable.

Stock-based compensation. We measure compensation cost related to stock-based awards at fair value on the date of grant, and recognize this cost as expense over the service period the awards are expected to vest, net of estimated forfeitures. The fair value of restricted stock and restricted stock units is determined based on the price of our common stock on the date of grant.

We did not grant any stock options in 2012, 2011 or 2010. Estimating the amount of share-based payments that will ultimately either vest or be forfeited requires judgment. We consider many factors when estimating expected forfeitures, including the type of the award, vesting terms, employee group, and historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates. See Note 14 to the Consolidated Financial Statements included in this Form 10-K for further disclosure regarding our stock-based compensation.

Income taxes. We determine deferred tax assets and liabilities based upon the difference between the financial statements and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. The tax consequences of most events recognized in the current year's financial statements are included in determining income taxes currently payable. However, because tax laws and financial accounting standards differ in their recognition and measurement of assets, liabilities, equity, revenue, expenses, gains and losses, 48 -------------------------------------------------------------------------------- Table of Contents differences arise between the amount of taxable income and pretax financial income for a year and the tax basis of assets or liabilities and their reported amounts in the financial statements. Because we assume that the reported amounts of assets and liabilities will be recovered and settled, respectively, a difference between the tax basis of an asset or a liability and its reported amount in the balance sheet will result in a taxable or a deductible amount in some future years when the related assets or liabilities are settled or the reported amount of the assets are recovered, hence giving rise to a deferred tax asset or liability. We must then periodically assess the likelihood that our deferred tax assets will be recovered from our future taxable income, and, to the extent we believe that it is more likely than not our deferred tax assets will not be recovered, we must establish a valuation allowance against our deferred tax assets. We recognize in our financial statements the tax benefit from an uncertain tax position taken or expected to be taken in an income tax return only if it is more likely than not that such benefit would be sustained on its technical merits in the event of a tax audit. The assessment of each tax position requires significant judgment. All tax positions are periodically analyzed and adjusted as a result of events, such as the resolution of tax audits or the expiration of statutes of limitations, which may result in charges or credits to the provision for income taxes. See Note 15 to the Consolidated Financial Statements included in this Form 10-K for further disclosure regarding income taxes.

Factors and Trends That Affect Our Results of Operations In reading our financial statements, you should be aware of the following factors and trends that our management believes are important in understanding our financial performance.

Revenue. We operate in a cyclical industry, and growth in our revenue is highly dependent on conditions in the global economy. From 2003 to 2008, our revenue grew from $42.0 million to $180.3 million, representing a compound annual growth rate of 33.8%. In 2009, our revenue decreased 9.6% to $163.0 million, due to the global economic downturn and related credit crisis that affected us along with the entire semiconductor industry. In 2010, our revenue increased 49.9% to $244.3 million and in 2011 increased 8.1% to $264.1 million. In 2012, our revenue was essentially flat, growing 0.1% to $264.4 million. There is no certainty that our business will continue to grow.

Generally, our revenue growth results from growing market acceptance of standard products we introduced in prior periods, increased sales of our standard products, derived from the introduction of new products, which expands the breadth and diversity of our standard product offerings, and the expansion of our domestic and international sales efforts.

In establishing current and future planned levels of operating expenses, we seek to balance near-term financial goals with our longer term strategic objectives. Accordingly, we took steps early in 2009 to reduce expenses across our business, and maintained certain of these measures throughout the year.

During 2010, 2011 and 2012, we increased spending to support our growth. Going forward, we expect to increase spending in research and development in order to remain competitive, and our plans for growth also require increased spending to support our operations, sales, marketing and administrative functions.

Gross margin. One of our objectives is to maximize our gross margin, which is our gross profit expressed as a percentage of our revenue. Our gross margins were 73.7% in 2012, 73.5% in 2011 and 74.4% in 2010. In general, we seek to introduce high performance products that are valued by our customers for their ability to address technically challenging applications, rather than commodity ICs for use in high volume applications where cost, rather than performance, is the highest priority. We also seek continuously to reduce our costs and to improve the efficiency of our manufacturing operations.

Our gross margin in any period is significantly affected by industry demand and the intensity of competition in the markets into which we sell our products and by pricing, including fluctuations in the relative proportion of high volume orders, on which we offer higher discounts. Gross margins are also 49 -------------------------------------------------------------------------------- Table of Contents significantly affected by product mix, that is, the percentage of our revenue in that period that is attributable to higher or lower margin products. Additional factors affecting our gross margins include changes in the cost of wafers and materials, the timing of indirect costs for pre-production masks and evaluation materials, changes in estimates for contracts recognized on a percentage of completion basis, variations in overhead absorption, charges for excess or obsolescent inventory, and other manufacturing efficiencies, and numerous other factors, some of which are not under our control. Our margins can be substantially affected by changes in our manufacturing yields. Our yields depend on many factors that we control, such as product design and the effectiveness of our own assembly and test operations, but they are also affected by the activities of third parties, such as the foundries and packaging subcontractors that supply us with critical materials and services, that are beyond our control. As a result of these or other factors, we may be unable to maintain or increase our gross margin in future periods.

Purchasing patterns of our standard products. A majority of our revenue in each quarter is typically derived from sales of our standard products.

Purchasers of our standard products generally do not enter into long-term contracts with us. Customers that purchase large volumes of our standard products generally provide us with periodic forecasts of their requirements for those products, but these forecasts do not commit the customer to minimum purchases, and customers generally may revise these forecasts without penalty. A significant portion of our revenue in each quarter is attributable to purchase orders for standard products that are received and fulfilled in that quarter, often including a large number of orders from diverse customers and markets. Our customers' requested lead times in general have become shorter. The price list for our standard products includes discounts based on purchase order volume, and, as a result, the revenue we receive from sales of a particular product in any period is influenced by the average order size for that product during that period. Our forecasting of sales of standard products takes into account a number of factors, including historical sales patterns for each individual product, our assessment of overall market conditions and our knowledge of the current requirements and purchasing practices of our larger customers. However, the absence, in most cases, of long-term purchase commitments for our standard products complicates the task of predicting the exact sources and amount of our revenue from standard products and thus, to some extent, the amount of our total revenue in any quarter. The difficulty of this task is compounded by the uncertainties we and our customers face, related to the recent global economic conditions.

Relationships with major customers. We have historically depended on a small number of customers for a large percentage of our annual revenue. Revenue derived from our 10 largest customers as a percentage of our annual revenue was 40.2% in 2012, 43.2% in 2011 and 36.5% in 2010. One customer, Boeing, accounted for 16% of our revenue in 2012, 16% in 2011 and 11% in 2010. We include in these calculations revenue from products sold to these customers directly by us or through sales representatives and our distributors, as well as from products sold to contract manufacturers for use in a system manufactured by the contract manufacturer for that customer. Our major customers often use our products in multiple systems or programs, sometimes developed by different business units within the customer's organization, each having differing product life cycles, end customers and market dynamics. While the composition of our top 10 customers varies from year to year, we expect that sales to a limited number of customers will continue to account for a significant percentage of our revenue for the foreseeable future.

Need for continued product and technology innovation. We believe that the breadth of our product line with respect to functionality, performance and frequency coverage, and our ability to introduce new products rapidly, afford us a significant competitive advantage and have contributed significantly to our revenue growth. Our product development strategy emphasizes internally funded research and development, as well as the acquisition of products and technologies through business combinations and licensing arrangements. As a result of these efforts, we introduced 54 new standard catalog products in 2012, 82 in 2011 and 122 in 2010. Additionally, we introduced 2 new product lines in 2012, 4 in 2011 50 -------------------------------------------------------------------------------- Table of Contents and 6 in 2010. Our future competitive position will depend in large part on our ability to continue to innovate, to anticipate the rapid changes in semiconductor technology and RF, microwave and millimeterwave circuit design techniques that characterize our industry and to develop, introduce and successfully market new products that meet the evolving application requirements of our customers. As the complexity and degree of integration of our products increases, maintaining or increasing our historical rate of new product introductions has become increasingly challenging. Driving and supporting this process of continuous innovation and new product introduction is one of our key priorities, and one that will require continuing expenditures.

Need to meet customer demand for on-time delivery and high quality. The success of our business also depends on our continued ability to supply our products on time and in quantities adequate to meet our customers' requirements, while maintaining the high standards of quality and reliability that our customers require. Our senior management spends a significant amount of its time on these key operational issues, and we devote substantial resources to maintain our sources of supply and to improve our manufacturing and quality control processes.

Need to continue to expand the diversity of our product lines, customer base, markets and target applications. The semiconductor industry in general, and specific segments of the markets that we serve, are highly cyclical and have historically experienced significant fluctuations in demand, including periods of rapid growth as well as periods of product overcapacity and weak demand, which occur even during periods of growth in the broader economy. Specific segments of the markets we serve may respond in different ways to conditions in the broader economy, for a variety of reasons. In 2012, our three largest markets were military, microwave and millimeterwave communications and test and measurement, which accounted for 75.6% of our annual revenue in 2012. In 2011 and 2010, our three largest markets were military, microwave and millimeterwave communications and cellular infrastructure, which accounted for 76.8% and 81.1% of our annual revenue in 2011 and 2010, respectively. An important objective of our management is to reduce our exposure to fluctuations in demand from any particular customer or industry segment by continuing to broaden our customer base and markets and the range of applications that our products address.

Results of Operations The following tables set forth, for the periods indicated, selected statement of operations data in dollar amount and expressed as a percentage of our revenue: Year Ended December 31, 2012 2011 2010 (in thousands) Revenue $ 264,395 $ 264,108 $ 244,256 Cost of revenue 69,415 69,935 62,617 Gross profit 194,980 194,173 181,639 Operating expenses: Research and development 49,202 38,899 31,467 Sales and marketing 23,966 22,047 19,420 General and administrative 14,598 12,078 11,568 Total operating expenses 87,766 73,024 62,455 Income from operations 107,214 121,149 119,184 Interest income 182 172 134 Other (expense) income, net (125 ) 430 (72 ) Income before income taxes 107,271 121,751 119,246 Provision for income taxes 38,702 37,063 42,215 Net income $ 68,569 $ 84,688 $ 77,031 51 -------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2012 2011 2010 Revenue 100.0 % 100.0 % 100.0 % Cost of revenue 26.3 26.5 25.6 Gross profit 73.7 73.5 74.4 Operating expenses: Research and development 18.6 14.7 12.9 Sales and marketing 9.0 8.3 8.0 General and administrative 5.5 4.6 4.7 Total operating expenses 33.1 27.6 25.6 Income from operations 40.6 45.9 48.8 Interest income 0.1 0.1 0.1 Other income (expense), net (0.1 ) 0.1 (0.1 ) Income before income taxes 40.6 46.1 48.8 Provision for income taxes 14.7 14.0 17.3 Net income 25.9 % 32.1 % 31.5 % Comparison of Year Ended December 31, 2012 to Year Ended December 31, 2011 Revenue. Our revenue increased $0.3 million, or 0.1%, to $264.4 million in 2012 from $264.1 million in 2011. Revenue from sales to customers outside the United States accounted for 52.9% of our total revenue in 2012, compared with 54.8% in 2011. Our revenue increase was primarily attributable to a $7.9 million increase in sales to the test and measurement market and a $6.6 million increase in sales to the space market, which were partially offset by a $6.1 million decrease in sales to the cellular market, a $4.1 million decrease in sales to the military market, a $2.2 million decrease in sales to the microwave and millimeterwave communications market and a $1.6 million decrease in sales to the broadband market. We believe that the growth in sales to the test and measurement and space markets reflects increased market share due to the broader range of our product offerings and increased market acceptance of products we introduced in prior years. The decrease in sales to the microwave and millimeterwave communications and cellular markets reflects weaker demand for our products used in infrastructure projects by our telecommunications customers. The decrease in sales to the military market primarily relates to our completion of a systems contract in 2011, as well as lower pricing on certain military programs, which were only partially offset by increased volume.

Gross margin. Our gross margin was 73.7% in 2012, compared with 73.5% in 2011. The increase in our aggregate gross margin across all products was attributable to a net 180 basis point improvement due to product mix and a net 80 basis point improvement due to lower manufacturing costs, partially offset by a net 240 basis point decrease due to pricing. Our gross margin for 2012 was within a normal range and consistent with our historical results.

Research and development expense. Our research and development expense increased $10.3 million, or 26.5%, to $49.2 million in 2012, and represented 18.6% of our revenue, compared with $38.9 million, or 14.7% of our revenue, in 2011. The increase in our research and development expense was attributable to a $2.6 million increase in personnel costs, a $1.9 million increase in supplies and materials, a $1.8 million increase in professional fees, a $1.5 million increase in equipment costs, a $1.2 million reduction in funding earned from various foreign government research and incentive programs, a $0.6 million increase in depreciation and amortization, a $0.4 million increase in occupancy costs and a $0.3 million increase in other costs. The increase in costs was primarily due to the growth of our engineering organization, including the opening of our new design centers in Virginia and Egypt 52 -------------------------------------------------------------------------------- Table of Contents in the fourth quarter of 2011, and costs of translation of certain existing products to other GaAs foundries.

Sales and marketing expense. Our sales and marketing expense increased $1.9 million, or 8.7%, to $24.0 million in 2012, and represented 9.1% of our revenue, compared with $22.0 million, or 8.3% of our revenue, in 2011. The increase in our sales and marketing expense was primarily attributable to a $2.4 million increase in personnel costs, partially offset by a $0.4 million decrease in depreciation and amortization and a $0.1 million decrease in other costs.

General and administrative expense. Our general and administrative expense increased $2.5 million, or 20.9%, to $14.6 million in 2012, and represented 5.5% of our revenue, compared with $12.1 million, or 4.6% of our revenue, in 2011.

The increase in our general and administrative expense was primarily attributable to a $1.3 million increase in professional fees and other legal costs, a $0.9 million increase in personnel costs and a $0.3 million increase in other costs.

Interest income. In 2012, our interest income was $0.2 million compared with $0.2 million in the corresponding period of 2011. Interest income in both periods reflects the low effective yields that are available due to the current market conditions.

Other (expense) income, net. In 2012, our other expense, net was $0.1 million compared with other income, net of $0.4 million in the corresponding period of 2011. The change was primarily due to net foreign currency losses.

Provision for income taxes. Our provision for income taxes increased $1.6 million to $38.7 million in 2012, from $37.1 million in 2011, representing an effective tax rate of 36.1% and 30.4% in 2012 and 2011, respectively. The effective tax rate increased 3.0% primarily due to a tax benefit recognized in 2011 related to the resolution of the U.S. Internal Revenue Service's examination of our fiscal 2005 through 2007 income tax returns and the related decrease in reserves for uncertain tax positions. Additionally, in the second quarter of 2012, we completed the initial phase of a global expansion project.

The objective of this project is to better service our international customers and better manage our global suppliers. The initial impact of implementing this project was to increase our effective tax rate, resulting in a net 2.3% increase in 2012. In the longer term, we expect our effective tax rate to decrease.

Comparison of Year Ended December 31, 2011 to Year Ended December 31, 2010 Revenue. Our revenue increased $19.9 million, or 8.1%, to $264.1 million in 2011 from $244.3 million in 2010. Revenue from sales to customers outside the United States accounted for 54.8% of our total revenue in 2011, compared with 55.1% in 2010. Our revenue increase was primarily attributable to a $10.6 million increase in sales to the test and measurement market and an $8.8 million increase in sales to the military market. The growth in sales to the test and measurement market was primarily due to the increased breadth of our product offerings and the increased market acceptance of products we introduced in prior years. The increase in sales to the military market was primarily due to shipments under a production order for microwave subsystems that we announced in February 2009, which was completed in the fourth quarter of 2011.

In the three months ended December 31, 2011, our revenue decreased $7.9 million, or 11.6%, to $60.2 million, compared with $68.1 million in the three months ended September 30, 2011. Our revenue decrease was primarily attributable to a $4.2 million decrease in sales to the military market, a $2.5 million decrease in sales to the microwave and millimeterwave communications market and a $2.0 million decrease in sales to the cellular market partially offset by a net $0.8 million increase in sales to our other markets. The decrease in sales to the military market reflected our completion of a systems contract in 2011, as well as weaker demand for our products used in military applications and lower pricing on certain military programs. The decrease in sales to the microwave and millimeterwave 53 -------------------------------------------------------------------------------- Table of Contents communications and cellular markets reflected weaker demand for our products used in infrastructure projects by our telecommunications customers.

Gross margin. Our gross margin was 73.5% in 2011, compared with 74.4% in 2010. The decrease in our aggregate gross margin across all products was attributable to a net 110 basis point decrease due to pricing and a net 10 basis point decrease due to higher manufacturing costs, partially offset by a net 30 basis point improvement due to product mix. The change in manufacturing costs was primarily due to an increase in the charge for excess and obsolescent inventory of $0.5 million in 2011. Our gross margin for 2011 was within a normal range and consistent with our historical results.

Research and development expense. Our research and development expense increased $7.4 million, or 23.6%, to $38.9 million in 2011, and represented 14.7% of our revenue, compared with $31.5 million, or 12.9% of our revenue, in 2010. The increase in our research and development expense was attributable to a $4.8 million increase in personnel costs, a $1.0 million increase in equipment costs, a $0.8 million increase in depreciation and amortization, a $0.7 million increase in occupancy costs, a $0.7 million increase in travel and a $0.6 million increase in supplies and materials and other costs. The increase in personnel costs was primarily due to the growth of our engineering organization, including the acquisition of Arctic Silicon Devices in January 2011. These increases were partially offset by a $1.2 million increase in funding earned from various foreign government research and development incentive programs.

Sales and marketing expense. Our sales and marketing expense increased $2.6 million, or 13.5%, to $22.0 million in 2011, and represented 8.3% of our revenue, compared with $19.4 million, or 8.0% of our revenue, in 2010. The increase in our sales and marketing expense was primarily attributable to a $1.6 million increase in personnel costs, a $0.4 million increase in travel costs, a $0.4 million increase in professional fees and a $0.2 million increase in occupancy costs and other costs. The increase in personnel costs related primarily to the growth of our worldwide direct sales and marketing organization.

General and administrative expense. Our general and administrative expense increased $0.5 million, or 4.4%, to $12.1 million in 2011, and represented 4.6% of our revenue, compared with $11.6 million, or 4.7% of our revenue, in 2010.

The increase in our general and administrative expense was primarily attributable to a $0.7 million increase in personnel costs and a $0.3 million increase in occupancy costs, partially offset by a $0.5 million decrease in professional fees and other costs.

Interest income. In 2011, our interest income was $0.2 million compared with $0.1 million in the corresponding period of 2010. Interest income in both periods reflects the low effective yields that are available due to the current market conditions.

Other income (expense), net. In 2011, our other income, net was $0.4 million compared with other expense, net of $0.1 million in the corresponding period of 2010. The change was primarily due to net foreign currency gains reflecting the appreciation of the U.S. dollar relative to most of the currencies of the countries where we operate.

Provision for income taxes. Our provision for income taxes decreased $5.2 million to $37.1 million in 2011, from $42.2 million in 2010, representing an effective tax rate of 30.4% and 35.4% in 2011 and 2010, respectively. The effective tax rate decreased primarily due to a $3.7 million benefit related to the resolution of the U.S. Internal Revenue Service's examination of our fiscal 2005 through 2007 income tax returns and the related decrease in reserves for uncertain tax positions. The effective tax rates differ from the federal and state statutory tax rates primarily due to the impact of the resolution of the U.S. tax examination and federal and state tax credits and incentives provided for under the American Jobs Creation Act of 2004, offset by the impact of non-deductible stock-based compensation.

54 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources As of December 31, 2012, we held $269.2 million of cash and cash equivalents. Cash provided by our operations was $68.1 million in 2012, of which the principal components were our net income of $68.6 million and non-cash charges of $28.0 million, partially offset by a net increase in operating assets and liabilities of $24.1 million and a net increase in deferred taxes of $4.5 million. The increase in net operating assets and liabilities includes an increase in inventory of $29.8 million primarily related to the advance purchases of wafers from a foundry we are transitioning from, a $2.7 million net decrease in income taxes payable, due to the timing of tax payments and receipts and a $0.5 million increase in other assets, partially offset by a $4.7 million decrease in accounts receivable, related to the timing of customer shipments and collections, a $2.2 million increase in deferred revenue and customer advances, due to product shipments under contracts with advanced billings and a $2.1 million increase in accounts payable and accrued expenses, due to the timing of disbursements.

We invested $11.9 million in the purchase of property and equipment in 2012, primarily related to building renovations, production tooling and production test equipment. We purchased $170.1 million of marketable securities in 2012, comprised of United States government treasury notes and bills, while maturities of marketable securities amounted to $30.0 million.

During 2012, shares issued upon vesting of restricted stock were net of 42,970 shares retained by us to cover employee tax withholdings of $2.6 million paid by us. In addition, we received $0.4 million from the exercise of stock options and $1.2 million from the excess tax benefit related to our stock-based compensation plans.

We maintain a stock repurchase program that is intended to offset the dilutive impact of equity-based compensation granted to our employees. Shares may be repurchased from time to time on the open market or in privately negotiated transactions. We did not repurchase any shares during 2012. The timing, price and volume of any additional repurchases will be based on market conditions, relevant securities law and other factors, as appropriate, and repurchases may be suspended or discontinued at any time.

We believe that our cash, cash equivalents and cash generated from operations will be sufficient to meet our anticipated cash requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending to support product development efforts, the expansion of our sales and marketing activities, the timing and introduction of new products, the costs to ensure access to adequate manufacturing capacity and the continuing market acceptance of our products. There is no assurance that additional financing, if required or desired, will be available in amounts or on terms acceptable to us, if at all.

Backlog We typically do not enter into long-term purchase contracts with our customers, and our revenue in any period is dependent to a significant extent on orders for standard products booked and shipped in that period. Our customers' requested delivery lead times in general have become shorter. Additionally, despite the existence of contractual penalties, our customers from time to time cancel or delay scheduled purchases. As a result, we use backlog as a key element of scheduling production but do not consider it to be an accurate indicator of sales for any future period. Generally, we include in our backlog all accepted purchase orders for which the customer has specified a delivery date within the next 12 months, as well as long-term production contracts that require longer than 12 months to perform and for which funding is committed. At December 31, 2012, our backlog was $67.2 million, compared to $67.4 million at December 31, 2011.

55 -------------------------------------------------------------------------------- Table of Contents Recent Accounting Pronouncements In June 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-05, "Presentation of Comprehensive Income." ASU 2011-05 requires an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income, or in two separate but consecutive statements. ASU 2011-05 eliminates the option to present components of other comprehensive income as part of the statement of equity. We adopted ASU 2011-05 effective January 1, 2012. Such adoption did not have a material effect on our financial position or results of operations.

In February 2013, the FASB issued ASU 2013-02, "Reporting Amounts Reclassified Out of Accumulated Other Comprehensive Income." ASU 2013-02 requires an entity to disclose amounts reclassified out of other comprehensive income by component. In addition, an entity will be required to present, either on the face of financial statements or in a single note, significant amounts reclassified out of accumulated other comprehensive income and the income statement line item affected by the reclassification. ASU 2013-02 will be effective for us on January 1, 2013. We do not believe that the adoption of ASU 2013-02 will have a material effect on our financial condition or results of operations.

Contractual Obligations At December 31, 2012, our known contractual obligations were as follows: Payments Due by Period Less than 1-3 3-5 More than Contractual Obligations Total 1 Year Years Years 5 Years (In thousands) Operating leases $ 2,772 $ 1,245 $ 1,511 $ 16 $ - As of December 31, 2012, the total amount of net unrecognized tax benefits for uncertain tax positions and the accrual for the related interest was $1.1 million. Although it is reasonably possible that the unrecognized tax benefits for tax positions taken on previously filed tax returns could materially change in the next 12 months, we are unable to make a reasonably reliable estimate as to when cash settlement of these unrecognized tax benefits, if any, will occur with a tax authority, as the timing of examinations and ultimate resolution of those examinations is uncertain.

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